Read this chapter for a brief overview of money, including its definitions and functions.
This chapter explains the definitions and functions of money, analyzes the demand and supply of money, and outlines the importance of monetary policy, and the structure and function of the Federal Reserve system.
Money describes the assets people accept for transactions. Communities have used different items for money throughout history, including stones, salt, cattle or shells. They have used metals extensively and gold in particular. Venetian merchants first used a paper form of money in the Middle Ages.
|While salt is not the official currency of any nation, some communities use it for monetary transactions. Sellers accept salt in exchange for their commodities because they know they will be able to use it to acquire other things. Salt is convenient because it is easily divisible and does not deteriorate.|
Functions of Money
Money is a medium of exchange. People use money as a standard to express value, through the prices they give certain goods or services. Money also serves as a storage facility for value and for future consumption. Money should be easily divisible and durable.
|If a monetary system is not available, people will revert to barter system, so they can exchange items of value to get what they need. A farmer may exchange an extra cow for a horse, two sheep, or a ton of eggs. Participants must match their needs: the person who has a cow may might some eggs. But the farmer may want a pound, rather than a ton, of eggs. These transactions are difficult when they lack an asset to exchange.|
Demand for Money
Demand for money stems from our need to exchange goods and services. We demand monetary assets for precautionary and speculative reasons. Transactional demand for money is not interest rate sensitive: we are buying or selling an item and not concerned about earning any interest. The asset demand for money is inversely related to the interest rate because money does not earn a return and loses purchasing power with inflation: we hold onto a smaller quantity of money when the interest rate is low. Demand for money is shown graphically as a downsloping curve.
|While we hold onto money so we can buy something, we often save some money in case we need to buy something in the future. This need may arise due to an unexpected accident or unforeseen bargain opportunity. Both of these transactions require the ability to make immediate payment. When we leave the house we should carry some cash in case of an emergency.|
Different definitions for money supply exist because we use various forms of money to make payments. The monetary authorities in the United States recognize four different types of money: M1, M2, M3 and L (liquidity). Economists depict the supply of money graphically as a vertical line because it is determined by forces exogenous to the money market. These forces include policy tools of monetary policy.
|Any asset that allows someone to make a payment qualifies as a form of money, and is, thus, part of money supply. Careful analysis reveals that many different assets qualify as money, and differ only in the time it takes to complete the desired payment: we describe this as their liquidity.|
Coins and bank notes are currency. Currency represents a small portion of money supply, compared to checks and other means of payment. Currency is a liability of the Federal Reserve Bank because the token value it represents (see below).
|We use currency to make small payments, such as to buy groceries, gasoline, and newspapers. We use credit cards and checks to complete large payments. It would be unsafe and time consuming to buy furniture, appliances or an automobile with bank notes.|
M1 refers to currency (paper notes and coins) and checkable deposits. M1 is the most restrictive definition of money supply.
|M1 includes only the most liquid forms of money. Payments with coins and bank notes are completed immediately. While recipients recognize check payments on the day of receipt, they cannot access the amount promised until the check clears the bank, which may take a day or more.|
Currency and coins are token money because their intrinsic value (the value of their paper or metal content) is a small fraction of the value they represent. We call them convenience money because they are necessary for small purchases.
|The metal or paper content of coins and bank notes does not come close to the monetary value they represent. If it did, the coin or bank note would disappear as a form of money. This happened in the 1960's when increases in the price of silver encouraged people to hoard quarters or convert them into jewelry. The U.S. government began minting new quarters that contained trace amounts of silver.|
Checkable or demand deposits represent money deposits in a commercial bank which the owner has the right to withdraw upon demand. Various forms of equivalent arrangement are available at savings banks, credit unions, and securities dealers. These include NOW (negotiable order of withdrawal), SDA (special deposit account), and ATS (automatic transfer service) accounts.
|Most transactions in a modern economy are completed by check writing. Businesses often refer to coins and bank notes as petty cash and is reserved for miscellaneous minor expenses (such as buying a birthday present for an employee).|
M2 includes M1 and various forms of small time deposits. These deposits include savings accounts and certificates of deposits. Withdrawal or redemption of these deposits often leads to some penalty in lost interest.
|Holding money in a checking account earns little interest if any. Checking accounts for most people should only include enough to pay for daily needs. It is often convenient to place these funds in a savings account or certificate of deposit where savers earn some interest and can redeem their money on short notice within a few hours: the time it takes to get to the bank.|
M3 includes M2 plus large time deposits (those larger than $100,000). A broader definition of money supply is L, which includes government securities.
|Beyond the savings accounts and certificates of deposits, a variety of financial instruments are available. These options often pay a higher interest rate or rate return, but may take longer to redeem.|
Near money refers to all forms of money, other than M1. Although near money is readily available, we must convert it into checkable deposits before we can use it. Credit cards are not considered money because their use is assumed to be conditional, as a loan from the issuer. We do not consider bank reserves when we tabulate the money supply because we already take it into account when we calculate savings: we do not want to double count these amounts.
|When interest rates were high in the 1980's, financial institutions created several new financial instruments. Mutual funds offered money market accounts with a rate of return that was much higher than normal bank certificates of deposit. Recent decreases in inflation and interest rates removed some of the appeal of money market. However, they usually offer a more profitable alternative to holding money in a checking account.|
Backing of Money
Policy makers abandoned the gold standard in the 1930s, which tied currencies to a specific amount of gold, because they deemed the supply of gold too unstable. A pronouncement of legal tender does not assure people will accept the currency as legitimate. The acceptance of money rests in the mutual trust people have that the value of their money will be maintained or preserved. Preserving monetary value depends entirely on its relative scarcity and the control of money supply via monetary policy.
|The value of money does not come from the weight of a precious metal, but from the amount of goods or services the currency can buy: the purchasing power of money. For example, the French government had to replace the livre with the franc in the late 18th century, because the French people did not consider the livre as a legitimate form of currency, despite spite the many official pronouncements from the French government.|