MONEY and BANKING: ECON 3115 Fall Chapter 3: What is Money?

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1 Professor Benjamin Russo Outline MONEY and BANKING: ECON 3115 Fall 2011 Chapter 3: What is Money? I) What is Money? II) What Does Money Do? Three Functions of Money. III) Barter Exchange, Monetary Exchange, and Economic Efficiency IV) What Assets Serve as Money in Modern Economies? V) Who Creates (most) Money in Modern Economies? VI) Who Controls the Creation of Money in Modern Economies? VII) How Do Central Banks Control the Money Stock? I) What is Money? uncc.edu 1) The question What is Money? may seem odd. Everyday experience makes the meaning of 'money' obvious, doesn t it? It may seem surprising, but the answer is no. Recall the movie character Forrest Gump, played by Tom Hanks. Gump reminisced that his wise and caring mother would admonish him by saying stupid is as stupid does. It may seem natural to follow Gump's Mom and think of money simply as what we use to buy stuff. In fact, some financial experts paraphrase Gump s Mom, saying money is as money does. But this statement oversimplifies the meaning of 'money.' 2) As well, many ordinary folk firmly, but incorrectly, believe that the value of money is tied to a real commodity, such as gold. This point of view may have its source in history or in the fact that green paper dollar bills have very little intrinsic value, or in an economic fallacy overturned in the Nineteenth Century. The fallacy is that commodities derive economic value solely from the ingredients used to make them. If this were true, supply curves alone would determine market prices: demand curves would be unnecessary. But this can't be true. Consider that you can buy a baseball at Dick's Sporting Goods for about fifteen dollars. Yet, at least one baseball is worth tens of thousands of dollars, namely the baseball Hank Aaron hit into Atlanta's Fulton Stadium bullpen for his 1974 record-breaking homerun #715. Yet the ball Aaron hit for homerun 715 consists of the same cork, rubber and yarn as every other baseball hit out of ballparks in Nineteenth Century economists showed that commodities have economic value because people value them. How else can anyone explain a collector paying thousands of dollars for a baseball card? The value money has in modern economies is not, and need not be, dependent on the value of any real commodity. 3) Money is not simply what people use to make trades. This is apparent from the fact that stuff that clearly is not money is used in exchange for commodities all the time. Kids trade baseball cards for marbles. Grown-up kids trade baseball cards for other valuable sports memorabilia. Some students who have not taken Money and Banking think credit cards are money. Neither baseball cards nor credit cards satisfy the criteria necessary to be called 'money.' 4) There is a grain of truth in the aphorism money is as money does.' Money is, after all, a medium of exchange. But money is much more, because: A) Money is the unique thing generally used in exchange for commodities. In order for something to be money it must be common in nearly all exchanges. One might trade a pristine 1949 Joe DiMaggio baseball card for a ticket to the Super bowl, but you cannot use it to buy a can of soup at Walmart.

2 2 B) Money, by law, can be used to repay debt (try making a house payment with a credit card). In fact, the face of U.S. currency states "this note is legal tender for all debts public and private." 5) Therefore, monetary economists define money as anything generally accepted in exchange for commodities and in the repayment of debt. II) What Does Money Do? Three Functions 1) The first, and at this point obvious, function of money is to serve as medium of exchange. 2) A second function of money is as a "unit of account." That is, money functions as a measure of the value of commodities. Money is like a yardstick for economic value. 3) The third function of money is as a "store of value." A) We use money to buy stuff. But we use credit cards to buy stuff too. Yet credit cards are not money. What differentiates money from credit cards? The third function of money addresses this question: money serves as an asset. Anything that retains value over time is an asset. Money retains economic value over time so money is an asset to its owner (it may be a liability to someone else. Can you figure out why, and to whom?). In contrast, a credit card is owned by the credit card company, not by its user. In fact, a credit card is simply a form of short-term (hopefully) debt. The card user hands the card to a cashier in exchange for a pair of running shoes and she is in debt for $100. At the end of the month, she will receive a credit card bill. The bill must be paid with money. 1 B) Money is only one among many assets. But only one asset is money. Why is that? 4) There are important qualifications to the store of value function of money: A) In contrast to many other assets, money's nominal value does not change (in most countries): the nominal value is printed on the face of a bill or coin. Because that number never changes we say the nominal value is "fixed." One result of this is that as inflation causes commodity price to increase, the amount of commodities each unit of money can buy, sadly, declines. That is, because the nominal value of money is fixed, inflation erodes money s ability to store real economic value. B) In the past, commodities, such as gold, often were used as money. Not surprisingly, this was called "commodity money." Commodity money does have intrinsic value in the sense that it can be used for things besides trade. E.G., gold has decorative and industrial uses. The money we use today is not commodity money. Instead, the money we use is fiat money. That is, in the first instance, it is money by government fiat. In other words, it is money because the federal government (in the U.S.) says its money. Nevertheless, governments' influence on money is limited. In the second instance, after a government decrees something as money, it retains its value only as long as people are willing to accept it in exchange for real commodities. Ultimately, fiat money derives its value from peoples' belief that if they accept it in exchange now, they will be able to exchange it for something 1 Some credit card promotions allow users to pay off old credit card debt with a new credit card. Nevertheless, ultimately credit card debt must be paid off with money.

