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CHAPTER
Money and
the Payments System
When you hear the word “money,” do you conjure up images of cash stacked from
floor to ceiling in a bank vault, coins cascading from a slot machine, or a $1 million
check presented to a lottery winner? The cash and the check are money—but to an
economist, the concept of money includes even more. Whether you are a miser, you like
to shop ’til you drop, or you fall somewhere between those extremes, you are undoubtedly familiar with money and its benefits. But to study money, you must know what it
is, what it does, and how it is measured. Those are the objectives of this chapter.
Consider how complicated and costly it would be to buy and sell goods and services if each state in the United States had its own money. Worse yet, what if no one
could agree on what to use as money? Now imagine how much easier traveling from
England to France to Germany to Italy—countries that have used different currencies—
would be if each country used the same currency. European countries have been moving toward such a monetary union because many economists argue that the gains from
such a union would be significant. The union would eliminate the costs of converting
currency in commercial and financial transactions and would unify the European market. The euro—the common currency—made its debut in January 1999, though it had
a rough time in its early years.
This example illustrates one use of money that we explore in this chapter: as a vehicle for improving trade between individuals and the well-being of citizens in an economy. To observe the impact of money on the economy, we need to know precisely what
money is. Therefore, after describing money and functions, we turn to measures of all
the money in the economy—the money supply. Movements in the money supply are
associated with changes in interest rates, inflation, and output—variables that are of
concern to us as households or businesses.
Meeting the Needs of Exchange with Money
Money is an integral part of all modern economies. Why? A partial answer is that
money allows the economy to operate more efficiently and hence improves the standard of living. To see why this is so, consider what life would be like without money.
In economies in early stages of development, most individuals are selfsufficient. They grow their own food, build their own homes, and make their own
clothes and tools. Such societies do not prosper greatly because, in doing everything,
an individual does some tasks well and does others poorly.
In more developed economies, individuals rely on specialization, producing the
goods or services for which they have relatively the best ability. Individuals then
exchange, or trade the goods or services they produce for those they need. If a furniture maker trades with a boat builder, they produce more and better furniture and
boats than if each produced both with no exchange. Moreover, by encouraging
production and higher-quality goods—and thus income—an economy’s allowance for
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CHAPTER 2
Money and the Payments System
13
specialization and trade increases its citizens’ standard of living. To reap the benefits of
specialization, an economy must develop ways for individuals to exchange goods with
one another. Then each person can obtain all the goods he or she needs, or wants, to
consume. We next examine three options that societies have developed to meet the
needs of trade: barter, government allocation, and the use of money.
Barter
Individuals can exchange goods and services by trading output directly with others. This
type of exchange is called barter. For example, the furniture maker could trade chairs
for a bushel of wheat. The furniture maker and farmer might agree that the price of eight
chairs is three bushels of wheat. In a barter system, each such potential trade requires a
price to be set in terms of the two goods.
Although individuals can specialize and be better off in a barter economy than in
an economy without specialization, this system has several drawbacks. First, effort
must be spent searching for trading partners—a type of transactions cost, or cost of
trade or exchange. A second drawback is that each good has many prices. The furniture maker might be able to exchange eight chairs for three bushels of wheat, ten chairs
for a boat, or a table for a wagon. This problem is akin to reading a recipe in which
the amounts of some ingredients are in ounces, others in pounds, others in grams, others in liters, and so on. Baking a loaf of bread would take days! In addition, the prices
are often inconsistent. One furniture store might quote the price of one type of chair as
100 pens, another as 500 eggs, and still another as 20 movie tickets. Needless to say,
you would have to think hard about how to make informed decisions about which is
the best buy! A barter economy with only 100 goods would have 4950 prices; one with
10,000 goods would have 49,995,000 prices.✝
A third complication arises from lack of standardization: A chair and a sack of
wheat can vary substantially in quality and size. A fourth drawback is that each individual must have exactly the good that the other wants for the exchange to take place—
a situation that economists call a double coincidence of wants. Suppose the boat maker
wants to buy wine from a wine maker but the wine maker does not want a boat. Will
exchange take place? The wine maker could accept the boat for a lower value than that
offered by the boat maker and try to trade it to someone else. The wine maker’s willingness to do so depends on whether other traders accept boats in payment for their
goods. Finally, imagine the difficulty of storing value when goods are perishable. Tomatoes are valuable in exchange only when they are fresh, for example.
Government Allocation
Another option is to sidestep voluntary trade and use government allocation to distribute goods and services. In this system, a central authority collects the specialized
output of each individual producer and distributes it to others according to some plan.
Although such a system may seem simpler than barter, it is not likely to prove useful
in a changing economy (even if the authority could make everyone happy initially).
Shifts in the costs of producing individual goods and services or in the value that consumers place on different goods and services will not be reflected in the amount of
goods and services allocated to each individual. Ignoring market forces reduces
✝ These
calculations are based on the formula for telling us how many prices we need with N goods—that is,
the number of prices when there are N items: Number of prices N(N 1)/2.
14
PART 1
Introduction
incentives to produce and leaves consumers unhappy with the goods and services they
receive. The collapse of economic systems in Eastern Europe and the former Soviet
Union during the late 1980s and early 1990s demonstrated that government allocation of goods and services did not successfully replace a market system.
Money
How can people benefit from specialization without incurring the high trading costs of
barter or the misallocations associated with government allocation? They can use
money. Money eliminates the need for people to have a double coincidence of wants.
Money has four key functions that make it the most efficient means of trade:
1. It acts as a medium of exchange.
2. It is a unit of account.
3. It is a store of value.
4. It offers a standard of deferred payment.
As Fig. 2.1 shows, the use of money makes it easier for people to trade with one another.
Money refers to anything that is generally accepted as payment for goods and services or in the settlement of debts, also called the medium of
exchange. For example, currency, such as bills and coins, is one type of money. The
amount of food you can buy at Burger King or Pizza Hut is usually limited by the
amount of cash you have in your pocket. For many purchases, however, currency is too
Medium of exchange.
FIGURE 2.1
Methods of Exchange
Society has developed three methods to gain the efficiency benefits of specialization: barter, government allocation, and the use of money.
