Like the human race, the current fi nancial system has evolved from a primitive state and will continue to evolve in the future. This tendency to change has been infl uenced signifi cantly by the technology used to execute transactions. The payments mecha-nism is the means by which transactions are completed— that is, how money is trans-ferred among transactors.
If someone now asked you what makes up the U.S. money supply, we hope you would answer “currency held by the public and checkable deposits, the primary compo-nents of M1.” Checkable deposits are payable on demand to third parties. For example, if you write a check to your grocer, the fi rst two parties are you and the depository institution; the grocer is the third party. The check in payment for goods purchased is an order for your bank to debit (subtract) a certain number of dollars from your check-able deposit account. The dollars are then credited (added) to the deposit account of the grocer, the third party. Thus, a checkable deposit is a means of payment, and the check is the method used to transfer own ership of the deposit between parties to a transaction. The point is that the check itself is not money; if it were, printing presses would work around the clock! The balances in checkable deposits are money.
Over the years, computer and telecommunications technologies have greatly al-tered the way in which payments are made. Technological innovations are making checks much less important, and perhaps soon obsolete as a means of transferring pur-chasing power. Today, we are making an increasingly larger percentage of payments through an electronic funds transfer system. In this system, payments are made to third parties in response to electronic instructions rather than instructions written on a paper check. Note that an electronic funds transfer system does not eliminate the need for deposit accounts; it is just a more effi cient way of transferring funds from one de-posit account to another. To pay your grocery bill, for instance, your account is debited by the amount of your bill, and the grocer’s account is credited by the same amount at the time of the exchange. The whole system is computerized so that no written checks are necessary. All you need is an account number and a debit card that you present to the grocer. The grocer, in turn, enters the prices of your purchases into a computer ter-minal (called a point- of- sale terter-minal), and at the end of the month, you receive a statement giving your current balance and a record of all the charges and deposits to your account. This is just like a checking account statement, but without the checks.
Other forms of electronic funds transfer systems are stored- value cards and smart cards. Stored- value cards are plastic cards that have a certain amount of funds embedded on a magnetic strip. The own er of the stored- value card has paid to have the funds transferred to the card. Stored- value cards look like credit cards and are swiped through a card reader when the own er wants to access the funds. As the funds are spent, the balance on the card is transferred electronically from the card to the card reader. Gift cards from your favorite store are an example of stored value cards.
Stored- value cards are pop u lar on college campuses to pay for such things are photo-copying in the library, meals in the dining hall, and parking fees. They are also used to prepay for toll roads and generally have a single use.
Payments Mechanism The means by which transactions are consum-mated; that is, how money is transferred in an exchange.
Electronic Funds Transfer System
The transfer of funds to third parties in response to from a deposit account to the account of a third party.
Stored- Value Cards Plastic cards that have a magnetic strip that is swiped through a card reader to make payments; usually single use.
A Closer Look
Smart cards are much more sophisticated than stored- value cards in that they have a micropro cessor chip embedded in them that stores information and usually includes a “digital signature.” The stored information leads to greater security for someone who accepts a smart card for a payment because the digital signature is verifi ed. Each time the card is used, the amount of the payment is deducted electroni-cally from the card and credited to the recipient of the payment by a point- of- sale terminal that is equipped to do so. At some point, the recipient transfers smart card payments from the point- of- sale terminal to its bank. If transferred immediately, the payment is completed in a matter of seconds. The micropro cessor checks the authen-ticity of the transaction by examining the digital signature that is embedded in the chip. Although the validity is authenticated, the transaction is kept anonymous as if cash were used. Some smart cards are issued by and accepted by a single institution only. Other smart cards are accepted by multiple institutions and multiple retailers.
Although they have not caught on to a large extent in the United States, smart cards offer the possibility of replacing cash and checks to make most payments because they may be more con ve nient and cheaper to use.
Currently, many employers, in cooperation with banks, pay salaries by automati-cally crediting their employees’ bank accounts rather than by issuing the customary check. Such automatic credits, referred to as direct deposits, are also a form of an electronic funds transfer system.
