Essay: The Functions of Money

Just what is money? There is an old saying that ”’money is what money does .”’ In a general sense, anything that performs the functions of money is money. Here are those functions: ”’ Medium of exchange First and foremost, money is a medium of exchange that is usable for buying and selling goods and services. A bakery worker does not want to be paid 200 bagels per week. Nor does the bakery owner want to receive, say, halibut in exchange for bagels. Money, however, is readily acceptable as payment. As we saw in Chapter 2, money is a social invention with which resource suppliers and producers can be paid and that can be used to buy any of the full range of items available in the marketplace. As a medium of exchange, money allows society to escape the complications of barter. And because it provides a convenient way of exchanging goods, money enables society to gain the advantages of geographic and human specialization. ”’ Unit of account Money is also a unit of account . Society uses monetary units”’dollars, in the United States”’as a yardstick for measuring the relative worth of a wide variety of goods, services, and resources. Just as we measure distance in miles or kilometers, we gauge the value of goods in dollars. With money as an acceptable unit of account, the price of each item need be stated only in terms of the monetary unit. We need not state the price of cows in terms of corn, crayons, and cranberries. Money aids rational decision making by enabling buyers and sellers to easily compare the prices of various goods, services, and resources. It also permits us to define debt obligations, determine taxes owed, and calculate the nation”’s GDP. ”’ Store of value Money also serves as a store of value that enables people to transfer purchasing power from the present to the future. People normally do not spend all their incomes on the day they receive them. To buy things later, they store some of their wealth as money. The money you place in a safe or a checking account will still be available to you a few weeks or months from now. When inflation is nonexistent or mild, holding money is a relatively riskfree way to store your wealth for later use.
People can, of course, choose to hold some or all of their wealth in a wide variety of assets besides money. These include real estate, stocks, bonds, precious metals such as gold, and even collectible items like fine art or comic books. But a key advantage that money has over all other assets is that it has the most liquidity , or spendability. An asset”’s liquidity is the ease with which it can be converted quickly into the most widely accepted and easily spent form of money, cash, with little or no loss of purchasing power. The more liquid an asset is, the more quickly it can be converted into cash and used for either purchases of goods and services or purchases of other assets. Levels of liquidity vary radically. By definition, cash is perfectly liquid. By contrast, a house is highly illiquid for two reasons. First, it may take several months before a willing buyer can be found and a sale negotiated so that its value can be converted into cash. Second, there is a loss of purchasing power when the house is sold because numerous fees have to be paid to real estate agents and other individuals to complete the sale. As we are about to discuss, our economy uses several different types of money including cash, coins, checking account deposits, savings account deposits, and even more exotic things like deposits in money market mutual funds. As we describe the various forms of money in detail, take the time to compare their relative levels of liquidity”’both with each other and as compared to other assets like stocks, bonds, and real estate. Cash is perfectly liquid. Other forms of money are highly liquid, but less liquid than cash. The Components of the Money Supply Money is a ”’stock”’ of some item or group of items (unlike income, for example, which is a ”’flow”’). Societies have used many items as money, including whales”’ teeth, circular stones, elephant-tail bristles, gold coins, furs, and pieces of paper. Anything that is widely accepted as a medium of exchange can serve as money. In the United States, currency is not the only form of money. As you will see, certain debts of government and financial institutions also are used as money.
