Money Defined: A Brief Review
We are so accustomed to using money that we seldom notice the roles it plays in almost all
of our everyday transactions. As with many other modern conveniences, we take money
for granted until something goes wrong with it! In fact, the easiest way to appreciate the
importance of money is to imagine what economic life would be like without it.
In this section we do just that. Our purpose in carrying out this “thought experiment” is
to distinguish money from other assets and to describe the characteristics of money that
lead people to hold it. These characteristics are central to an analysis of the demand for
money.
Money as a Medium of Exchange
The most important function of money is to serve as a medium of exchange, a generally accepted
means of payment. To see why a medium of exchange is necessary, imagine how
time-consuming it would be for people to purchase goods and services in a world where
the only type of trade possible is barter trade—the direct trade of goods or services for
other goods or services. To have her car repaired, for example, your professor would have
to find a mechanic in need of economics lessons!
Money eliminates the enormous search costs connected with a barter system because
money is universally acceptable. It eliminates these search costs by enabling an individual
to sell the goods and services she produces to people other than the producers of the goods
and services she wishes to consume. A complex modern economy would cease functioning
without some standardized and convenient means of payment.
Money as a Unit of Account
Money’s second important role is as a unit of account, that is, as a widely recognized measure
of value. It is in this role that we encountered money in Chapter 14: Prices of goods,
services, and assets are typically expressed in terms of money. Exchange rates allow us to
translate different countries’ money prices into comparable terms.
The convention of quoting prices in money terms simplifies economic calculations by
making it easy to compare the prices of different commodities. The international price
comparisons in Chapter 14, which used exchange rates to compare the prices of different
countries’ outputs, are similar to the calculations you would have to do many times each
day if different commodities’ prices were not expressed in terms of a standardized unit of
356 PART THREE Exchange Rates and Open-Economy Macroeconomics
account. If the calculations in Chapter 14 gave you a headache, imagine what it would be
like to have to calculate the relative prices of each good and service you consume in terms
of several other goods and services—for example, the price of a slice of pizza in terms of
bananas. This thought experiment should give you a keener appreciation of using money
as a unit of account.
Money as a Store of Value
Because money can be used to transfer purchasing power from the present into the future,
it is also an asset, or a store of value. This attribute is essential for any medium of
exchange because no one would be willing to accept it in payment if its value in terms of
goods and services evaporated immediately.
Money’s usefulness as a medium of exchange, however, automatically makes it the
most liquid of all assets. As you will recall from the last chapter, an asset is said to be
liquid when it can be transformed into goods and services rapidly and without high
transaction costs, such as brokers’ fees. Since money is readily acceptable as a means
of payment, money sets the standard against which the liquidity of other assets is
judged.
What Is Money?
Currency and bank deposits on which checks may be written certainly qualify as money.
These are widely accepted means of payment that can be transferred between owners at
low cost. Households and firms hold currency and checking deposits as a convenient
way of financing routine transactions as they arise. Assets such as real estate do not
qualify as money because, unlike currency and checking deposits, they lack the essential
property of liquidity.
When we speak in this book of the money supply, we are referring to the monetary
aggregate the Federal Reserve calls M1, that is, the total amount of currency and checking
deposits held by households and firms. In the United States at the end of 2009, the
total money supply amounted to trillion, equal to roughly 12 percent of that
year’s GNP.1
The large deposits traded by participants in the foreign exchange market are not considered
part of the money supply. These deposits are less liquid than money and are not used
to finance routine transactions.
How the Money Supply Is Determined
An economy’s money supply is controlled by its central bank. The central bank directly
regulates the amount of currency in existence and also has indirect control over the
amount of checking deposits issued by private banks. The procedures through which the
central bank controls the money supply are complex, and we assume for now that the central
bank simply sets the size of the money supply at the level it desires. We go into the
money supply process in more detail, however, in Chapter 18.
$1.722
1 A broader Federal Reserve measure of money supply, M2, includes time deposits, but these are less liquid than
the assets included in M1 because the funds in them typically cannot be withdrawn early without penalty. An
even broader measure, known as M3, is also tracked by the Fed. A decision on where to draw the line between
money and near-money must be somewhat arbitrary and therefore controversial. For further discussion of this
question, see Chapter 3 of Frederic S. Mishkin, The Economics of Money, Banking and Financial Markets, 9th
edition (Boston: Addison Wesley, 2010).
