Chapter 3
What is Money?
Money and Banking
Deokwoo Nam
Department of Economics and Finance Hanyang University
1. INTRODUCTION
1 Introduction
Money have taken di¤erent forms at di¤erent times, but it has "always" been important to people and to the economy.
– Before the Civil War, the principal forms of money in the United States were gold and silver coins and paper notes issued by private banks (called banknotes).
– Today, you use not only coins and dollar bills issued by the government as money, but also checks written on accounts held at banks.
To understand the e¤ects of money on the economy, we must understand exactly what money is. In this chapter, we develop precise de…nitions by doing the following:
1. exploring the functions of money,
2. looking at why and how it promotes economic e¢ ciency, and 3. examining how money is currently measured.
2. MEANING OF MONEY
2 Meaning of Money
Economists de…ne money (also referred to as the money supply ) as anything that is generally accepted in payment for goods or services or in the repayment of debts.
– Currency, consisting of dollar bills and coins, clearly …ts this de…nition and is one type of money.
– To de…ne money merely as currency is too much narrow for economists.
Because checks are also accepted as payment for purchases, checking account deposits are considered money as well.
Other items such as savings deposits can function as money if they can be quickly and easily converted into currency or checking account deposits.
– As we can see, no single, precise de…nition of money or the money supply is possible, even for economists.
3. FUNCTIONS OF MONEY
3 Functions of Money
Money has three primary functions in any economy: as a medium of exchange, as a unit of account, and as a store of value.
– Of the three functions, its function as a medium of exchange is what distinguish money from other assets such as stocks, bonds, and houses.
3.1 Medium of Exchange
In almost all market transactions in our economy, money in the form of currency or checks is a medium of exchange.
– It is used to pay for goods and service.
The use of money as a medium of exchange promotes economic e¢ ciency by minimizing "the time spent in exchanging goods and services" (called a transaction cost).
– Let’s think about a barter economy, one without money, in which goods and services are exchanged directly for other goods and services.
In a barter economy, transaction costs are high because people have to satisfy a "double coincidence of wants"— they have to …nd someone who has a good or service they want and who also wants the good or service they have to o¤er.
When money is introduced, however, the problem of the double coincidence of wants is avoided, and people save a lot of time, which they may spend doing what they do best.
Therefore, money promotes economic e¢ ciency (1) by eliminating much of the time spent exchanging goods and services and (2) allowing people to specialize in what they do best.
3. FUNCTIONS OF MONEY
3.2 Unit of Account
The second role of money is to provide a unit of account.
– It is used to measure value in the economy.
When we introduce money into the economy, we can quote the prices of all di¤erent goods and services in terms of units of that money, say, dollars.
– As a result, using money as a unit of account lowers transaction costs in an economy by reducing the number of prices that need to be considered.
– The bene…ts of this function of money grow as the economy becomes more complex (i.e., the number of goods/services (their prices) becomes enormously large).
3.3 Store of Value
Money also functions as a store of value.
– It is a repository of purchasing power over time. In other words, a store of value is used to save purchasing power from the time income is received until the time it spent.
This function is useful, because most of us do not want to spend our income immediately upon receiving it, but rather prefer to wait until we have the time or the desire to shop.
However, money is not unique as a store of value: any asset (whether money, stocks, bonds, land, houses, art, or jewelry) can be used to store wealth.
– Of all such assets, money is the most desirable in terms of "liquidity," the relative ease and speed with which an asset can be converted into a medium of exchange. This is because money is the medium of exchange.
4. MEASURING OF MONEY
4 Measuring of Money
The de…nition of money as anything that is generally accepted in payment for goods and services tells us that money is de…ned by people’s behavior.
– To measure money in practice, we need a "precise" de…nition that tells us exactly which assets should be included.
The Federal Reserve’s Monetary Aggregates
– The Federal Reserve System, the central banking authority responsible for monetary policy in the U.S., has established the following "measures of the money supply", which is also referred to as monetary aggregates.
– Here are two measures of monetary aggregates, M1 and M2:
4. MEASURING OF MONEY
1. M1
It is the narrowest measure of money that the Fed reports, and includes the most liquid assets: cur- rency, checking account deposits (demand deposits and other checkable deposits), and traveler’s checks:
M1 = Currency+Demand deposits+Other checkable deposits
| {z }
=Checking account deposits
+Traveler’s checks
(a) Currency:
– It includes only paper money and coins in the hands of the nonbank public, and does not include cash held in ATMs or bank vaults.
(b) Demand deposits:
– They include business checking accounts that do not pay interest, as well as traveler’s checks issued by banks.
(c) Other checkable deposits:
– They includes all other checkable deposits, particularly interest-bearing checking accounts held by households.
(d) Traveler’s checks:
– They include only traveler’s checks not issued by banks.
These assets are clearly money because they can be used directly as a medium of exchange.
4. MEASURING OF MONEY
2. M2
It adds to M1 other assets that are not quite as liquid as those included in M1: assets that have check- writing features (money market deposit accounts and money market mutual fund shares) and other assets (savings deposits and small-denomination time deposits) that can be turned into cash quickly at very little cost:
M2 = M1
+Small-denomination time deposits
+Savings deposits and money market deposit accounts +Money market mutual fund shares (retail)
(a) Small-denomination time deposits:
– They are certi…cates of deposit with a denomination of less than $100; 000 that can be redeemed only at a …xed maturity date without a penalty.
(b) Savings deposits and money market deposit accounts:
– Saving deposits are nontransaction deposits that can be added to or taken out at any time.
– Money market deposit accounts are similar to money market mutual funds, but are issued by banks.
(c) Money market mutual fund shares (retail):
– They are retail accounts on which households can write checks.
4. MEASURING OF MONEY
Figure 1 plots the growth rates of M1 and M2 aggregates from 1960 to 2011.
1. The growth rates of these two monetary aggregates do tend to move together.
– The timing of their rise and fall is roughly similar until the 1990s, and they both show a higher growth rate, on average, in the 1970s than in the 1960s.
2. However, some glaring discrepancies exists in the movements of these two aggregates.
– There are periods such as 1992-1994 and 2004-2007, when they move in opposite directions, providing con‡icting recommendations about the course of monetary policy, because what one monetary aggre- gate tells us is happening to the money supply might be quite di¤erent from what another monetary aggregate would tell us.
Therefore, obtaining a single precise, correct measure of money does seem to matter and it does make a di¤erence which monetary aggregate policymakers and economists choose as the true measure of