3 valuable later. The value of money is based on faith in its value! 3 C) The value fiat money has is a miracle of the sociology of trade. This phenomenon is called a "self-fulfilling prophecy;" that is, it occurs because people believe it will occur. If people believe it won't occur, it don't occur! (bad grammar, irresistible rhyme). Selffulfilling prophecies are very common in financial economics. If people generally believe an asset s price will increase, it increases, sometimes in contrast with the asset's fundamental value (think housing bubble). D) Self-fulfilling prophecies have potentially severe downsides. If people s faith in money s real value erodes, they tend to spend it faster, to avoid the loss in value. If everyone acts this way, the mass attempt to avoid loses causes inflation. But inflation, of course, means money loses real value, which reinforces the original belief, which leads people to spend faster, which causes more inflation. Whew! We're going around in circles. That's what self-fulfilling prophecies often do. In the worst cases, inflation accelerates exponentially. This is called hyperinflation. In hyperinflations money loses all its real value, and exchange regresses to barter. It happened in Germany after WWI and in Hungary after WWII. What was wrong with that? Rapid and accelerating inflation wrecks economies. E) The adverse economic effects of self-fulfilling inflation prophecies provide a central motivation for modern monetary policy, which is to protect the value of money by maintaining low inflation. III) Barter Exchange, Monetary Exchange, and Economic Efficiency 1) Anthropologists teach us that nearly every society that has developed a system of trade in commodities also has introduced monetary exchange, in place of barter. Why should this be? In barter exchange, different commodities may be used in different trades. Barter has high transactions costs because it consumes gobs of time. The opportunity cost of time spent in barter exchange is the value of other things one can do with that time. The transition from barter exchange to monetary exchange reduces transactions costs: that is, monetary exchange reduces the amount of time used up in exchange, freeing time for use producing things people value. Thus, monetary exchange is more efficient than barter. 2 The following (somewhat goofy) example makes the point in a simple way. A) In a barter economy no single commodity is generally accepted in transactions. In this case, a peach farmer who needs a haircut must track down a peach-loving barber. Although I have no first-hand experience here, I am guessing locating hungry barbers takes a lot of time. E.G., suppose, in his quest for hair removal, the first person an un-groomed farmer meets along the road to market is a peach-loving shoemaker. The farmer must search longer. The next person he meets may be a barber with a peach allergy: no deal here either. B) In contrast, in monetary exchange, the farmer sells peaches in exchange for money, and then takes the money to the barber to pay for a haircut. On average, these two transactions cost less time than barter exchange. Farmers, barbers, and their customers are better off because they have more time for producing stuff, for spending time with their families, or for enjoying their favorite pastime (baseball?). Monetary exchange is more efficient than 2 Did you think we would get through a discussion without using the word 'efficiency'?