Money facilitates trade best by being accepted as a medium of exchange.
Barter
• Goods exchanged
directly
• Requires double
coincidence of
wants
Good for sale
Money
• Goods exchanged
for money
• Eliminates double
coincidence of wants
Government allocation
• Authority allocates
goods and services
• Difficult to make
prices reflect cost
and demand
CHAPTER 2
Money and the Payments System
15
narrow a definition of acceptable money. You can probably buy books at your local
bookstore by writing a check, for example.
To go back to our earlier example, the furniture maker would not have to want
wheat, and the farmer would not have to want a chair. Both would exchange their
products for money. Suppose that a boat maker values gold because other traders do
not want to trade their goods for boats. The boat maker would probably give a furniture maker a better deal on a boat if the furniture maker paid in gold instead of chairs.
In the same way, if a single good, such as gold, were accepted by many individuals with
specialized goods to sell, all would get a better deal in trade. Thus society achieves
greater prosperity when a single good is recognized as a medium of exchange.
Using a good as a medium of exchange confers another benefit:
It reduces the need to quote so many different prices in trade. Instead of having to quote
the price of a single good in terms of many other goods, each good has a single price
quoted in terms of the medium of exchange. This function of money gives traders a unit
of account, a way of measuring value in the economy in terms of money. When an economy uses a commodity such as gold, then each good (such as wheat, chairs, and boats)
has a price in terms of gold.
Unit of account.
A function of money;
the accumulation of
value by holding
dollars or other assets
that can be used to
buy goods and
services in the future.
Store of value. Money allows value to be stored easily, resulting in a store of value:
If you do not use all your accumulated dollars to buy goods and services today, you can
hold the rest for future use. In fact, a fisherman and a farmer would be better off maintaining their wealth in money rather than in inventories of their perishable goods. The
acceptability of money in future transactions depends on its not losing value over time as
its freshness deteriorates.
Hence money is also an asset, or a thing of value that can be owned. We often say that
individuals in Forbes magazine’s list of richest Americans have a lot of money. We don’t
really mean that they have a lot of currency in their pockets (or hidden away in their mansions or yachts) but that they own valuable assets, such as stocks, bonds, or houses.
Money, like other assets, is a component of wealth, which is the sum of the value of assets
less the value of liabilities. However, only if an asset serves as a medium of exchange can
it be called money.
Although wealth and income (the flow of earnings over a period of time) are important measures of value, we do not use these terms interchangeably with money in this
book. That is, the amount of money an individual has is represented by the stock of currency and currency substitutes (such as checking account deposits or traveler’s checks)
owned, not by the stock of wealth or a monthly or yearly salary or flow of income.
Money is not the only store of value. Any asset—shares of General Motors stock,
Treasury bonds, real estate, or Renoir paintings, for example—represents a store of
value. Indeed, financial assets offer an important benefit relative to holding money
because they generally pay a higher rate of interest or offer the prospect of gains in value.
Other assets (such as a house) also have advantages relative to money, as they provide
services (such as a place to sleep).
Why, then, would you bother to hold any money? The answer goes back to liquidity, or the ease with which a given asset can be converted into the medium of
exchange. When money is the medium of exchange, it is the most liquid asset. You
incur transactions costs when you exchange other assets for money. When you sell
bonds or shares of stock to buy a car, for example, you pay a commission to your
broker. If you have to sell your house on short notice to finance an unexpected major
16
PART 1
Introduction
medical expense, you pay a commission to a real estate agent and probably have to
accept a lower price to exchange the house for money quickly. To avoid such transactions costs, people are willing to hold some of their wealth in the form of money, even
though other assets offer a greater return as a store of value.
Web Site Suggestions:
http://www.gpoaccess.
gov/indicators/
index.html
The Council of Economic Advisers’ Economic Indicators offers
information on price
deflators and inflation.
Standard of deferred payment. Money is also useful because of its ability to
serve as a standard of deferred payment in credit transactions. Money can facilitate
exchange at a given point in time by providing a medium of exchange and unit of
account. It can facilitate exchange over time by providing a store of value and standard
of deferred payment. Hence a furniture maker may be willing to sell the boat builder a
chair now in exchange for money in the future.
How important is it that money be a reliable store of value and standard of
deferred payment? People care about how much food, clothing, and other goods and
services their dollars will buy. The value of money depends on its purchasing power,
the ability of money to be used to acquire goods and services. A decline in the purchasing power of money is known as inflation, a condition in which rising prices cause
a given amount of money to purchase fewer goods and services. The opposite condition, in which the value of money increases, indicating falling prices, is called deflation.
You have probably heard relatives or friends exclaim, “A dollar doesn’t buy what
it used to!” They really mean that the purchasing power of a dollar has fallen, that a
given amount of money will buy a smaller quantity of the same goods and services in
the economy than it once did.
Just how much has the dollar shrunk? Consider the quantity of real goods and
services that $1.00 would buy at the beginning of 2003. To buy the same quantity
would have cost 56¢ in 1980, 27¢ in 1970, 20¢ in 1960, 16¢ in 1950, and 8¢ in 1940.
Less than a dime earned in 1940 would buy $1.00 worth of goods and services today!
Obviously, the U.S. economy has experienced significant inflation since 1940.
Changes in the purchasing power of money affect money’s usefulness as a store of
value and standard of deferred payment and, in turn, individuals’ willingness to hold
money. In 1989, newly elected Argentine President Carlos Menem faced an inflation
rate of 12,000% per year. Very high inflation rates—say, in excess of 50% per month—
are referred to as hyperinflation. With such rapid inflation, households and firms
refused to hold official money. Instead they resorted to barter and the use of U.S. dollars. This example underscores our analysis of what serves as money: For money to be
acceptable as a medium of exchange, households and firms must believe that it has
value and will be acceptable. In Argentina, rapid erosion of money’s purchasing power
undermined this belief. Policymakers have significant concerns about maintaining the
purchasing power of official money.
The value of money is determined by the quantity of goods and services you can
purchase with it. Using a price index, a summary statistic that reflects changes in the
price of a group of goods and services relative to the price in a base year, you can see
how the value of money has changed over time. Some commonly used price indexes are
summarized in the appendix to this chapter.
