Money as a Tool

Functions of Money

The main functions of money are as a medium of exchange, a unit of account, and a store of value.

Learning Objectives

Describe the function of money

Key Takeaways

Key Points

  • When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange.
  • A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions.
  • To act as a store of value, money must be able to be reliably saved, stored, and retrieved. In this case, the value of the money must also remain stable over time.
  • Money can also function as a “standard of deferred payment,” which means that its status as legal tender allows it to function for the discharge of debts.

Key Terms

  • unit of account: a standard monetary unit of measurement of value/cost of goods, services, or assets.
  • store of value: An asset such as money or gold that is purchased or accepted as payment for goods and services for its ability to purchase other assets in the future without rapidly losing its purchasing power.
  • medium of exchange: An intermediary used in trade to avoid the inconveniences of a pure barter system, such as money.

Money acts as a standard measure and common denomination of trade. As a result, it is a basis for quoting and bargaining prices. It is necessary for developing efficient accounting systems, but its most important use is that it provides a method to compare the values of dissimilar objects. Money functions as:

  1. A medium of exchange
  2. A unit of account
  3. A store of value

A Medium of Exchange

When money is used to intermediate the exchange of goods and services, it is performing the function of a medium of exchange. It avoids the inefficiencies of a barter system, such as the dependence on the occurrence of a coincidence of wants. To be widely acceptable, a medium of exchange should have stable purchasing power. Therefore, it should possess the following characteristics:

  • Valuation of common assets
  • Constant utility
  • Low cost of preservation
  • Transportability
  • Divisibility
  • High market value in relation to volume and weight
  • Recognizability
  • Resistance to counterfeiting

Gold was popular as a medium of exchange and store of value because it was inert. Gold was convenient to move because even small amounts of it had considerable value. Gold also had a constant value due to its special physical and chemical properties, which made it cherished by men.

A Unit of Account

A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a “measure” or “standard” of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements. To function as a unit of account, whatever is being used as money must meet these characteristics:

  • It must be divisible into smaller units without a loss of value. For example, precious metals can be coined from bars or melted down into bars again.
  • It must be fungible. In other words, one unit or piece must be perceived as equivalent to any other. This is why diamonds, works of art, or real estate are not suitable as money.
  • It must have a specific weight, measure, or size in order to be verifiably countable. For instance, coins are often milled with a reeded edge, so that any removal of material from the coin (lowering its commodity value) will be easy to detect.

A Store of Value

To act as a store of value, money must be able to be reliably saved, stored, and retrieved. Moreover, it must be predictably usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time. Put simply, money acting as a store of value allows its owner to transfer real purchasing power from the present to the future. Some have argued that inflation, by reducing the value of money, diminishes its ability to function as a store of value. Money can also function as a “standard of deferred payment,” which means that its status as a legal tender allows it to function for the discharge of debts.

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Functions of Money: Money, such as the U.S. dollar, functions as a medium of exchange, a unit of account, and a store of value.

Types of Currency

Nearly all contemporary money systems are based on fiat money, which is modern currency that has value only by government order.

Learning Objectives

Describe the different types of mediums used as currency

Key Takeaways

Key Points

  • Fiat money is money that derives its value from government regulation or law. Value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold).
  • Commodity money value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity. For example gold, silver, copper, rice, salt, alcohol, and cigarettes are commodities that have been used as a medium of exchange.
  • Commercial bank money or demand deposits are claims against financial institutions that can be used for the purchase of goods and services.

Key Terms

  • commodity money: money whose value comes from a commodity of which it is made. It is objects that have value in themselves as well as for use as money.
  • Fiat money: money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold).
  • Bretton Woods System: The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states in the mid-20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states.

Currency refers to physical objects generally accepted as a medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation’s money supply. The other part of a nation’s money supply consists of bank deposits (sometimes called deposit money), ownership of which can be transferred by means of checks, debit cards, or other forms of money transfer. Deposit money and currency are money in the sense that both are acceptable as a means of payment.