4 barter. 4 2) Money also serves as a unit of account. Having a unit of account also reduces transactions costs because the unit of account makes it easier to determine the real prices of commodities. A) In order to state what the exchange value of a commodity is in a world with no unit of account, the value would have to be given in terms of other commodities, say haircuts, or gasoline, or firewood, or who knows? With no unit of account to measure the value of each commodity, one farmer might state the price of food in units of haircuts, another in units of gasoline, and another in units of firewood. This would make comparison shopping difficult. B) Having a unit of account is efficient because it reduces the amount of time required to figure out the real price of commodities. This frees up time (for watching baseball). IV) What Assets Serve as Money in Modern Economies? 1) For the most part, circulating currency and checkable deposits serve as money in modern economies. Circulating currency is currency in the hands of the non-bank public. 3 Note that circulating currency makes up a relatively small share of the money stock. Checkable deposits make up the majority of the money stock. 2) In the U.S., the Federal Reserve (Fed, hereafter) determines which assets satisfy the economic definition of money. The two measures of the money stock most commonly used by the Fed are M1 and M2. A) The Fed s M1 money stock consists of: a) checkable deposits b) circulating currency c) traveler s checks B) The Fed s M2 money stock consists of: a) M1 b) small denomination certificates of deposit c) saving and money market deposit accounts d) money market mutual fund shares. C) The Fed provides more than one definition of money because economists have not reached consensus on which measure, M1 or M2, is most effective in achieving its goals (see below). Some economists argue that the assets in M2 are so liquid they have the same economic impact as the assets in M1 (so M2 is sometimes called near money ). For our purposes, it does not matter whether M1 or M2 is used to measure the money stock, because central banks no longer use the money stock to achieve their goals (next). D) The U.S. Congress, which created the Fed in 1913, mandates the Fed's goals. In 1913, the Fed's goals were to create a "stable" and "elastic" money supply, and act as a "lender of last resort." A stable money supply does not rise and fall randomly. An elastic money 3 Non-circulating currency refers to currency stored in bank vaults. The U.S. Federal Reserve Bank does not include noncirculating currency in its money stock measurements.

5 supply supports economic growth by growing with the economy. A lender of last resort provides banks with bank reserves, to prevent bank runs. 5 E) The Employment Act of 1946 changed the Fed's mandate somewhat. In addition to acting as lender of last resort, the Fed's goals are to stabilize prices (I.E., prevent inflation), and promote high employment. V) Who Creates Most of the Money in Modern Economies? The answer to this question may be surprising. To answer, think about who creates the largest share of M1 assets, namely checkable deposits. You must know the answer to this question. VI) Who Controls the Creation of Money in Modern Economies? To answer this question, think about why the monetary authorities are called authorities. You must know the answer to this question too. VII) How Do Central Banks Control the Money Stock? 1) Good question, if I say so myself. Note that this is a brief introduction to central bank control of the money supply. This material will be discussed in more detail in Chapter 18. 2) Commercial bank reserves (aka reserves) are funds commercial banks hold to pay deposit outflows and because the Fed requires banks hold reserves against their bank deposits. Reserves consist of cash held in bank vaults as well as bank deposits held at the Fed. 3) Commercial banks hold only a small fraction of their deposits on reserve. What do they do with the deposits that they don't hold on reserve? Bank reserves have an opportunity cost, namely the additional interest banks could earn by lending out the funds rather than holding them on reserve. This opportunity cost provides a powerful incentive to lend out the reserves. After all, the lion's share of commercial bank profits come from interest earned on loans. Thus, in normal times (unlike today) commercial banks lend out as much reserves as possible. 4) Open Market Operations refer to Fed purchases or sales of U.S. Treasury debt on the open market. Anyone can enter the open market. 4 The Fed pays for the Treasury debt it buys on the open market by creating new commercial bank reserves. If commercial banks sell the Treasury debt to the Fed, the banks receive the newly created reserves, which they lend to households and businesses. 5 Commercial banks make these loans by issuing checking deposits, which are money. Thus, Fed purchases of Treasury debt leads banks to create money. 5) Central banks can cause banks to reduce the money supply by running open market operations in reverse. In this case, the Fed sells Treasury debt. Commercial banks pay for the debt they buy from the Fed by giving reserves back to the Fed. Because this process causes bank reserves to decline, banks have fewer reserves to lend, and bank lending declines. In turn, fewer checking deposits are created, and the money supply would decline. 6) The long and short of it is that central banks use open market operations to control the amount of money commercial banks create. 4 As opposed to auction bond markets, which often exclude all but very large buyers. 5 But even if a non-bank owner of the Treasury debt sells it, the Fed must create new reserves to pay for the Treasury debt. Thus, no matter who sells the debt to the Fed, reserves are created and the money stock increases.