Now that we understand what money is, we’ll examine how money is used to settle transactions in the economy.
What Can Serve as Money?
Having a medium of exchange helps to make transactions easier and thus allows the
economy to work more smoothly. The next logical question is: What can serve as
CHAPTER 2
OTHER
TIMES,
Money and the Payments System
OTHER
Is the Euro a Success?
Effective January 1, 1999, the euro
entered the world of major currencies.
Worth about $1.09 in mid-2003 (versus $1.18 at its introduction), the euro
in early 2002 began circulating as
notes and coins. It replaced national
currencies in Austria, Belgium, Finland,
France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and
Spain.
PLACES
17
...
Will the use of the euro as a currency
benefit Europe? On the one hand, the
new currency lowers the transactions
costs of exchanging currencies, and a
single currency will likely promote
competition in the European Union.
On the other hand, using a single currency can allow some parts of Europe
to boom while other parts languish. In
the United States, where the dollar is
used in all 50 states, a downturn in
one region is cushioned by fiscal
transfers (that is, using tax revenues
collected in one region to cushion the
depressed region), whereas Europe
lacks this important cushion. While
economists have expressed views on
either side, much of the European
support for the euro reflects a political belief that a single currency will
give Europe a large political role in
world affairs.
money? That is, which assets should be used as the medium of exchange? You learned
earlier that an asset must, at a minimum, be generally accepted as payment to serve as
money. In practical terms, however, it must be even more.
What makes a good suitable to use as a medium of exchange? There are five
criteria:
1. The good must be acceptable to (that is, usable by) most traders.
2. It should be of standardized quality, so that any two units are identical.
3. It should be durable, so that value is not lost by spoilage.
4. It should be valuable relative to its weight, so that amounts large enough to be
useful in trade can be easily transported.
5. Because different goods are valued differently, the medium of exchange should
be divisible.
A mechanism for
conducting
transactions in the
economy. Commercial
banks play a key role
in this system by
clearing and settling
transactions in the
economy.
U.S. Federal Reserve Notes meet all these criteria.
What determines the acceptability of dollar bills as a medium of exchange? Basically, it is through self-fulfilling expectations: You value something as money only if
you believe that others will accept it from you as payment. Our society’s willingness to
use green paper notes issued by the Federal Reserve System as money makes them an
acceptable medium of exchange. This acceptability property is not unique to money.
Your personal computer has the same keyboard organization of letters as other computer keyboards because manufacturers agreed on a standard layout. You learned to
speak English because it is probably the language that most people around you speak.
The Payments System
Web Site Suggestions:
http://www.federal
reserve.gov/
paymentsys.htm
Discusses the payments systems.
Money facilitates transactions in the economy. The mechanism for conducting such
transactions is known as a payments system. The payments system has evolved over
time from precious metals to currency and checks to electronic funds transfer services.
Definitive money is money that does not have to be converted into a more basic
medium of exchange, such as gold, silver, or Federal Reserve Notes. The use of definitive money for trading goods and services at a point in time or over time, through
credit, is the simplest type of payments system.
18
CONSIDER
PART 1
Introduction
THIS
...
currency at the time), but Russian merchants and taxi drivers discouraged
payments in rubles. A bewildering
Some years ago, I learned a great les- array of fares were always quoted in
son about money from Russian cab terms of U.S. dollars, German marks,
drivers. In August 1989, along with a or Japanese yen. And the fares varied
group of American economists, I trav- inconsistently from cab to cab.
eled to Moscow and Leningrad (now
St. Petersburg) to discuss with Soviet When I relayed this frustraeconomists some economic problems tion to my wife at our hotel one
evening, she told me that she had
faced by both countries.
encountered no such difficulty. She
Taking taxis in Moscow to and from used Marlboro cigarettes! When I
meetings and dinners was an ordeal. experimented with her Marlboros the
Our hosts had given us rubles (Soviet
What’s Money?
Ask a Taxi Driver!
next day (no other brand worked as
well), I found my exchange problems
vastly simplified. The cigarettes served
as a medium of exchange, as well as a
unit of account, as all the taxi drivers
could easily convert all major currencies to Marlboro equivalents.
Official money (rubles) had been displaced by Marlboros as a medium of
exchange. Marlboros are of standardized quality, are easily recognized,
and retain their value when unused—
a logical money indeed.
Commodity Money
In earlier times, traders used precious metals such as gold and silver as media of
exchange. These physical goods were the dominant means by which trade was accomplished and were known as commodity money. Commodity money meets the criteria
for a medium of exchange, but it has a significant problem: Among other factors, its
value is related to its purity. Therefore someone who wanted to cheat could mix impure
metals with a precious metal. Hence, unless traders trusted each other completely, they
needed to check the weight and purity of the metal at each trade. Respected merchants,
who were the predecessors of modern bankers, solved this problem by assaying metals
and stamping them with a mark certifying weight and purity, earning a commission in
the process. Unstamped (uncertified) commodity money was acceptable only at a discount. It wasn’t long before rulers became interested in this process. If a profit was to
be made from the minting of commodity money of certified purity and weight, why
shouldn’t the sovereign claim it? Kings and dukes with wars and palaces to finance
found this opportunity difficult to resist.
Fiat Money
An economy’s reliance on precious metals alone makes for a cumbersome payments
system. What if you had to transport gold bullion to settle your transactions? Not only
would doing so be difficult and costly, but you would run the risk of being robbed. To
get around this problem, private institutions or governments began to store the definitive money and issue paper certificates representing it. In modern economies, paper currency is generally issued by a central bank, which is a special governmental or
quasi-governmental institution in the financial system that regulates the medium of
exchange. If you look at a U.S. dollar bill, you will see that it is actually a Federal
Reserve Note, issued by the Federal Reserve System, which is the central bank in the
United States. Federal Reserve currency is legal tender in the United States; that is, the
federal government mandates its acceptance to discharge debts and requires that cash
or checks denominated in dollars be used in payment of taxes. Nonetheless, without
everyone’s acceptance, dollar bills would not be a good medium of exchange and could
not serve as money.
