The Nature and Creation of Money

Read these sections, "What is Money?" and "The Banking System and Money Creation", to examine money and its impact on real GDP and the price level.  Specifically, learn about what money is and its three functions. Distinguish between the M1 and M2 definitions of money. Also, learn about the money creation process and role of banks in it in a fractional reserve banking system. You will revisit certain sections of the chapter later in this unit.

Start Up: How Many Macks Does It Cost?

Larry Levine helped a client prepare divorce papers a few years ago. He was paid in mackerel.

"It's the coin of the realm," his client, Mark Bailey told the Wall Street Journal. The two men were prisoners at the time at the federal penitentiary at Lompoc, California.

By the time his work on the case was completed, he had accumulated "a stack of macks," Mr. Levine said. He used his fishy hoard to buy items such as haircuts at the prison barber shop, to have his laundry pressed, or to have his cell cleaned.

The somewhat unpleasant fish emerged as the currency of choice in many federal prisons in 1994 when cigarettes, the previous commodity used as currency, were banned. Plastic bags of mackerel sold for about $1 in prison commissaries. Almost no one likes them, so the prison money supply did not get eaten. Prisoners knew other prisoners would readily accept macks, so they were accepted in exchange for goods and services. Their $1 price made them convenient as a unit of account. And, as Mr. Levine's experience suggests, they acted as a store of value. As we shall see, macks served all three functions of money - they were a medium of exchange, a unit of account, and a store of value.

In this chapter and the next we examine money and the way it affects the level of real GDP and the price level. In this chapter, we will focus on the nature of money and the process through which it is created.

As the experience of the prisoners in Lompoc suggests, virtually anything can serve as money. Historically, salt, horses, tobacco, cigarettes, gold, and silver have all served as money. We shall examine the characteristics that define a good as money.

We will also introduce the largest financial institution in the world, the Federal Reserve System of the United States. The Fed, as it is commonly called, plays a key role in determining the quantity of money in the United States. We will see how the Fed operates and how it attempts to control the supply of money.

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