Money in the form of currency has predominated throughout most of history. Usually (gold or silver) coins of intrinsic value (commodity money) have been the norm. However, nearly all contemporary money systems are based on fiat money. In other words, modern currency has value only by government order (fiat). Usually, the government declares the fiat currency (typically notes and coins issued by the central bank) to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, both public and private.

Fiat Money

Fiat money is money that derives its value from government regulation or law. Value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). The term fiat currency is also used when the fiat money is used as the main currency of the country. Some bullion coins such as the Australian Gold Nugget and American Eagle are legal tender, but they trade based on the market price of the metal content as a commodity, rather than their legal tender face value (which is usually only a small fraction of their bullion value).

Fiat money, if physically represented in the form of currency (paper or coins), can be accidentally damaged or destroyed. However, fiat money has an advantage over representative or commodity money in that the same laws that created the money can also define rules for its replacement in case of damage or destruction. For example, the U.S. government will replace mutilated Federal Reserve notes (U.S. fiat money) if at least half of the physical note can be reconstructed, or if it can be otherwise proven to have been destroyed. By contrast, commodity money which has been lost or destroyed cannot be recovered.

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Money: Fiat, Commodity, and Commercial Bank money are three main types of money

Currently, most modern monetary systems are based on fiat money. However, for most of history, almost all money was commodity money, such as gold and silver coins. As economies developed, commodity money was eventually replaced by representative money, such as the gold standard, as traders found the physical transportation of gold and silver burdensome. Fiat currencies gradually took over in the last hundred years, especially since the breakup of the Bretton Woods system in the early 1970s.

Commodity Money

Many items have been used as commodity money such as naturally scarce precious metals, conch shells, barley, and beads, as well as many other things that are thought of as having value. Commodity money value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity. Examples of commodities that have been used as mediums of exchange include gold, silver, copper, rice, salt, peppercorns, large stones, decorated belts, shells, alcohol, cigarettes, cannabis, and candy. The use of commodity money is similar to barter, but a commodity money provides a simple and automatic unit of account for the commodity which is being used as money.

Commercial Bank Money

Commercial bank money or demand deposits are claims against financial institutions that can be used for the purchase of goods and services. A demand deposit account is an account from which funds can be withdrawn at any time by check or cash withdrawal without giving the bank or financial institution any prior notice. Banks have the legal obligation to return funds held in demand deposits immediately upon demand (or “at call”). Demand deposit withdrawals can be performed in person, via checks or bank drafts, using automatic teller machines (ATMs), or through online banking.

Commercial bank money is created through fractional-reserve banking, which is the banking practice where banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets). Banks then lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand. Commercial bank money differs from commodity and fiat money in two ways. First, it is non-physical, as its existence is only reflected in the account ledgers of banks and other financial institutions. Second, there is some element of risk that the claim will not be fulfilled if the financial institution becomes insolvent.

Measuring the Money Supply

In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time.

Learning Objectives

Describe the standard measures used to classify the money supply

Key Takeaways

Key Points

  • There are several ways to define ” money,” but standard measures usually include currency in circulation and demand deposits (depositors’ easily accessed assets on the books of financial institutions).
  • Public and private sector analysts have long monitored changes in money supply because of its possible effects on the price level, inflation and the business cycle.
  • The different types of money are typically classified as “M”s. The “M”s usually range from M0 (narrowest) to M3 (broadest) but which “M”s are actually used depends on the country’s central bank.
  • Different measures of a nation’s money supply reflect various degrees of asset liquidity, which marks the ease at which a monetary asset can be turned into cash.

Key Terms

  • money: a generally accepted means of exchange and measure of value
  • money supply: The total amount of money available in an economy at a specific time.
  • currency: In economics, currency is a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation’s money supply.

Monetary Aggregates in the U.S.

In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define “money,” but standard measures usually include currency in circulation and demand deposits (depositors’ easily accessed assets on the books of financial institutions).

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Money supply: In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time.

Money supply data are recorded and published, usually by the government or the central bank of the country. Public and private sector analysts have long monitored changes in money supply because of its possible effects on the price level, inflation and the business cycle.

The different types of money are typically classified as “M”s. The “M”s usually range from M0 (narrowest) to M3 (broadest) but which “M”s are actually used depends on the country’s central bank.