Money Definition M 1 The narrowest definition of the U.S. money supply is called M 1 . It consists of two components: ”’ Currency (coins and paper money) in the hands of the public. ”’ All checkable deposits (all deposits in commercial banks and ”’thrift”’ or savings institutions on which checks of any size can be drawn). 2 Government and government agencies supply coins and paper money. Commercial banks (”’banks”’) and savings institutions (”’thrifts”’) provide checkable deposits. Figure 31.1a shows that M1 is about equally divided between the two components. C urrency: Coins 1 Paper Money The currency of the United States consists of metal coins and paper money. The coins are issued by the U.S. Treasury while the paper money consists of Federal Reserve Notes issued by the
Federal Reserve System (the U.S. central bank). The coins are minted by the U.S. Mint while the paper money is printed by the Bureau of Engraving and Printing. Both the U.S. Mint and the Bureau of Engraving and Printing are part of the U.S. Department of the Treasury. As with the currencies of other countries, the currency of the United States is token money . This means that the face value of any piece of currency is unrelated to its intrinsic value ”’the value of the physical material (metal or paper and ink) out of which that piece of currency is constructed. Governments make sure that face values exceed intrinsic values to discourage people from destroying coins and bills to resell the material that they are made out of. For instance, if 50-cent pieces each contained 75 cents”’ worth of metal, then it would be profitable to melt them down and sell the metal. Fifty-cent pieces would disappear from circulation very quickly! Figure 31.1a shows that currency (coins and paper money) constitutes 51 percent of the M 1 money supply in the United States. C heckable Deposits The safety and convenience of checks has made checkable deposits a large component of the M 1 money supply. You would not think of stuffing $4896 in bills in an envelope and dropping it in a mailboxto pay a debt. But writing and mailing a check for a large sum is commonplace. The person cashing a check must endorse it (sign it on the reverse side); the writer of the check subsequently receives a record of the cashed check as a receipt attesting to the fulfillment of the obligation. Similarly, because the writing of a check requires endorsement, the theft or loss of your checkbook is not nearly as calamitous as losing an identical amount of currency. Finally, it is more convenient to write a check than to transport and count out a large sum of currency. For all these reasons, checkable deposits (checkbook money) are a large component of the stock of money in the United States. About 49 percent of M 1 is in the form of checkable deposits, on which checks can be drawn. It might seem strange that checking account balances are regarded as part of the money supply. But the reason is clear: Checks are nothing more than a way to transfer the ownership of deposits in banks and other financial institutions and are generally acceptable as a medium of exchange. Although checks are less generally accepted than currency for small purchases, for major purchases most sellers willingly accept checks as payment. Moreover, people can convert checkable deposits into paper money and coins on demand; checks drawn on those deposits are thus the equivalent of currency. To summarize: Money, M 1 5 currency 1 checkable deposits
I nstitutions That Offer Checkable Deposits In the United States, a variety of financial institutions allow customers to write checks in any amount on the funds they have deposited. Commercial banks are the primary depository institutions. They accept the deposits of households and businesses, keep the money safe until it is demanded via checks, and in the meantime use it to make available a wide variety of loans. Commercial bank loans provide short-term financial capital to businesses, and they finance consumer purchases of automobiles and other durable goods. Savings and loan associations (S&Ls), mutual savings banks, and credit unions supplement the commercial banks and are known collectively as savings or thrift institutions , or simply ”’thrifts.”’ Savings and loan associations and mutual savings banks accept the deposits of households and businesses and then use the funds to finance housing mortgages and to provide other loans. Credit unions accept deposits from and lend to ”’members,”’ who usually are a group of people who work for the same company. The checkable deposits of banks and thrifts are known variously as demand deposits, NOW (negotiable order ofwithdrawal) accounts, ATS (automatic transfer service) accounts, and share draft accounts. Their commonality is that depositors can write checks on them whenever, and in whatever amount, they choose. T wo Qualifications We must qualify our discussion in two important ways. First, currency held by the U.S. treasury, the Federal Reserve banks, commercial banks, and thrift institutions is excluded from M 1 and other measures of the money supply. A paper dollar or four quarters in the billfold of, say, Emma Buck obviously constitutes just $1 of the money supply. But if we counted currency held by banks as part of the money supply, the same $1 would count for $2 of money supply when Emma deposited the currency into her checkable deposit in her bank. It would count for $1 of checkable deposit owned by Buck and also $1 of currency in the bank”’s cash drawer or vault. By excluding currency held by banks when determining the total supply of money, we avoid this problem of double counting. Also excluded from the money supply are any checkable deposits of the government (specifically, the U.S. Treasury) or the Federal Reserve that are held by commercial banks or thrift institutions. This exclusion is designed to enable a better assessment of the amount of money available to the private sector for potential spending. The amount of money available to households and businesses is of keen interest to the Federal Reserve in conducting its monetary policy (a topic we cover in detail in Chapter 33).
