Chapter 7: The Asset Market, Money, and Prices

Learning Objectives

• Define money, discuss its functions, and describe how it is measured in the United States.

• Discuss the factors that affect how people choose which assets they own (portfolio allocation).

• Examine macroeconomic variables that affect the demand for money.

• Discuss the fundamentals of asset market equilibrium.

• Discuss the relationship between money growth and inflation.

What is Money?

Definition and Functions of Money

Money refers to assets that are widely used and accepted as payment for goods and services. It plays a central role in the functioning of modern economies.

• Medium of Exchange: Money is used to facilitate transactions. It overcomes the inefficiencies of barter, such as the double coincidence of wants, by allowing people to sell their labor or goods for money and then use that money to purchase other goods and services. This function enables specialization and division of labor.

• Unit of Account: Money serves as the basic unit for measuring economic value, simplifying the comparison of prices, wages, and incomes. In countries with high inflation, people may use a more stable foreign currency as a unit of account to avoid frequent price changes.

• Store of Value: Money can be used to hold wealth over time. However, most people use money as a store of value only for short periods and small amounts, since it typically earns less interest than other assets like bank deposits.

Example: Commodity Money in a Prisoner of War Camp

• In Radford's study, cigarettes became money in a POW camp because barter was inefficient.

• Cigarettes were standardized, low in value (allowing for making change), portable, and sturdy.

• Even nonsmokers used cigarettes as money, but a limitation was that cigarettes could not be both consumed and used as money at the same time.

Measuring Money: The Monetary Aggregates

Distinguishing what counts as money can be complex, especially with financial innovations. For example, money market mutual funds (MMMFs) allow check writing and offer higher returns than checking accounts, raising questions about their classification as money.

• There is no single best measure of the money supply; instead, economists use several aggregates.

Key Monetary Aggregates

• M1: Includes currency held by the public, transaction accounts (such as checking accounts), and, since 2021, savings accounts (as the Federal Reserve no longer distinguishes between savings and transaction deposits).

• M2: Includes all of M1 plus less liquid assets such as small time deposits (under $100,000) and non-institutional MMMF balances.

Additional info: The inclusion of savings accounts in M1 in 2021 led to a substantial increase in the reported size of M1, but historical data were only revised back to May 2020, creating a break in the time series.