CHAPTER 2
Money and the Payments System
19
The modern U.S. payments system is a fiat money system. In such a system, money
authorized by a central bank or governmental body is the definitive money and does not
have to be exchanged by the central bank for gold or some other commodity money.
What this means is that the Federal Reserve System is not required to give you gold or
silver (or even aluminum cans) for your dollar bills. You, along with everyone else, agree
to accept Federal Reserve currency as money. In the United States, the Federal Reserve
System issues dollar bills and holds deposits of banks and the federal government. Banks
can use these deposits to settle transactions with one another. In the United States, the
Fed has a monopoly on the right to issue currency. Although checks drawn on accounts
at private banks are a substitute for Federal Reserve Notes in paying for goods and services, private banks cannot issue their own bank notes.
As of May 2003, Federal Reserve Notes in circulation totaled about $642 billion.
What stops the Fed from issuing as many dollars as it wants? In principle, nothing!
In Part 5, we discuss how much money the Fed circulates. For now, however, let’s
assume that the Fed issues the “right” amount of dollars.
Checks
Paper money can also be expensive to transport for settling large commercial or financial transactions. Imagine going to buy a car with a suitcase full of dollar bills! Another
major innovation in the payments system came from the use of a substitute for definitive money: checks. Checks are promises to pay definitive money on demand and are
drawn on money deposited with a financial institution. They can be written for any
amount and are more difficult to use fraudulently than currency or precious metals are.
As a result, they are a convenient way to settle transactions. Another benefit of using
checks is that traders avoid paying the cost of shipping currency back and forth, as
many payments among parties cancel each other. Traveler’s checks serve a similar purpose; purchased from a financial institution, they are pieces of paper that can be used
to settle transactions.
Settling transactions with checks requires more steps than settling transactions with
currency. Suppose that your roommate owes you $50. If she gives you $50 in cash, nothing further is needed to settle the transaction. Suppose, however, that she writes you a
check for $50. You first take the check to your bank. Your banker, in turn, must present
the check for payment to your roommate’s bank, which then must collect the money from
her account. This process generally takes several business days. Processing the enormous
flow of checks in the United States costs the economy several billion dollars each year.
Checks and other substitutes for definitive money are less liquid than cash, and there
is a cost to using checks. The cost of converting checks affects the seller’s willingness to
accept them in a transaction instead of definitive money. If you had to pay $10 to cash
each check you received, you would undoubtedly prefer to receive cash. Another cost is
the information cost: the time and effort required for the seller to verify whether the
check writer (the buyer) has a sufficient amount of definitive money on deposit to cover
the amount of the check. Accepting checks requires more trust on the part of the seller
than accepting dollar bills does.
Electronic Funds and Electronic Cash
Electronic telecommunication breakthroughs have improved the efficiency of the payments system, reducing the time needed for clearing checks and the costs of paper flow
for making payments. Settling and clearing transactions can now be done with
20
A summary statistic
that incorporates
changes in the price of
a set of goods relative
to the price in some
base year.
Web Site Suggestions:
http://patriot.net/
~bernkopf
Discusses the role of
e-cash.
PART 1
Introduction
computers in electronic funds transfer systems, computerized payment-clearing devices.
Important examples include debit cards for point-of-sale transfers and automated teller
machines (ATMs).
Debit cards can be used like checks: Cash registers in supermarkets and retail stores
are linked to bank computers, so when a customer uses the debit card to buy groceries
or other products, the customer’s bank instantly credits the store’s account with the
amount and deducts it from the customer’s account. Such a system eliminates the problem of trust between the buyer and seller that is associated with checks because the
bank computer authorizes the transaction. Lest you think that such electronic transactions are just futuristic glimpses, the overwhelming majority of the dollar value of
transactions among financial institutions is conducted electronically.
Twenty years ago, you had to stand in line at a bank teller’s window during working
hours to make deposits, withdrawals, and payments. Today, ATMs allow you to perform
the same transactions at your bank whenever it is most convenient for you. Moreover,
ATMs are connected to networks (such as Cirrus) so that you can make withdrawals of
cash away from your home bank. Hence U.S. travelers can withdraw money in Paris to
buy meals and souvenirs. Beyond ATMs, Chemical Bank (before its merger with Chase)
and the First National Bank of Boston introduced in 1995 an electronic check that could
become widely available for payments between computer users on the Internet.
The boundaries of electronic funds transfers have expanded to include electronic
money (or e-money), money that is stored electronically on cards or computer
accounts. The simplest version of electronic money is a debit card (described earlier),
which permits consumers to buy goods and services by transferring funds from their
bank accounts to a merchant’s bank account. Such cards resemble credit cards and are
used with card readers.
Stored-value cards have the physical characteristics of a debit card but contain an
amount of digital cash. That amount can be preset or, on so-called smart cards,
increased as desired. Stored-value cards are common in Europe, Canada, Chile, Australia, Singapore, and China. Some recent developments offer electronic money transfers among individuals. Stored-value cards are in their comparative infancy in the
United States.
Finally, electronic cash (or e-cash) is digital cash employed to buy goods and services on the Internet. The e-cash is acquired by a consumer from an Internet bank and
transferred to a merchant’s computer when a purchase is made. Electronic checks, or
Internet banking, make it possible for consumers to pay bills by e-check over the Internet. Electronic checks significantly decrease the cost of transactions relative to the cost
of paper checks.
The developments in e-money are exciting and lead some commentators to talk
about a “cashless society.” In reality, a cashless society is unlikely. First, the infrastructure for an e-payments system is expensive to build. Second, many households and businesses worry about protecting their privacy in an electronic system that is subject to
computer “hackers.” While the flow of paper in the payments system is likely to shrink,
it is unlikely to disappear.
To summarize, the efficiency of the payments system, which increases as the cost of
settling transactions decreases, is important for the economy. Suppose that the banking
system broke down and all transactions—commercial and financial—had to be carried
out in cash. You would have to carry large amounts of cash to finance all your purchases
and would incur additional costs for protecting your cash. No bank credit would be possible, severely harming the financial system’s role in matching savers and borrowers. Thus
CHAPTER 2
Money and the Payments System
21
disruptions in the payments system increase the cost of trade and credit. Many economists, for example, blame the collapse of the banking system for the severity of the Great
Depression of the 1930s. The efficient functioning of the economy’s payments system is
a significant public policy concern. Governments typically regulate the medium of
exchange and establish safeguards to protect the payments system.