Money Definition M 2 A second and broader definition of money includes M 1 plus several near-monies. Near-monies are certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into currency or checkable deposits. The M2 definition of money includes three categories of near-monies. ”’ Savings deposits, including money market deposit accounts A depositor can easily withdraw funds from a savings account at a bank or thrift or simply request that the funds be transferred from a savings account to a checkable account. A person can also withdraw funds from a money market deposit account (MMDA) , which is an interest-bearing account containing a variety of interest-bearing short-term securities. MMDAs, however, have a minimum-balance requirement and a limit on how often a person can withdraw funds. ”’ Small-denominated (less than $100,000) time deposits Funds from time deposits become availableat their maturity. For example, a person can convert a 6-month time deposit (”’certificate of deposit,”’ or ”’CD”’) to currency without penalty 6 months or more after it has been deposited. In return for this withdrawal limitation, the financial institution pays a higher interest rate on such deposits than it does on its MMDAs. Also, a person can ”’cash in”’ a CD at any time but must pay a severe penalty. ”’ Money market mutual funds held by individuals By making a telephone call, using the Internet, or writing a check for $500 or more, a depositor can redeem shares in a money market mutual fund (MMMF) offered by a mutual fund company. Such companies use the combined funds of individual shareholders to buy interest-bearing short-term credit instruments such as certificates of deposit and U.S. government securities. Then they can offer interest on the MMMF accounts of the shareholders (depositors) who jointly own those financial assets. The MMMFs in M 2 include only the MMMF accounts held by individuals; those held by businesses and other institutions are excluded. All three categories of near-monies imply substantial liquidity. Thus, in equation form,
Money, M 2 5
M 1 1 savings deposits, including MMDAs 1 small-denominated (less than $100,000) time deposits 1 MMMFs held by individuals In summary, M 2 includes the immediate medium-ofexchange items (currency and checkable deposits) that constitute M 1 plus certain near-monies that can be easily converted into currency and checkable deposits. In Figure 31.1b we see that the addition of all these items yields an M 2 money supply that is about five times larger than the narrower M 1 money supply.
What ”’Backs”’ the Money Supply? The money supply in the United States essentially is ”’backed”’ (guaranteed) by government”’s ability to keep the value of money relatively stable. Nothing more! Money as Debt The major components of the money supply”’paper money and checkable deposits”’are debts, or promises to pay. In the United States, paper money is the circulating debt of the Federal Reserve Banks. Checkable deposits are the debts of commercial banks and thrift institutions.
Paper currency and checkable deposits have no intrinsic value. A $5 bill is just an inscribed piece of paper. A checkable deposit is merely a bookkeeping entry. And coins, we know, have less intrinsic value than their face value. Nor will government redeem the paper money you hold for anything tangible, such as gold. To many people, the fact that the government does not back the currency with anything tangible seems implausible and insecure. But the decision not to back the currency with anything tangible was made for a very good reason. If the government backed the currency with something tangible like gold, then the supply of money would vary with how much gold was available. By not backing the currency, the government avoids this constraint and indeed receives a key freedom”’the ability to provide as much or as little money as needed to maintain the value of money and to best suit the economic needs of the country. In effect, by choosing not to back the currency, the government has chosen to give itself the ability to freely ”’manage”’ the nation”’s money supply. Its monetary authorities attempt to provide the amount of money needed for the particular volume of business activity that will promote full employment, price-level stability, and economic growth. Nearly all today”’s economists agree that managing the money supply is more sensible than linking it to gold or to some other commodity whose supply might change arbitrarily and capriciously. For instance, if we used gold to back the money supply so that gold was redeemable for money and vice versa, then a large increase in the nation”’s gold stock as the result of a new gold discovery might increase the money supply too rapidly and thereby trigger rapid inflation. Or a long-lasting decline in gold production might reduce the money supply to the point where recession and unemployment resulted. In short, people cannot convert paper money into a fixed amount of gold or any other precious commodity. Money is exchangeable only for paper money. If you ask the government to redeem $5 of your paper money, it will swap one paper $5 bill for another bearing a different serial number. That is all you can get. Similarly, checkable deposits can be redeemed not for gold but only for paper money, which, as we have just seen, the government will not redeem for anything tangible. Value of Money So why are currency and checkable deposits money, whereas, say, Monopoly (the game) money is not? What gives a $20 bill or a $100 checking account entry its value? The answer to these questions has three parts. A cceptability Currency and checkable deposits are money because people accept them as money. By virtue of long-standing business practice, currency and checkable. deposits perform the basic function of money: They are acceptable as a medium of exchange. We accept paper money in exchange because we are confident it will be exchangeable for real goods, services, and resources when we spend it. L egal Tender Our confidence in the acceptability of paper money is strengthened because government has designated currency as legal tender . Specifically, each bill contains the statement ”’This note is legal tender for all debts, public and private.”’ That means paper money is a valid and legal means of payment of any debt that was contracted in dollars. (But private firms and government are not mandated to accept cash. It is not illegal for them to specify payment in noncash forms such as checks, cashier”’s checks, money orders, or credit cards.) The general acceptance of paper currency in exchange is more important than the government”’s decree that money is legal tender, however. The government has never decreed checks to be legal tender, and yet they serve as such in many of the economy”’s exchanges of goods, services, and resources. But it is true that government agencies”’the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA)”’insure individual deposits of up to $250,000 at commercial banks and thrifts. That fact enhances our willingness to use checkable deposits as a medium of exchange. R elative Scarcity The value of money, like the economic value of anything else, depends on its supply and demand. Money derives its value from its scarcity relative to its utility (its want-satisfying power). The utility of money lies in its capacity to be exchanged for goods and services, now or in the future. The economy”’s demand for money thus depends on the total dollar volume of transactions in any period plus the amount of money individuals and businesses want to hold for future transactions. With a reasonably constant demand for money, the supply of money provided by the monetary authorities will determine the domestic value or ”’purchasing power”’ of the monetary unit (dollar, yen, peso, or whatever). Money and Prices The purchasing power of money is the amount of goods and services a unit of money will buy. When money rapidly loses its purchasing power, it loses its role as money. T he Purchasing Power of the Dollar The amount a dollar will buy varies inversely with the price level; that is, a reciprocal relationship exists between the general price level and the purchasing power of the dollar. When the consumer price index or ”’cost-of-living”’ index goes up, the value of the dollar goes down, and vice versa. Higherrices lower the value of the dollar because more dollars are needed to buy a particular amount of goods, services, or resources. For example, if the price level doubles, the value of the dollar declines by one-half, or 50 percent. Conversely, lower prices increase the purchasing power of the dollar because fewer dollars are needed to obtain a specific quantity of goods and services. If the price level falls by, say, one-half, or 50 percent, the purchasing power of the dollar doubles. In equation form, the relationship looks like this: $ V 5 1y P To find the value of the dollar $ V , divide 1 by the price level P expressed as an index number (in hundredths). If the price level is 1, then the value of the dollar is 1. If the price level rises to, say, 1.20, $ V falls to .833; a 20 percent increase in the price level reduces the value of the dollar by 16.67 percent. Check your understanding of this reciprocal relationship by determining the value of $ V and its percentage rise when P falls by 20 percent from $1 to .80. Inflation and Acceptability In Chapter 26 we noted situations in which a nation”’s currency became worthless and unacceptable in exchange. These instances of runaway inflation, or hyperinflation , happened when the government issued so many pieces of paper currency that the purchasing power of each of those units of money was almost totally undermined. The infamous post”’World War I hyperinflation in Germany is an example. In December 1919 there were about 50 billion marks in circulation. Four years later there were 496,585,345,900 billion marks in circulation! The result? The German mark in 1923 was worth an infinitesimal fraction of its 1919 value. 3 Runaway inflation may significantly depreciate the value of money between the time it is received and the time it is spent. Rapid declines in the value of a currency may cause it to cease being used as a medium of exchange. Businesses and households may refuse to accept paper money in exchange because they do not want to bear the loss in its value that will occur while it is in their possession. (All this despite the fact that the government says that paper currency is legal tender!) Without an acceptable domestic medium of exchange, the economy may simply revert to barter. Alternatively, more stable currencies such as the U.S. dollar or European euro may come into widespread use. At the extreme, a country may adopt a foreign currency as its own official currency as a way to counter hyperinflation.
Similarly, people will use money as a store of value only as long as there is no sizable deterioration in the value of that money because of inflation. And an economy can effectively employ money as a unit of account only when its purchasing power is relatively stable. A monetary yardstick that no longer measures a yard (in terms of purchasing power) does not permit buyers and sellers to establish the terms of trade clearly. When the value of the dollar is declining rapidly, sellers do not know what to charge and buyers do not know what to pay. Stabilizing Money”’s Purchasing Power Rapidly rising price levels (rapid inflation) and the consequent erosion of the purchasing power of money typically result from imprudent economic policies. Since the purchasing power of money and the price level vary inversely, stabilization of the purchasing power of a nation”’s money requires stabilization of the nation”’s price level. Such pricelevel stability (2”’3 percent annual inflation) mainly necessitates intelligent management or regulation of the nation”’s money supply and interest rates (monetary policy) . It also requires appropriate fiscal policy supportive of the efforts of the nation”’s monetary authorities to hold down inflation. In the United States, a combination of legislation, government policy, and social practice inhibits imprudent expansion of the money supply that might jeopardize money”’s purchasing power. The critical role of the U.S. monetary authorities (the Federal Reserve) in maintaining the purchasing power of the dollar is the subject of Chapter 33. For now, simply note that they make available a particular quantity of money, such as M 2 in Figure 31.1 , and can change that amount through their policy tools.

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