In part 1 of this series, I discussed the bank run scene in the movie It’s a Wonderful Life. In the scene, the depositors at the local building and loan lined up to withdraw their money from the institution. The protagonist, George Bailey, then uses his and his wife’s honeymoon money to pay out claims to the depositors, thus stopping the panic. What were these pieces of paper that Mr. Bailey was handing out?
Given the picture of Herbert Hoover on the wall, the scene likely occurs in 1932. One of the interesting things about the Great Depression is that it was a period in which industrial countries rapidly moved from one monetary system to another. In 1932, the currency which George Bailey was dispersing to depositors was the Federal Reserve Note – a currency issued by the (relatively) recently formed U.S. central bank. The quantity of these notes was partially backed by the quantity of gold held in the vaults of the federal reserve banks. As such, the country was on a “gold standard,” meaning that holders of these notes could convert them into gold at the price of $20.67 per ounce. However, President Roosevelt suspended convertibility in 1933. Ever since then, the U.S. has been on a “fiat” money system.
So, what exactly is money?
Economists define money based on the three functions in which it must serve. These functions are to serve as a medium of exchange, a store of value, and a unit of account.
Money as a Medium of Exchange
The most basic function of money is as a means of payment in exchange for goods and services. To highlight this, economists often imagine a world without money. In such a world, individuals exchange goods and services directly for other goods and services. This mechanism of direct exchange is known as “barter.” In a barter economy, an exchange can only occur when there is a “double coincidence of wants.” By this, we mean that someone who, say, grows pumpkins and wants shoes must find someone who has shoes and also wants pumpkins.
Economists recognize that the barter example is hypothetical. Early writers on monetary theory assumed that money was a kind of evolution stemming from early mankind’s use of barter. However, this seems false, as there is no archeological evidence of early societies relying exclusively on barter. Rather, transactions often involved “IOUs,” which entitled the holder to some good or service provided in the future. If the guarantee of the IOU was strong enough, the IOU itself could circulate as a medium of payment. Many transactions, then and now, occur this way.
However, the reference to barter is still instructive in showing the utility of money. For example, take money out of the equation and every good must be “priced” in reference to every other good in the economy. So, even in an economy with a small amount of goods and services, the number of relative prices for each good grows impractically large. (Structured as a combinatorics problem of arranging pairs, an economy with one hundred goods and services would have 4,950 different relative prices).
We can also see money as a means of promoting specialization and efficiency. By eliminating the need for direct exchange, money allows each member of an economy to focus on the most efficient use of their skills
So, how does a society choose a particular form of money to act as this medium? A given form of money becomes widely accepted partly from social convention and partly because a government declares such money as “legal tender.” By legal tender, we mean that the state has designated such money as the medium of payment for taxes and the settlement of contracts (the enforcement of private contracts being one of the most important functions of the state). In this way, the state can guarantee demand for the designated form of money. In this sense, money is both a creature of social convention and an instrument of the state.
Money as a Store of Value
For a given form of money to continue in use, holders must trust that it will purchase future goods at roughly the same rate of exchange at which it will purchase current goods.
Changes in the price level determine how well money serves as a store of value. For longer periods, many assets serve as (superior) stores of value. For example, someone saving for retirement is likely to swap money for assets such as stocks, bonds, or real estate, given that these assets are more likely to generate a return exceeding the rate of inflation (the decline in the amount of goods and services which money will purchase). Over shorter periods, however, individuals will prefer liquid assets – assets which can be sold quickly without impairment in value. Since money is the most liquid asset, individuals will choose to hold money in lieu of less-liquid alternatives.
Money as a Unit of Account
Money is also an abstract unit of measure, similar in concept to other units of measure. For example, when we think of a measure of distance, such as an inch, foot, meter, etc., we tend to think of the distance which these measures represent. However, an inch or a meter are merely abstract representations of distance, rather than distance itself. Likewise, units of currency such as dollars ($), euros (€), and yen (¥) are abstract representations of economic value. Of course, we have tokens of euros, dollars, and yen – i.e., the paper and coinage which represent these units and fractions thereof – but the physical should not deter from the abstract. Besides, these tokens represent a small portion of the money supply. In modern economies, most “money” exists in electronic form as balances held in bank accounts.
The Monetary Standard
In modern economies, money is known as “fiat” money in that it is backed only by the full faith and credit of the issuing government (“fiat” means decree). This is in contrast to a commodity standard, such as the gold standard, where a certain quantity of a commodity “backs” the paper issuance.
Economists refer to fiat money as a monetary standard. In a monetary standard, the central bank influences the amount of money which is in circulation. And if the rate of money growth exceeds the rate of growth of the production of goods and services, prices will increase (inflation). However, most central banks operate under a legislative mandate to promote stable prices. They attempt to do so by influencing the amount of credit and money in the economy, primarily through the adjustment of a short-term interest rate (in the U.S. this rate is the federal funds rate). We will explore the role of central banks and the money supply process in subsequent posts.
Measures of the Money Supply
In a monetary system, authorities often try to measure the amount of “broad money” within the economy. The idea being that the money supply (however defined) gives policy makers a general idea of the amount of purchasing power held by households and firms, and thus the potential to generate higher prices.
In the U.S., the most cited measures of the money supply are M1 and M2.
M1 is a measure of the most liquid assets held by the public. Thus, M1 is the sum of currency held by the public, demand deposits (checking accounts), and other checkable deposits.
M2 is the more widely used measure of the money supply. M2 consists of M1 plus small time deposits, savings accounts, and money market accounts.
Over shorter time periods, the relationship between the money supply and prices has been less dependable. Over the longer run, however, there is a clearer causal relationship between money supply growth and higher prices.
Conclusion
Throughout history, societies have developed means of exchanging goods and services. Money is based on trust – people must believe that others will accept the medium as payment before accepting the medium themselves.
The prime function of money is to serve as a medium of exchange. But money also serves two other functions. First, money acts as a temporary store of purchasing power. Second, money acts as a unit for measuring economic value.
Our current system is a “paper” or “fiat” money system, in that it is unbacked by a commodity or precious metal. In such a system, the central bank plays a prime role in controlling the scarcity or abundance of money.
In part 3 of this series, we will examine the evolution of the monetary system in the United States.
Sources:
Capra, Frank. It’s a Wonderful Life. Hollywood, California. Liberty Films, 1946.
Coggan, Philip. Paper Promises: Debt, Money, and The New World Order. New York: PublicAffairs, 2012.
Mishkin, Frederic. The Economics of Money, Banking, and Financial Markets, 2nd ed. New York: Addison-
Wesley, 2010.