We are so accustomed to using money that we seldom notice the roles it plays in almost all
of our everyday transactions. As with many other modern conveniences, we take money
for granted until something goes wrong with it! In fact, the easiest way to appreciate the
importance of money is to imagine what economic life would be like without it.
In this section we do just that. Our purpose in carrying out this “thought experiment” is
to distinguish money from other assets and to describe the characteristics of money that
lead people to hold it. These characteristics are central to an analysis of the demand for
money.
Money as a Medium of Exchange
The most important function of money is to serve as a medium of exchange, a generally accepted
means of payment. To see why a medium of exchange is necessary, imagine how
time-consuming it would be for people to purchase goods and services in a world where
the only type of trade possible is barter trade—the direct trade of goods or services for
other goods or services. To have her car repaired, for example, your professor would have
to find a mechanic in need of economics lessons!
Money eliminates the enormous search costs connected with a barter system because
money is universally acceptable. It eliminates these search costs by enabling an individual
to sell the goods and services she produces to people other than the producers of the goods
and services she wishes to consume. A complex modern economy would cease functioning
without some standardized and convenient means of payment.
Money as a Unit of Account
Money’s second important role is as a unit of account, that is, as a widely recognized measure
of value. It is in this role that we encountered money in Chapter 14: Prices of goods,
services, and assets are typically expressed in terms of money. Exchange rates allow us to
translate different countries’ money prices into comparable terms.
The convention of quoting prices in money terms simplifies economic calculations by
making it easy to compare the prices of different commodities. The international price
comparisons in Chapter 14, which used exchange rates to compare the prices of different
countries’ outputs, are similar to the calculations you would have to do many times each
day if different commodities’ prices were not expressed in terms of a standardized unit of
356 PART THREE Exchange Rates and Open-Economy Macroeconomics
account. If the calculations in Chapter 14 gave you a headache, imagine what it would be
like to have to calculate the relative prices of each good and service you consume in terms
of several other goods and services—for example, the price of a slice of pizza in terms of
bananas. This thought experiment should give you a keener appreciation of using money
as a unit of account.
Money as a Store of Value
Because money can be used to transfer purchasing power from the present into the future,
it is also an asset, or a store of value. This attribute is essential for any medium of
exchange because no one would be willing to accept it in payment if its value in terms of
goods and services evaporated immediately.
Money’s usefulness as a medium of exchange, however, automatically makes it the
most liquid of all assets. As you will recall from the last chapter, an asset is said to be
liquid when it can be transformed into goods and services rapidly and without high
transaction costs, such as brokers’ fees. Since money is readily acceptable as a means
of payment, money sets the standard against which the liquidity of other assets is
judged.
What Is Money?
Currency and bank deposits on which checks may be written certainly qualify as money.
These are widely accepted means of payment that can be transferred between owners at
low cost. Households and firms hold currency and checking deposits as a convenient
way of financing routine transactions as they arise. Assets such as real estate do not
qualify as money because, unlike currency and checking deposits, they lack the essential
property of liquidity.
When we speak in this book of the money supply, we are referring to the monetary
aggregate the Federal Reserve calls M1, that is, the total amount of currency and checking
deposits held by households and firms. In the United States at the end of 2009, the
total money supply amounted to trillion, equal to roughly 12 percent of that
year’s GNP.1
The large deposits traded by participants in the foreign exchange market are not considered
part of the money supply. These deposits are less liquid than money and are not used
to finance routine transactions.
How the Money Supply Is Determined
An economy’s money supply is controlled by its central bank. The central bank directly
regulates the amount of currency in existence and also has indirect control over the
amount of checking deposits issued by private banks. The procedures through which the
central bank controls the money supply are complex, and we assume for now that the central
bank simply sets the size of the money supply at the level it desires. We go into the
money supply process in more detail, however, in Chapter 18.
$1.722
1 A broader Federal Reserve measure of money supply, M2, includes time deposits, but these are less liquid than
the assets included in M1 because the funds in them typically cannot be withdrawn early without penalty. An
even broader measure, known as M3, is also tracked by the Fed. A decision on where to draw the line between
money and near-money must be somewhat arbitrary and therefore controversial. For further discussion of this
question, see Chapter 3 of Frederic S. Mishkin, The Economics of Money, Banking and Financial Markets, 9th
edition (Boston: Addison Wesley, 2010).
No comments:
Post a Comment