C H E C K P O I N T
Do you think that cash and checks will one day become obsolete and all payments
will be made electronically? What benefits do you see from such an arrangement?
What might prevent such an arrangement from being fully realized? In the early
1990s, analysts speculated that debit cards would soon be used for a significant fraction of consumers’ purchases by the end of the decade. These electronic transactions
are less costly than checks and more convenient for consumers than cash. A cashless
society is not likely, however. Cash would still be used for small purchases. In addition,
certain legal issues have not been resolved, such as whether you would be liable if
someone discovered your secret account access code and illegally transferred funds
from your account. Finally, some individuals value the anonymity afforded by using currency. Individuals engaging in illegal transactions (drug deals or tax evasion schemes,
for example) would be unlikely debit card users. ♦
Measuring the Money Supply
Households, firms, and policymakers are all interested in measuring money because, as
we noted in Chapter 1, changes in the quantity of money are associated with changes
in interest rates, prices, and economic activity. To understand money’s role as an economic variable, we need to measure it.
The definition of money (a medium of exchange for goods and services and the settlement of debts) depends on beliefs about whether others will use the medium in trade
now and in the future. This definition offers guidance for measuring money in an economy. Interpreted literally, this definition says that money should include only those
assets that function obviously as a medium of exchange: currency, checking account
deposits, and traveler’s checks. These assets can easily be used to buy goods and services and thus act as a medium of exchange.
This strict interpretation is too narrow as a measure of the money supply in the real
world, though. Many other assets can be used as a medium of exchange, but they are
not as liquid as a checking account deposit or cash. For example, you can convert your
savings account at a bank to cash without paying a large transactions cost. Likewise,
if you have an account at a brokerage firm, you can write checks against the value of
securities the firm holds for you. Although these alternatives have restrictions and some
transactions costs, these assets are plausibly part of the medium of exchange.
Economists have developed several different definitions of the money supply based
on the differences in the assets included as money. The definitions range from narrow
to broad, depending on how substitutable different assets are for definitive money. Substitutability in this case refers to liquidity, the cost at which an asset can be converted
to definitive money. Thus the most narrow money measure is definitive money itself. A
broad measure would include other assets that could be easily converted to cash—your
checking account or savings account, for example. In the United States, the Fed has
defined certain measures of money as part of its effort to estimate the effects of the
money supply on prices and economic activity.
22
PART 1
Introduction
The Fed has conducted several studies of the appropriate definition of money. This
job has become more difficult during the past two decades as innovation in financial
markets and institutions has created new substitutes for the traditional measures of the
medium of exchange. During the 1980s, the Fed adapted its definitions of money in
response to financial innovation.
Web Site Suggestions:
http://www.federal
reserve.gov/releases/
h6/Current/
Presents data on monetary aggregates in
the United States.
Measuring Monetary Aggregates
Charged with regulating the quantity of money in the United States, the Federal Reserve
has developed three definitions of money that include assets broader than currency. Figure 2.2 illustrates these definitions—referred to as monetary aggregates—graphically.
Let’s see how the current set of definitions works.
The narrowest aggregate measure of money is M1. As Fig. 2.2
shows, M1 measures money as the traditional medium of exchange. M1 includes currency, traveler’s checks, and checking account deposits. Through the early 1980s,
checking accounts were deposits that paid no interest and thus were close substitutes
for definitive money. Since then, financial innovation in the banking industry and government deregulation in the 1970s, 1980s, and 1990s have made more types of bank
accounts acceptable as close substitutes for checking deposits. These new accounts
M1 aggregate.
FIGURE 2.2
Measuring Monetary Aggregates, July 2003
Monetary aggregates offer measures of different definitions of money. Each measure includes the content of the level above plus other assets.
Sources: Federal Reserve Bulletin; Monthly Economic Indicators.
What’s measured?
Billions of dollars
Narrow medium
of exchange
$1247.9
M1
$6071.4
Broader medium of exchange
M2
Broader medium of exchange
and stores of value
$8851.8
M3
What’s included?
M1
Currency in circulation +
• Traveler’s checks
• Demand deposits
• Other checkable
deposits
M2
M1
1+
• Small-denomination
time deposits
• Savings deposits
• Money market
deposit accounts
• Noninstitutional
money market
fund shares
• Overnight repurchase
agreements
• Overnight Eurodollars
M3
M2
2+
•
time deposits
•
market fund balances
• Term repurchase
agreements
• Term Eurodollars
Money and the Payments System
CHAPTER 2
USING
THE
NEWS
23
...
and better information, it revises its money supply. However, forecasters
initial estimates. Revisions to money have found that over longer periods,
stock estimates can be significant, so such as a year, the initial and revised
To find out how rapidly the money initial estimates may not be a reliable money supply series produce similar
supply is growing, consult the “Money guide to short-term movements in the longer-term growth rates.
and Investing” section of The Wall
MONETARY AGGREGATES
Street Journal. On most Fridays, the
(daily average in billions)
Journal publishes data on M1, M2,
1 WEEK ENDED:
Jul. 14
Jul. 7
and M3. The example shown here
Money supply (M1) sa ......................
1266.1
1266.8
Money supply (M1) nsa ....................
1247.9
1259.1
summarizes information for July 25,
Money supply (M2) sa ......................
6084.2
6092.3
Money supply (M2) nsa ....................
6071.4
6101.7
2003. The sa entries have been seaMoney supply (M3) sa ......................
8887.2
8890.3
sonally adjusted. This adjustment
Money supply (M3) nsa ....................
8851.8
8862.7
4 WEEKS ENDED:
removes seasonal fluctuations in the
Jul. 14
Jun. 16
money supply (such as the increase in
Money supply (M1) sa ......................
1272.4
1267.1
Money supply (M1) nsa ....................
1269.8
1263.9
money holdings during the summer
Money supply (M2) sa ......................
