What is Money?

From an economic viewpoint, money is anything that is generally accepted as final payment for goods and services or for the repayment of debt - cash/currency, checks, gold, tobacco, salt, etc.

To start our discussion of money, its functions, etc. first imagine what the economy would be like if we didn't have money.  Trade would still take place, but how would we execute trade?

Barter - trading goods and services for goods and services.

Problems with barter:




When do we see barter re-emerge? When the price system breaks down.

1. Hyperinflation - Germany after WWI, 1000%/month, price level rose 30Bx in two years. See pages 666-667.
2. High marginal tax rates - income tax evasion
3. Non-convertible currency (Pepsi and Stolys Vodka)
4. Price controls

Because of the obvious inefficiencies of barter, some form of money has almost always emerged in economies and societies throughout history (just like language emerges to facilitate communication), usually in the form of  COMMODITY MONEY , to facilitate trade and exchange.  Even the U.S. until 1970 had a weak link to commodity money - how??

Point: A well-functioning, efficient monetary system contributes to our high standard of living by significantly lowering the transaction costs of trade.

Examples of commodity money in history:
1. Old Testament mentions salt. It was used as money. The word "salary" comes from salt. 
2. Tobacco - prisons, POW camps, Russia, early US colonies. Tobacco was the legal currency for 200 years in the early colonies - VA, NC, etc.
3. Gold and silver and copper coins

Question: How is inflation caused under a gold standard?

Five Desirable Characteristics of Commodity Money:
1. V
2. IV
3. P
4. D and H
5. D/NP.

Tobacco experience in the early colonies illustrates two basic concepts in monetary theory: 1) inflation and 2) Gresham's Law

Since money supply was not originally fixed or limited in any way, there were constant problems with price inflation. Too much money chasing too few goods. Individual tobacco growers were upset, because the increase in the MS (tobacco) decreased the purchasing power of their crop. Laws were passed to try to control production of tobacco by 1) preventing some people from growing it, 2) destroying part of the crop each year and 3) prohibiting growing for one year, etc. Nothing worked, riots broke out and people went around destroying tobacco crops. Eventually tobacco was abandoned as commodity money.

Gresham's Law - "bad money drives out good money." If there are two types of money, and one is more valuable than the other, the inferior money/bad money gets used/circulated and it drives the valuable/superior money out of circulation. People will hoard the "good" money and not spend it. Taxes, debts, payments were specified in terms of bales of tobacco. Tobacco growers used the poorest quality tobacco for payments and kept the best tobacco for export to Europe in exchange for "hard" currency - gold and silver. Only the poorest quality tobacco circulated.

Other examples of Gresham's Law:
1. 1964 - silver was eliminated from the US quarter and dime. People started to hoard the pre-1964 coins.
2. Coin collecting - removing the valuable coins from circulation.

Fiat money - the world has now gone to fiat money, or paper money, backed by the issuing agency, usually the fed gov or central bank.  Why are people willing to accept "worthless" paper for payment of labor services or goods, etc.??




Whether money is salt, gold or silver coins, or green paper, it serves three functions in the economy.

1. Unit of Account - Money is used to price goods and services, deferred payments (debts). Money is used as a standard of value, measuring rod of value, as our unit of measure for pricing goods/services. Everything is priced in US in terms of dollars, makes comparison shopping very easy. Money as a unit of account allows us to avoid barter, we price everything in a common measure, like dollars or Yen, to reduce the cost of conducting trade.  

At a 1000 good supermarket, there are 1000 prices. In a barter economy there would be about 500,000 terms of trade or trading ratios, see formula at the bottom of page 50.

Using money as a unit of account facilitates and simplifies trade, credit and accounting by reducing transaction costs.  Having a standard unit of account facilitates accounting and bookkeeping. How would you produce an income stmt or balance sheet under barter?

However, unlike a unit of measure like feet, or pounds, or liters, the unit of account (money) changes in value over time due to what???  We need to adjust for this.

2. Medium of Exchange - using money to make final payment for goods and services. Goods are priced in dollars and we use dollars to make payment, to avoid barter, and avoid the "double coincidence of wants."

Using money as medium of exchange and unit of account lowers transactions costs.

M1 = money as medium of exchange = cash, checks (demand deposit) and travellers checks.  This function of money distinguishes money from assets like stocks and bonds, which cannot be used for final payment.

3. Store of Value - money can be used to store wealth/value/income for future consumption/spending.  Savings = deferred consumption.  Allows us to transfer purchasing power forward into the future. Money is only one of many assets that can be used to store wealth/income for future spending - stocks, bonds, real estate, art, jewelry, baseball cards, etc.

Advantages of money as a store of value?

Disadvantages of money as store of value?