In economics, the monetary base (also base money, money base, high-powered money, reserve money, or, in the UK, narrow money) is a term relating to (but not being equivalent to) the money supply (or money stock) or the amount of money in the economy. The monetary base is highly liquid money that consists of coins, paper money (both as bank vault cash and as currency circulating in the public), and commercial banks ‘ reserves with the central bank. Measures of money are typically classified as levels of M, where the monetary base is the smallest and lowest M-level: M0. Base money can be described as the most acceptable (or liquid) form of final payment. Broader measures of the money supply also include money that does not count as base money, such as demand deposits (included in M1), and other deposit accounts like the less liquid savings accounts (included in M2), etc. (The narrow money supply is an earlier term used in the U.S. to describe currency held by the non-bank public and demand deposits of banks, M1).

Different Types of Money are Typically Classified as “M”s

  • M0: In some countries, such as the United Kingdom, M0 includes bank reserves, so M0 is referred to as the monetary base, or narrow money.
  • MB: This is referred to as the monetary base or total currency. This is the base from which other forms of money (like checking deposits) are created and is traditionally the most liquid measure of the money supply.
  • M1: Bank reserves are not included in M1.
  • M2: Represents money and “close substitutes” for money. M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions. M2 is a key economic indicator used to forecast inflation.
  • M3: M2 plus large and long-term deposits. Since 2006, M3 is no longer tracked by the U.S. central bank.

The ratio of a pair of these measures, most often M2/M0, is called an (actual, empirical) money multiplier.

Different measures of a nation’s money supply reflect various degrees of asset liquidity, which marks the ease at which a monetary asset can be turned into cash. Liquid assets include coins, paper currency, checkable-type deposits, and traveler’s checks. Less liquid assets include money market deposits and savings account deposits. Measure MI, the most narrow of measures, includes only the most liquid forms of monetary assets; all currency and bank deposits held by a nation’s public. M2, a slightly “broader” measure includes all values incorporated under MI, in addition to assets held in savings accounts, certain time deposits and mutual funds balances.

Money supply is important because it is linked to inflation by the equation of exchange in an equation, MV=PQ, proposed by Irving Fisher in 1911:

  • M is the total dollars in the nation’s money supply,
  • V is the number of times per year each dollar is spent (velocity of money);
  • P is the average price of all the goods and services sold during the year;
  • Q is the quantity of assets, goods and services sold during the year.

Control of the Money Supply

A nation’s money supply is determined by the monetary policy actions of its central bank.

Learning Objectives

Summarize the argument against the role of open market operations in determining the nation’s money supply

Key Takeaways

Key Points

  • Open market operations, the most dominant instrument of monetary policy, is the behavior of a nation’s central bank to trade or purchase government securities for cash in attempts to expand or contract the total money supply.
  • By controlling the national interest rate, a central bank can adequately meet and further dictate the consumer demand for money.
  • Under fractional reserve banking, a nation’s central bank is responsible for holding a certain fraction of all deposits as cash or on account with the central bank.
  • The central bank’s ability to predict how much money should be in circulation, given current employment rates and inflation rates, is often debated.

Key Terms

  • open market operations: An open market operation (also known as OMO) is an activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.
  • monetary base: The monetary base s a term relating to (but not being equivalent to) the money supply; the amount of money in the economy. The monetary base is highly liquid money that consists of coins, paper money (both as bank vault cash and as currency circulating in the public), and commercial banks’ reserves with the central bank.
  • Phillips curve: In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation. While it has been observed that there is a stable short run tradeoff between unemployment and inflation, this has not been observed in the long run

A nation’s money supply is determined by the monetary policy actions of its central bank. Examples of Central Banks include the Federal Reserve, the Bank of England, and the Bank of Canada, shown here. Commercial banks, as required by the central bank, must keep a fraction of all accepted deposits on reserve either in bank vaults or in central bank deposits. Accordingly, a nation’s central bank can maintain control of such reserves by lending to commercial banks and altering the rate of interest to be charged on such loans. These actions are known as open market operations and allow central banks to achieve a desired level of reserves.