6075.8
6026.0
Money supply (M2) nsa ....................
6042.4
5995.3
vacation season or the Christmas
Money supply (M3) sa ......................
8842.7
8727.1
Money supply (M3) nsa ....................
8787.7
8711.4
shopping season) from the data.
Finding Up-to-Date
Information on Money
For the week ending July 14, 2003,
M1 averaged $1247.9 billion. Is this
an exact count of all components of
M1? No. It is based on initial estimates
by the Fed. As the Fed receives more
MONTH
Jun.
May
Money supply (M1) sa ......................
1272.1
1258.3
Money supply (M2) sa ......................
6046.3
6000.0
Money supply (M3) sa ......................
8760.6
8702.5
nsa—Not seasonally adjusted. sa—Seasonally adjusted.
Source: The Wall Street Journal, July 25, 2003, Page C11. Republished
by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc.
© 2003 Dow Jones and Company, Inc. All Rights Reserved Worldwide.
include checking accounts at savings institutions and credit unions, as well as interestbearing checking accounts at commercial banks. Measures of M1 now include these
other deposits against which checks may be written, along with non-interest-bearing
checking account deposits, traveler’s checks, and currency.
M2 aggregate. M2, the next measure of money shown in Fig. 2.2, is slightly broader
than M1. In addition to the assets included in M1, it covers short-term investment
accounts. These accounts can be converted to definitive money but not as easily as the
components of M1. Originally, M2 consisted predominantly of small-denomination time
deposits (less than $100,000) and savings accounts. Now it also includes some assets
that offer check-writing features, such as money market deposit accounts at banks and
noninstitutional money market mutual fund shares.
M3 includes more assets than M2 and M1. In addition to currency,
traveler’s checks, checking deposits, and short-term investment accounts, M3 is composed of such less liquid assets as large-denomination time deposits ($100,000 or
more), institutional money market mutual fund balances, term repurchase agreements,
and Eurodollars.
In addition to monetary aggregates, the Fed reports information on debt as a store of
value. In particular, the Fed reports outstanding credit market debt of domestic nonfinancial sectors. We explore the differences among various debt instruments in Chapter 3.
M3 aggregate.
Selecting Monetary Aggregates
Which is the correct measure of money? The answer depends on the purpose of the measurement. Until the 1980s, M1 was generally accepted as the measure of money. In the
24
PART 1
Introduction
1980s, M1’s role as a measure was challenged as the new substitutes for simple checking
accounts were included in M2. In the 1980s and 1990s, economists and policymakers
generally discussed M2 as the measure of the money supply, though developments in the
financial system during that period have made complicated attempts to define money. The
Fed has also experimented with hybrid measures of money using portions of components
of the monetary aggregates. For example, if money market mutual fund shares are held
for both transactions and investment purposes, they could be allocated in part to an M1type measure and in part to an M2-type measure.
Because the Fed’s monetary aggregates are attempts to measure some underlying
true stock of money, economists and policymakers want to know whether the aggregates move together. For example, if M1, M2, and M3 tend to rise or fall together, the
Fed could use any one of them to try to influence the economy’s output, prices, or interest rates. If these measures of money do not move together, they may tell different stories about what is happening to money. As a result, policymakers would have difficulty
deciding on an appropriate monetary policy.
As is shown in Fig. 2.3, it turns out that monetary aggregates move broadly
together over long periods of time. However, some significant differences in monetary
aggregate movements have occurred during certain periods. For example, while the
growth rate of M1 rose during the 1970s and mid-1980s, the growth rates of the
Growth Rates of M1, M2, and M3, 1960–2002
Monetary aggregates move together broadly over long periods of time. However, their growth rates diverge during some periods.
Source: Federal Reserve Bulletin.
Annual rate (%)
FIGURE 2.3
18
16
M3
M1
M2
14
12
10
8
6
4
2
0
2
4
1960
1965
1970
1975
1980
1985
1990
1995
2000
2001
2002
Year
CHAPTER 2
Money and the Payments System
25
broader M2 and M3 aggregates actually decreased. Hence the different monetary
aggregates give a different picture of movements in the money supply over time.
How then do the Fed and private forecasters decide which measures to use? As we
noted earlier, the Fed continues to experiment with hybrid measures of money in which
different assets have different degrees of liquidity. In addition, Federal Reserve economists, academic economists, and private forecasters conduct research on which monetary aggregates are most closely tied to movements in economic variables, such as the
economy’s total output, the price level, and interest rates. In Part 6, we examine these
empirical approaches more carefully.
KEY TERMS AND CONCEPTS
Asset
Medium of exchange
Purchasing power
Barter
Monetary aggregates (M1, M2, M3)
Specialization
Central bank
Money
Standard of deferred payment
Definitive money
Payments system
Store of value
Deflation
Checks
Transactions cost
Electronic money
Commodity money
Unit of account
Government allocation
Electronic funds transfer systems
Wealth
Inflation
Fiat money
Legal tender
Price index
SUMMARY
1. Specialization increases economic efficiency: Individuals produce things they are good at producing.
Because of such specialization, people create surpluses and need ways to trade the things they produce. The three possible allocations rely on barter,
government allocation, and money. The problem
with barter is that it cannot easily match the highly
specific needs of buyers and sellers. Government
allocation often fails because it misallocates
resources. Money works well in facilitating trade,
allocating resources efficiently, and avoiding the
need for matching each buyer and seller.
2. In its role as a medium of exchange, money is a generally accepted means of payment. A particular item
becomes a medium of exchange because people
believe that it will be mutually acceptable.
3. Money provides a unit of account so that all prices
can be quoted in monetary terms. Money also reduces
the costs of trading over time. As a store of value,
money allows people to hold it today and buy things
with it in the future. As a standard of deferred payment, money makes credit transactions possible.
4. Definitive money is money that does not have to be
converted into a more basic legal medium of exchange.
In commodity money systems, commodities (such as
gold) are definitive money. In fiat money systems, paper
currency and coin issued by the government or central
bank are definitive money.
5. The payments system consists of ways to conduct
transactions in the economy. Over time, payments
systems have changed from simple (paper currency as
the main method of payment) to complex (automatic
clearing of payments by computer and electronic
money).
