Money and the Money Supply

What is money?

Money is any good that is widely accepted in exchange or repayment of debts. Historically, money has been in the form of gold, silver, copper, rocks, cattle, and shells. Money takes the form of whatever the general population of a society agrees upon. Without money, our society would have to rely strictly on trade in order for people to get the goods and services they want. In a barter economy, you often don’t get what you want because the person you need to trade with doesn’t want the things you have to offer. For example, if you wanted a car, you would have to trade with someone who is willing to give away their car. Joe has a car, but he is looking specifically for a horse in return. Joe will not trade with you because you do not have a horse. Therefore neither you nor Joe can get what you want at that moment. However, if you were able to use money as a way to exchange your goods, you could buy the car from Joe with money and then Joe could buy a horse from someone else with that money.

What are the functions of money?

Money has three major functions. The first function is that money is used as a medium of exchange. A medium of exchange is anything that is generally acceptable in exchange for good and services. Without money, you would have to exchange goods and services directly for other goods and services – an exchange called bartering. If you bought the car from Joe, you were using money as a medium of exchange. Money is part of almost every exchange made in the market and therefore the most important function of money. In order for something to serve as a good medium of exchange, it must be readily identifiable, durable, divisible, stable, and portable.

Money is also used as a unit of account. A unit of account is a common measurement used to express the value of goods or services. We don’t measure prices of goods in terms of another good - all market goods can be expressed in terms of money. For example, we express the value of a house in terms of dollars (say, $280,000), the value of a car in terms of dollars (say, $30,000), and the value of an oil change in terms of dollars (say, $30).

Thirdly, money is used as store of value. A good is a store of value if it maintains value over time. For example, you can sell your labor services today, collect money in payment, and wait for a future date to spend the money on goods and services. You do not have to rush to buy goods and services with the money today, it will store value to be used at a future date. To say that money is a store of value does mean that it is a constant store of value. If prices rise, the value of money falls, and if prices fall, the value of money rises. Liquidity is the term used for something that can easily be converted into cash without losing its value.

The Money Supply

The money supply is physical cash in circulation plus the money held in checking and savings accounts. It does not include other forms of wealth, such as investments, home equity, or assets. They must be sold to convert them to cash. It also does not include credit, such as loans, mortgages and credit cards. People use these as money to improve their standard of living, but they aren't part of the money supply.

Our central bank of the United States, the Federal Reserve, measures the U.S. money supply with two categories: M1 and M2. M1 is a more narrow definition of money. It includes the sum of all currency in circulation (including coins and paper bills), all traveler's checks, and checking account deposits, including those that pay interest. This part of the money supply is very liquid, meaning it includes items that are easily convertible to cash. M2 is a more broad definition of money. It includes everything in the M1 category, plus is adds savings accounts, money market accounts, and money market mutual funds, and time deposits under $100,000. Some economists also refer to M3, which consists of everything from M2 plus larger time deposit accounts (over $100,000), but the Fed does not track M3.

What Isn’t Money? Checks are not money, they are an instruction to a bank to make a payment with your money. A credit card is not money because it does not make a payment; in fact, it’s the opposite. When you use your credit card, you create debt which you eventually pay off with money. A debit card is also not money, it is an electronic equivalent of a paper check.

Fractional Reserve Banking

Money has become much more sophisticated in recent year with the increase in the use of electronic forms of payment, like debit cards and electronic billing - making banks more important than ever. Federal laws define a bank as an institution that accepts demand deposits and makes commercial loans. However, most people today say “bank” when they speak of any financial institution that provides certain financial services, like accepting and holding deposits, making loans, and collecting/transferring funds.

What many people don’t know is that much of the money in our economy is generated through a process called fractional reserve banking. Because about half of the money supply is made up of demand deposits (money deposited that can be withdrawn without prior notice), that money is kept in banks. Under a fractional reserve banking system, when a deposit is made to a bank, that bank is only required to keep a fraction of the deposit amount so that it may lend out the remainder to other customers. This fraction or percentage of your original deposit that must be kept by the bank is called the reserve requirement, or reserve ratio . The rest of your money that is loaned out is then deposited into yet another bank, where a fraction of the amount is retained and the bulk of the deposit is again lent out. This process creates “new money” which is then circulated. For example, if you deposit $100 in the bank, and the reserve requirement is 20%, the bank is only required to keep $20 of your $100, and it will loan the other $80 to other people. Because your $100 is still considered intact and available to you yet a portion of it has also been loaned out to other customers, this system “creates” money where there was none before.

But if your money was lent out, what if you want to withdraw your $100? Is it no longer available? In a system of fractional reserve banking, there must be a central bank that acts as a regulator and insurer of funds for bank customers. In our banking system, The Federal Reserve acts as the central bank which determines the amount of required reserve a bank must keep and has a reserve of money to use in the case that all bank customers want to withdraw their money all at once. In the case of you wanting to withdraw your $100, if the bank did not have the $80 it had already lent out, it would get back-up money from the Federal Reserve in order to make sure you had your money.

Money and the Money Supply Questions

Why does money exist?

Complete the chart about the functions of money Definition Example

Medium of Exchange

Unit of Account

Store of Value

Identify each of the following scenarios as money being used as a medium of exchange (ME), unit of account (UA), or store of value (SV). Scenario Function of Money 1. Joe buys a bag of Doritos from the grocery store. 2. A house is put on the market for $600,000. 3. Mary is paid $30 to mow her neighbor’s lawn.

4. Julian saves for 3 months to buy a new pair of skis. 5. Monica’s Moroccan Restaurant advertises a dinner special for $15.

6. Tina has $2000 in a savings account.

After reading about the functions of money, explain why tomatoes would make a bad form of money.

What are some examples of what money isn’t?

Fractional Reserve Banking

Trace the increase in the money supply from a deposit of $100,000

Deposit at Bank A 100,000 Deposit $______Money Supply Expansion Required Reserves (20%) $______