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Various Central Banks: Clockwise from top-left: Federal Reserve, Bank of England, European Central Bank, Bank of Canada.

In determining a nation’s money supply, its central bank first sets the supply of the monetary base and upholds certain restrictions on the value of assets and liabilities held by smaller commercial banks. Although the consumer demand for liquidity is dictated by the public, small commercial banks are required to meet consumer demand and do so by identifying certain conditions including a set interest rate which apply to the loaning of bank liabilities. Commercial bank behavior, ultimately regulated by the nation’s central banking institution, and in conjunction with consumer demand define the total stock of money, bank credit, and rates of interest which shape national economic conditions. The value of the money supply is determined by themoney multiplier and the monetary base. The monetary base consists of the total quantity of government-produced money and includes all currency held by the public and reserves held by commercial banks. The central bank retains tight control over its nation’s money supply through the use of open market operations, the discount rate, and reserve requirements.

Open Market Operations

Open market operations, the most dominant instrument of monetary policy, are the behavior of a nation’s central bank to trade or purchase government securities for cash in attempts to expand or contract the total money supply. While purchases of government securities prove to expand the total monetary base, the selling of government securities will ultimately contract a nation’s monetary base.

The Discount Rate

A nation’s central bank is also responsible for supplying commercial banks with enough currency to meet consumer demand. By controlling the national interest rate, a central bank can adequately meet and further dictate the consumer demand for money. A decrease in the interest rate will spark an increase in the consumer demand for money; an increase in the rate of interest will lessen its demand. Changes in the interest rate also play a role in the setting of price levels. Any increase in the demand for money will increase spending levels and cause prices to rise. A decrease in the demand for money will slow spending levels and produce a subsequent decrease in price levels. If consumers expect price levels to fall, the demand for money will increase. If consumers expect price levels to increase, the demand for money will decline.

Reserve Requirements

Under fractional reserve banking, a nation’s central bank is responsible for holding a certain fraction of all deposits as cash or on account with the central bank. Central banks may alter the total money supply by changing the required percentage of total deposits to be held by commercial banks. An increase in reserve requirements would decrease the monetary base; a decrease in the requirements would increase the monetary base.

Criticism

In recent years, some academic economists renowned for their work on the implications of rational expectations have argued that open market operations are irrelevant. The Keynesian side points to a major example of ineffectiveness of open market operations encountered in 2008 in the United States, when short-term interest rates went as low as they could go in nominal terms, so that no more monetary stimulus could occur.

The main functions of the central bank are to maintain low inflation and a low level of unemployment, although these goals are sometimes in conflict (according to Phillips curve). A central bank may attempt to do this by artificially influencing the demand for goods by increasing or decreasing the nation’s money supply (relative to trend), which lowers or raises interest rates, which stimulates or restrains spending on goods and services.

The central bank’s ability to predict how much money should be in circulation, given current employment rates and inflation rates, is often debated. Economists such as Milton Friedman believed that the central bank would always get it wrong, leading to wider swings in the economy than if it were just left alone. This is why they advocated a non-interventionist approach—one of targeting a pre-specified path for the money supply independent of current economic conditions— even though in practice this might involve regular intervention with open market operations (or other monetary-policy tools) to keep the money supply on target.

International Exchange of Money

The foreign exchange market is a form of exchange for international currencies that determines the relative values of different currencies.

Learning Objectives

Discuss the factors that influence supply and demand for currencies

Key Takeaways

Key Points

  • Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.
  • The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay Euros.
  • The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors.
  • At the top is the interbank market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle.
  • Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

Key Terms

  • fixed exchange rate: Sometimes called a pegged exchange rate, a type of exchange rate regime wherein a currency’s value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.
  • exchange rate: An exchange rate between two currencies is the rate at which one currency will be exchanged for another.
  • floating exchange rate: A floating or fluctuating exchange rate is a type of exchange rate regime wherein a currency’s value is allowed to fluctuate according to the foreign exchange market.

In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. For example, an interbank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers where currency trading is continuous (24 hours a day except weekends, i.e., trading from 20:15 GMT on Sunday until 22:00 GMT Friday). The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

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Exchange Rate: In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another.

In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.

The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.