Money and Its Role in the Economy

Definition and Importance of Money

Money is a fundamental invention in economic history, serving as a medium that facilitates exchange, specialization, and economic growth. Economists define money as any asset that people are generally willing to accept in exchange for goods and services or for payment of debts.

• Asset: Anything of value owned by a person or a firm.

• Money enables efficient trade and the development of complex economies.

Barter and the Need for Money

Before money, economies relied on barter, the direct exchange of goods and services. Barter requires a double coincidence of wants, meaning both parties must want what the other offers. This system is inefficient and limits economic growth.

• Societies eventually adopted commodity money—goods with intrinsic value, such as animal skins or precious metals.

• The introduction of money allowed for greater specialization and economic development.

The Four Primary Functions of Money

1. Medium of Exchange: Money is widely accepted as payment for goods and services.

2. Unit of Account: Money provides a standard measure of value, simplifying price comparisons.

3. Store of Value: Money allows individuals to transfer purchasing power into the future, provided it remains liquid and stable in value.

4. Standard of Deferred Payment: Money facilitates transactions over time, as its value is expected to remain predictable.

Characteristics of Good Money

For an asset to function effectively as money, it should be:

• Acceptable to most people.

• Of standardized quality (uniform units).

• Durable (not easily destroyed or worn out).

• Valuable relative to its weight (easy to transport).

• Divisible (usable for both small and large transactions).

Commodity Money

Commodity money has value independent of its use as money. Examples include:

• Cowrie shells in Asia

• Precious metals (gold, silver)

• Animal pelts and skins in colonial North America

• Cigarettes in prisons and POW camps

Paper Money and Fiat Money

Paper money originated in China and was initially exchangeable for commodities like gold. In modern economies, fiat money is issued by central banks and is not backed by physical commodities.

• Fiat money: Currency authorized by a central bank or government, not exchangeable for a commodity.

• The Federal Reserve is the central bank of the United States.

Advantages and Disadvantages of Fiat Money

• Advantage: Greater flexibility for central banks in managing the money supply.

• Disadvantage: Relies on public confidence; if trust is lost, fiat money loses value.

Modern Payment Systems and Money

• Not all assets used for transactions are considered money. For example, debit cards access money in checking accounts, but the card itself is not money.

• Credit cards provide short-term loans and are not counted as money.

• Cryptocurrencies like Bitcoin are not currently included in official measures of the money supply (M1 or M2).

Measuring the Money Supply

Definitions of Money Supply

• M1: The sum of currency in circulation, checking account deposits, and savings account deposits.

• M2: Includes M1 plus small-denomination time deposits and noninstitutional money market fund shares.

As of September 2023:

• M1 ≈ $18.1 trillion

• M2 ≈ $20.8 trillion

• About 13% of M1 is currency; 75% of U.S. paper currency is in $100 bills.

Which Measure to Use?

• Recent changes have made M1 and M2 similar, so either can be used for most discussions.

• The money supply includes both checking and savings account balances, as well as currency.

• Banks play a crucial role in determining the money supply.

The Role of Banks in the Economy

Bank Functions and Balance Sheets

Banks are profit-making firms that accept deposits and make loans. Their balance sheets list assets (loans, reserves, securities) and liabilities (deposits, borrowings, stockholders' equity).

Reserves and Required Reserves

• Reserves: Deposits that banks keep as cash in their vaults or on deposit with the Federal Reserve.

• Previously, banks were required to hold a fraction of deposits as required reserves (e.g., 10%), but this requirement was eliminated in March 2020.

Economic Importance of Bank Lending

• Banks reduce transaction costs and information problems (asymmetric information) through economies of scale and statistical analysis.

• Banks specialize in evaluating credit risk and facilitating loans, which supports economic activity.

Fintech and Interest Rate Ceilings

• Financial technology (fintech) firms offer peer-to-peer lending but may increase risky loans.

• Proposals to cap credit card interest rates may limit access to credit for some borrowers.

How Banks Create Money

Fractional Reserve Banking

Banks keep less than 100% of deposits as reserves, lending out the rest. This system is called fractional reserve banking.

• When a deposit is made, the bank keeps a fraction as reserves and lends out the remainder, creating new deposits in the process.

The Money Multiplier

The process of lending and redepositing creates a money multiplier, defined as:

• The multiplier effect means that an initial deposit can lead to a much larger increase in the total money supply.

• Since 2007, the money multiplier has become unstable, so the Federal Reserve now focuses more on controlling interest rates.

Interest on Reserve Balances

• Since 2008, the Fed pays interest on reserves held by banks, encouraging them to hold more reserves (ample-reserves regime).

Why the Money Multiplier Fluctuates

• Changes in the amount of reserves banks hold relative to deposits.

• Changes in the amount of currency households and firms hold relative to deposits.

The Federal Reserve System

Bank Runs and Panics

• A bank run occurs when many depositors try to withdraw funds simultaneously due to loss of confidence.

• A bank panic happens when multiple banks experience runs at the same time.

• The Federal Reserve acts as a lender of last resort to prevent panics.

Establishment and Structure of the Federal Reserve

• Founded in 1914 after a series of bank panics.

• Makes discount loans to banks at the discount rate.

• Composed of the Board of Governors (7 members, 14-year terms) and 12 Federal Reserve districts.

• The Federal Open Market Committee (FOMC) manages open market operations and the money supply.

Deposit Insurance and Moral Hazard

• The Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000, reducing the risk of bank runs.

• Moral hazard: Insuring deposits may encourage banks to take more risks, knowing depositors are protected.

The Shadow Banking System and Financial Crises

Shadow Banking System

• Includes investment banks, money market mutual funds, and hedge funds.

• These institutions are less regulated and do not have FDIC insurance, making them more vulnerable to runs.

• Securitization: The process of transforming loans into securities that can be traded.

The Financial Crisis of 2007–2009

• Shadow banks were highly leveraged and suffered large losses when mortgage-backed securities declined in value.

• The Fed and U.S. Treasury intervened to stabilize the financial system.

The Quantity Theory of Money and Inflation

The Quantity Theory of Money

This theory links the money supply to the price level and inflation. It assumes the velocity of money (the average number of times each dollar is used in transactions) is constant.

• If the money supply grows faster than real GDP, inflation occurs.

• If the money supply grows slower than real GDP, deflation occurs.

• If both grow at the same rate, the price level is stable.

Empirical Evidence and Hyperinflation

• There is a positive relationship between money supply growth and inflation, though not perfectly predictable due to changes in velocity.

• Hyperinflation: Extremely high inflation (over 50% per month), often caused by excessive money supply growth, as seen in Zimbabwe and Venezuela.

Practice Questions and Applications

• Is cash in your pocket counted in M1? Yes, currency is part of M1.

• Are checking account funds counted in M1? Yes, checking deposits are part of M1.

• Are savings account funds counted in M1? No, but they are included in M2.

• Is Bitcoin counted in M1 or M2? No, cryptocurrencies are not part of the official money supply.

• Are credit cards counted in M1 or M2? No, credit cards represent loans, not money.

Example: Effect of Withdrawing Currency

• Withdrawing $100 from a checking account does not change M1, as both checking deposits and currency are included in M1.

Example: Bank Lending and the Money Supply

• Depositing $2,000 in currency increases deposits by $2,000 but reduces currency by $2,000—no net change in M1.

• If the bank lends out 80% ($1,600), new deposits are created, increasing the money supply by $1,600.

Formula for Money Creation:

Example: (deposit) (currency) (loan) net increase in money supply.