6. Financial assets are grouped into different monetary
aggregates, depending on their liquidity—that is, how
easily they can be traded for definitive money. The
Federal Reserve System, the central bank of the
United States, defines monetary aggregates and collects data on them. These aggregates include measures designed to reflect money’s role as a medium of
exchange (M1 and M2) and those designed to capture
its role as a short-term store of value (M3).
26
PART 1
MOVING
Introduction
FROM
THEORY
TO
PRACTICE
THE WALL STREET JOURNAL
...
MAY 1, 2001
When Money Isn’t What
You Think It Is
Through four grueling years
Argentine sociologist
of recession, while friends Artemio Lopez says this
and neighbors were losing b “hyper-illiquidity” is intheir jobs, Monica Guerra
creasingly being felt up the
used her thick Rolodex and social ladder. More than
sheer willpower to keep half the Argentines now
business rolling into her living in poverty are forarchitecture studio.
mer members of the middle
But over the past four class, he says, noting that
months, as a banking since October the unemfreeze and a devalued cur- ployment rate has jumped
rency sapped much of the to 24% from 18.3% . . . .
cash from Argentines’
Ms. Guerra’s travails
pockets, the country’s ever- began in December, when the
intensifying financial crisis government froze deposits to
has finally caught up with halt a bank run, allowing
her . . . .
only small weekly withAs Argentina’s econ- drawals. It destroyed her
omy ground virtually to a business designing middlehalt in recent months, even income housing, since home
the most resourceful mem- buyers could no longer access
bers of the middle class their savings. Another blow
have resorted to similar followed when Argentina
informal work and finan- allowed the currency to
cial acrobatics. Barter devalue in January: The city
clubs are now common in government abruptly termithe capital’s leafy suburbs. nated her design contracts,
Buenos Aires homemakers and most real-estate comare taking long rides to the merce ceased.
outskirts of town, to shop
At first Ms. Guerra,
a at discounted produce who counts politicians and
markets. Consumers who captains of industry among
once scoffed at the provin- her friends, started calling
cial scrip that circulates in around to drum up business
Buenos Aires find they or even take on part-time
don’t have much else to work. But even a call to the
spend.
assistant cabinet chief, an
old acquaintance, yielded
no results. And she got little
response from sending out
hundreds of resumés, including to design firms in
Switzerland and Brazil.
“For the first month and a
half I cried all day. I thought
it was my own fault,” she
recalls, as her daughter
Natalia, 11, nods in recognition.
Ms. Guerra, a divorcée
who supports her children
mostly unassisted, had little money in the bank to
cushion the blow. She
started by slashing costs:
buying cheaper brands at
the supermarket, turning
off lights at home, mending last year’s rugby jerseys
and cutting small luxuries
like taxis . . . .
To stay a step ahead of
the crisis she also assiduously follows the local
news. She was tuned into
the radio news on a recent
Friday when the government announced that an
open-ended banking holiday would begin the following Monday. Rushing
to the bank, she emptied c
her savings account.
CHAPTER 2
ANALYZING
THE
Money and the Payments System
NEWS
Argentina’s default on its outstanding
government debt in late 2001 led to
the virtual collapse of its domestic
banking system. When the Argentine
government froze most consumer bank
balances, the question of what would
be “money” in Argentina came to the
forefront of daily life.
a Before the crisis, Argentina held
to a simple monetary rule: One
Argentine peso equals one U.S. dollar.
Earlier, in August 2001, to generate
additional liquidity, the country’s
Buenos Aires province issued another
currency—the patacon. The province
asserted the new currency would be
legal tender to pay public employees
and suppliers. While most businesses
failed to accept patacons at face value,
the scrip circulated as a shadow
money as the official financial system
collapsed. The province agreed to pay
27
...
7% interest after one year to patacon
holders.
Another solution is old-fashioned—
barter. An increase in barter retarded
commercial and financial transactions
in Argentina. The loss of faith in official
money can be costly for an economy.
the government’s broken promises on
currency conversion. Consumers and
businesses lose from the switch into
currency, as banks can no longer offer
much value for maintaining transactions and savings balances or for recycling deposits into credit in the
economy.
b The loss of an agreed-upon For further thought…
money makes it hard for businesses to transact with one another, What would be the pluses and minuses
pay workers, or borrow and repay for Argentina if it simply dollarized—
funds. While U.S. dollars could be used that is, used U.S. dollars as money?
as a currency, the collapse in the
Source: Excerpted from Pamela Druckerman, "Argentina’s Middle
peso’s value wiped out the savings of Class Makes Do," The Wall Street Journal, May 1, 2002, Pages A14,
many Argentines. The wildly fluctuating A16, © 2002, Dow Jones. Reprinted with permission.
values of quasi-moneys such as the
patacon offered a poor store of value
for savers and businesses.
The desire to convert money balances from bank deposits to cash
was heavily influenced in Argentina by
c
28
PART 1
Introduction
REVIEW QUESTIONS
QUIZ
1. What makes a dollar bill money? What makes a personal check money? What factors, if changed, would
affect your willingness to accept a dollar bill or a
check as money?
2. How does specialization improve an economy’s standard of living?
3. What are the costs of a barter system?
8. How does high and accelerating inflation change the
value of money? How does it change the usefulness of
money as a medium of exchange?
9. Is the store-of-value function unique to money? If
not, give some other examples of stores of value.
Must money be a store of value to serve its function
as a medium of exchange? Why or why not?
4. What are the four main functions of money? Describe
each function.
10. Which roles of money are adversely affected by
inflation?
5. What is commodity money? How does it differ from
fiat money?
11. What is the purpose of having several definitions of
the money supply? Why doesn’t the Federal Reserve
simply decide on the best definition of the money supply and discard the other definitions?
6. How does a monetary system affect the development of
a credit system? If legal money is not broadly accepted
as a medium of exchange, are credit contracts likely to
be expressed in monetary terms? Why or why not?
12. Why aren’t credit cards included in any of the definitions of the money supply?
7. What is a payments system? If there were a decrease
in the efficiency of the payments system, what would
be the cost to the economy?