Most of the time, in most countries, a single monetary unit fills all three functions of money. In US, prices are in dollars, we make final payment in dollars, and we use dollars as a store of value.

Not always the case:
1) Casino. Unit of account? Med of exchange?
2) Israel - unit of acct (dollars), med of exchange (shekls) Menu Costs
3) Stamps used to be accepted as med of exchange
4) Subway tokens
5) SDRs (pound, dollar, mark, Yen and FF)
6) ECUs (basket of currency)
7) Cuckoo's Nest - cigarettes used in card game.

See page 53, discussion of Euro - European Union.
Advantages of Euro? Disadvantages? Controversial


Innovation in money and payment systems because of cheap computer technology.

1. Debit card - not a charge card. Alternative to writing a check. Funds are immediately taken from your account.

2. Stored-value card - Fixed amount of stored digital cash, like the copy cards in the library, but for general use. Looks like a charge card, debit card. More common outside the U.S. - Europe, Canada, S. America, etc. Alternative to cash, checking. Smart cards are reusable sophisticated stored-value cards. Tested at the 1996 Atlanta Olympics.

3. E-cash, Digital cash. Money of the future? For use on the Internet to purchase products online.

4. Electronic checks. Allows you to pay bills over the Internet without writing a check. You authorize payment after logging onto your account at the bank. Advantage: cheaper, easier, more convenient than a paper check for you, the bank and the company you are paying. No stamp, reduced processing time, less check clearing cost, no bank statement/cancelled check to mail out.....

CASHLESS SOCIETY?  Probably not. Why?

1. There is a cost to setting up computers, card readers, network, telecommunication, etc. However, that cost is approaching zero.

2. Paper checks provide a physical receipt, advantage.

3. Paper checks provide the check writer with several days of "float" - the period that it takes for the check to clear before the funds actually get transferred.

4. Privacy and security concerns about digital cash, etc. People (hacker) could possibly get into your bank account and steal funds by transferring them. Also, your personal data, buying habits may not be totally private on the Internet. Government, marketers, employees may be able to get info about you.

Conclusions: we are moving toward a cashless society, but the trend will probably be gradual, due to the issues raised above.


To conduct monetary policy, we need to measure money, so we therefore need a precise definition of what money is.  Definitions of money are somewhat arbitrary. We can define money very narrowly or broadly. And we can use either a theoretical approach or an empirical approach. Pure definition vs. practical definition. In other words, we want to measure money in such a way that it allows us to predict the rate of inflation or the business cycle, for example. This is the practical approach - choose the definition of money that best predicts, or has the closest relationship to inflation.

Conclusion: the precise definition of money is elusive. Somewhat of a problem because FRS and policymakers are supposed to manage the economy, they need to know how to measure money.

One solution is to use different measures of money, and we use three: M1, M2, M3.

1. The narrowest definition is M1, looking only at money in its function as a medium of exchange. M1 = Cash, checking accounts and traveller's checks, since those are the only forms of money that can be used to make a final payment.  

Note: Banks couldn't pay interest on checking accounts (and until mid 70s only commercial banks could offer checking accounts) from 1933-1980, so M1 originally included all non-interest bearing forms of money. Now all banks offer checking accounts and many do pay interest on checking accounts.  Checking accounts now include Demand deposits, which pay 0 interest and Other checkable deposits do pay interest, see page 58.

Total M1 currently $1100B or $1.1T. Currency = $460B and Checking deposits  = $630B (approx.)

2. M2 = M1 + we add forms of money that are used as "Store of Value" - Savings Accts, CDs, Money market accounts, money market mutual funds, overnight Eurodollars, overnight repurchase agreements. $4.4T (approx).  These forms of money are less liquid than M1, but are still highly liquid

3. M3 = M2 + Slighly less liquid forms of savings: Large CDs, institutional money market accts, term Eurodollars, term repo agreements, etc. $5T approx.

See page 59, graph. M2 and M3 move closer together. M1 more volatile. M2 more stable. Graphs in Ch. 1 (p. 9, 10, 12) use M2.  We can also see that in the last ten years, M1 has moved differently than M2/M3.  Recently, M2/M3 have been rising and M1 has been falling or steady, showing that different measures of money move differently, and indicating that monetary policy can be complicated.


All econ data gets revised, including MS. MS gets reported every week, data gets revised later. Some initial reports are estimates - small banks only report to FRS periodically - data gets revised. Also, seasonal adjustments get made. Adjustment factors may change as more data gets added to sample.

See page 61, for an example of money supply revision. The changes cancel out. Initial rate = 5.5%. Revised rate = 5.6%.

Point: put more faith in long run measures, over years, than short term measures, monthly....

Problems: 2, 3-6, 8-10