What is money?

Ms. Ross

As adapted from Federal Reserve Workshop

“Money is what money does.”

Why did money develop?

Barter, swapping goods and services for other goods and services, is likely to be difficult.-- Barter requires a coincidence of wants.

-- Trade is slowed if there is no coincidence of wants

Many societies have used many things as money, including stones, shells, elephant tail bristles, gold and silver coins, furs, salt, whales’ teeth, and pieces of paper.

Functions of Money

Medium of Exchange-- Money can be used for buying and selling goods and services.

-- Money allows society to avoid the difficulties associated with barter.

Unit of Account-- Money can be used to judge the relative value of different goods and services.

-- Money assists consumers and producers in making rational decisions.

Functions of Money

Store of value

-- Money can be used to transfer purchasing power from the present into the future.

Characteristics of “Good” Money Divisible Relatively Scarce Durable Portable Desirable Distinguishable

Money Definitions

M1 M2 M3

M1 – Money Definition

M1 is the “narrowest” definition of money in the United States.

M1 is the “most liquid” M1 includes

--Currency (coins and paper money) in the hands of the public-- All checkable deposits (all deposits in commercial banks and savings institutions on which checks of any size can be drawn.

M1 = 1.372 trillion (as of March, 2008)

More on Components of M1

Coins + paper money

-- coins represent 2-3% of M1

-- paper currency represents a little less than 50% of M1

-- US coins in circulation are token money because the value of the metal in the coin is worth less than the value of the coin.

-- All paper money is in the form of Federal Reserve Notes

-- There is more than 700 billion in currency in circulation

More on Components of M1

Checkable Deposits

-- Checkable deposits represent about 50% of M1.

-- Checks and debit cards represent a convenient, safe way of transporting money and making payments.

-- People can generally convert checkable deposits quickly into paper money and coin. Therefore, checks drawn on these deposits are viewed as equivalent to currency.

M2 – Money Definition

M2 is a “broader” definition of money and includes M1, plus a number of “near-monies”:

-- Savings deposits, including money market deposit accounts (MMDA’s)

-- small (less than $100,000) time deposits (CD’s)

These “near-monies” can be easily converted into currency and checkable deposits.

M2 = $7.6616 trillion ( March 2008)

M3 – Money Definition

M3 is an even “broader” definition of money and includes M2 and :-- Large ($100,000 or more) time deposits

-- Balances in institutional money funds

-- Repurchase liabilities issues by depository institutions

-- Eurodollars

M3 = $9.727 trillion (as of July 14, 2005)

Commodity Money

Commodity money is anything that serves as money and has an alternative use.

-- Corn, tobacco, and salt are some examples of commodities that have been used as money at different times and places in the world.

-- Precious metals have also been used as commodity money

Fiat Money

Fiat money is any item, without intrinsic value, which has been declared to be money by the government.

Federal Reserve Notes are fiat money; they have no intrinsic value.

Legal Tender

Federal Reserve Notes are legal tender. Legal tender means that paper currency must

be accepted in payment of a debt, or else the creditor forfeits the privilege of charging interest and the right to sue the debtor for non-payment.

Coins and checks are not legal tender, yet they are widely accepted.

MV=PQ

M: the supply of money in the economy V: the velocity of money, or the number of

times a year that the average dollar is spent on final goods and services

P: the overall price level in the economy Q: the quantity of all goods and services

produced; also known as real output

MV=PQ

This is a simple model of a macro economy during a time period.

MV represents the total amount spent by buyers in the economy.

PQ represents the total amount received by sellers.

Therefore MV should be roughly equal to PQ

MV=PQ

If there is a change in one of the variables, there must be a change in one of the other variables to keep MV equal to PQ.

Money and Prices

There exists a negative relationship between prices and the value of the dollar.

-- Higher prices lower the value of the dollar because more dollars are needed to buy a particular amount of goods, services, or resources

-- Lower prices tend to raise the value of the dollar because fewer dollars are needed to buy a particular amount of goods, services, or resources.

Money and Prices

Very high levels of inflation can result in:

-- A breakdown in money’s function as a medium of exchange.

-- A breakdown in money’s function as a store of value.

-- A breakdown in money’s function as a unit of account.