ANALYTICAL PROBLEMS
QUIZ
13. During the late nineteenth century the United States
experienced a period of sustained deflation. How
might this have affected money’s usefulness?
14. Why might a $20 Federal Reserve Note be more
desirable as a form of money than a $20 gold coin
from the point of view of an individ-ual? How about
from the point of view of the government?
15. Why would someone keep currency in his or her
pocket when money in the bank pays interest?
16. Suppose that your bank lowers its minimum balance
requirement on a NOW account (a checking account
that pays interest). You take $500 out of your NOW
account and put it in a passbook savings account (a
type of savings deposit) that pays a slightly higher interest rate. What is the overall effect on M1 and M2?
17. If your income increases 10% in a year, are you better off? Why or why not?
18. Suppose that a primitive economy uses a rare stone as
its money. Suppose also that the number of stones
declines as stones are accidentally destroyed or used as
weapons. What happens to the value of the stones over
time? What would be the consequence if someone discovered a large amount of new stones?
19. Consider the country of Friedmania, where the
money is gold crowns, each of which contains 1 gram
of gold. The Royal Mint in Friedmania freely makes
crowns out of raw gold. Then one day a new king
orders the mint to put only 0.9 gram of gold in all
new crowns and orders that the new crowns trade
one-for-one with the old crowns. What do you think
happens to the use of crowns as a medium of
exchange? If you lived in Friedmania and had some
old crowns and some new crowns, which would you
spend first?
20. During the 1980s, broad price indexes in Germany
rose less than those in Italy. What should happen to
the value of money in Germany relative to the value
of money in Italy? Suppose that Germany and Italy
trade freely. What would happen to the purchasing
power of Germans buying Italian goods? Of Italians
buying German goods?
21. Define “liquidity.” Rank the following assets in terms
of liquidity, from most to least liquid: money market
mutual fund, passbook savings account, corporate
stock, dollar bill, house, gold, checking account.
22. Match each of the following items with the smallest
monetary aggregate (M1, M2, or M3) of which it is
part: money market deposit account, term repurchase
CHAPTER 2
Money and the Payments System
agreement, commercial paper, traveler’s check,
overnight repurchase agreement, U.S. savings bond,
currency, large time deposit, small time deposit,
short-term Treasury bond, checking account.
Questions 23 and 24 pertain to the appendix.
23. The consumer price index (CPI) had the value 148.2
for 1994, with 1982–1984 as the base period (that is,
the CPI over 1982–1984 is taken as 100). Now sup-
29
pose that 1994 becomes the base year (that is, the
new CPI in 1994 is taken as 100). What is the new
CPI for 1982–1984?
24. If the price index was 100 for 1993 and 120 for 2003,
and nominal gross domestic product (GDP) was $720
billion for 1993 and $960 for 2003, what is the value
of 2003 real GDP in terms of 1993 dollars?
DATA QUESTIONS
Questions 25 through 28 pertain to the appendix.
25. In the latest copy of the Economic Report of the President, (a) look up the value of nominal GDP (the
value of all final goods and services produced in the
economy during the course of a year) for 1992 and
2002; (b) find the value of the GDP implicit price
deflator in 1982 and 1992; (c) calculate real GDP for
both years; and (d) find the percentage change in real
GDP over the decade.
26. Find the consumer price index in the latest copy
of the Economic Report of the President. Find
the value of the index in the years 1960, 1970, 1980,
1990, and 2000. Calculate the inflation rates for the
decades of the 1960s, 1970s, 1980s, and 1990s.
27. Repeat Problem 26 for the GDP implicit price deflator and the producer price index. How do the inflation rates compare?
28. In the latest issue of the Federal Reserve Bulletin, find
the current figures for M1, M2, and M3. Now look in
the Economic Report of the President to find the latest data on the population of the United States.
Divide the money aggregate numbers by the population to get average money holdings per person. Do
the numbers look reasonable to you? Explain why the
numbers are so large.
29. The Council of Economic Advisers’ Economic Indicators offers information on price deflators and inflation at http://www.gpoaccess.gov/indicators/browse.
html. Find the most recently listed report, and compare changes in consumer and producer prices over
the past 10 years. Has the inflation rate increased or
decreased during this time period? Which variable—
consumer or producer prices—is more volatile?
30. Technology has greatly increased the volume of electronic funds transfers in recent years. Consider this
effect on the U.S. payments system. Go to the Federal
Reserve’s Payment System’s web site (http://www.federalreserve.gov/paymentsys.htm) and look at the Fedwire Funds Service’s annual statistics for the past ten
years. How much has the volume of transfers originated increased over the course of the years listed?
Compute the ratio of volume of transfers originated to
value of transfers originated for the years 2002, 1998,
and 1994. Discuss possible reasons why this figure has
changed during this time period (besides improvements
in electronic technology that have occurred).
31. The Federal Reserve regularly publishes data pertaining to monetary aggregates. Look at the most recent
money stock measures in the Federal Reserve Statistical Release at http://www.federalreserve.gov/releases/
h6/current/. Compute, compare, and discuss the percentage changes in M1, M2, and M3 over the past
two years.
32. Perhaps the most popular CPI calculator on the Internet is managed by the Federal Reserve Bank of Minneapolis. Go to its web site at http://woodrow.mpls.
frb.fed.us/research/data/us/calc/ and compare the purchasing power of a dollar from the year you were
born to today.
30
PART 1
Introduction
31
PART 1
Introduction
APPENDIX
Calculating Price Indexes
A price index is calculated by dividing the price of selected goods making up a market
basket P in some year t by the price of the market basket in a base year 0 (and multiplying by 100 to convert to percentage terms):
(Price Index)t =
P1
× 100.
P0
For example, if prices increased by 20% between the year 0 and year t, the index would
be 1.20 100 120.
The most commonly watched price indexes in the United States are the following:
GDP deflator: the index of prices of all goods and services included in the gross
domestic product (the final value of all goods and services produced in the economy).
Producer price index (PPI): the index of prices that firms pay in wholesale markets for crude materials, intermediate goods, and finished goods.
Consumer price index (CPI): the index of prices of the market basket of goods purchased by urban consumers (used as a measure of the cost of living).