One of the best known and most pop u lar forms of electronic transfer of funds is the automated teller machine (ATM). Your depository institution most likely has ATMs, which permit you to make deposits and withdrawals, even late at night when the institution itself is closed. In all probability, your college has several ATMs on cam-pus. ATMs are also visible in grocery and con ve nience stores, at car washes, and at shopping malls. Recently, portable ATMs in vans have been established that can be moved to sporting event locations, concerts, and so on. As you may have guessed, the vans housing the ATMs have multiple security features that prevent theft. As the own ership of personal computers and modems has spread, it has become possible to conduct a large portion of one’s fi nancial transactions from home.
In conclusion, electronic funds transfer systems are nothing more than the ap-plication of computer and telecommunications technology to the entire area of fi nan-cial transactions and ser vices. The aim is to reduce the physical handling and labor costs associated with an ever- expanding volume of paper checks, deposit slips, and the like, as well as to provide increased con ve nience and ser vice to the public. Transferring funds and making payments electronically is generally much cheaper than writing checks or using other paper instructions to transfer funds. The application of computer and telecommunications technologies thus greatly reduces the costs of making pay-ments and improves the effi ciency of the paypay-ments system. As questions regarding the privacy of fi nancial rec ords, security of the systems, and legal responsibilities are being resolved, new payments practices and electronic funds transfer systems are spreading rapidly. One thing is certain: In the future, more payments will be made electronically because they are cheaper and, in most cases, more con ve nient. The result will be fur-ther evolution in how money is used and, perhaps, changes in what functions as money.
From barter to gold and silver coins to checkable deposits to electronic money, the evolution of money and the payments mechanism goes hand in hand with the develop-ment of an economy and computer and telecommunications technologies.
Smart Cards Plastic cards with a micropro cessor chip that are used to make payments; the chip stores information that allows the payment to be validated.
Automated Teller Machine (ATM) A machine that permits a depositor to make deposits and withdrawals to an account even when the fi nancial institution is closed.
was to nudge the economy in the desired direction so that the objectives the Fed had set for the economy would be achieved.
During the late 1980s, M2 gained importance and prominence in the execution of monetary policy by the Fed. Throughout this period, the relationship between changes in M2 and economic activity seemed more stable than that between changes in M1 and economic activity. Consequently, the Fed watched the growth rate of M2 for signals about how well the economy was doing and deemphasized the role of M1. But in the early 1990s, the stable relationship between changes in M2 and changes in economic activity also seemed to break down. The growth rate of M2 moved in erratic and unpre-dictable ways. As a result, the Fed deemphasized the use of M2 as a policy indicator.
Beginning in the early 1990s, the Fed increasingly used changes in the growth rate of DNFD as an indicator of the direction of the economy. Changes in DNFD seemed, at least at that time, to have a stable relationship with changes in economic ac-tivity. If credit growth was increasing, then spending was likely to be going up. If credit extension was slowing, then the growth rate of economic activity was also likely to be slowing. By the late 1990s and continuing into the late 2000s, the Fed was using many other economic variables as barometers of economic conditions in addition to the mon-etary aggregates and DNFD. The monmon-etary aggregates and DNFD were increasingly deemphasized in formulating policy and now are used primarily as informational vari-ables along with many other indicators.
For our purposes, then, it is probably best to think of M1 as a mea sure of transac-tions money and M2 as a broader mea sure of money that, at times, has been closely re-lated to economic activity. Likewise, DNFD, although not a monetary aggregate, is a broad credit aggregate that has also been closely related to economic activity and monitored by the Fed.
The Fed keeps track of two mea sures of money: M1 (transactions money) is currency in the hands of the public plus checkable deposits; M2 includes everything in M1 plus other highly liquid assets (near monies). In addition to M1 and M2, the Fed monitors DNFD, a broad mea-sure of credit. DNFD includes public and private debt but excludes the debt of fi nancial insti-tutions to avoid double counting. Sometimes a given aggregate has been more highly correlated with the level of economic activity than at other times. Since the late 1990s, the monetary aggregates and DNFD have been deemphasized in monetary policy formulation.
Recap
2-4
M1, M2, and DNFD Over Time
0 5000 10000 15000 20000 25000 30000 35000
1965Q1 1967Q3 1970Q1 1972Q3 1975Q1 1977Q3 1980Q1 1982Q3 1985Q1 1987Q3 1990Q1 1992Q3 1995Q1 1997Q3 2000Q1 2002Q3 2005Q1 2007Q3
M1 M2 DNFD