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What Is Money?
Learning Objectives
1. Define money and discuss its four basic functions.
2. Distinguish between commodity money and fiat money, giving examples of each.
3. Explain demand for money and factors that affect demand affect demand for money
4. Define what is meant by the money supply and tell what is included in the Central Banks’ Reserve System’s two definitions of it (M1 and M2).
If cigarettes and mackerel can be used as money, then just what is money? Money is anything that serves as a medium of exchange. A medium of exchange is anything that is widely accepted as a means of payment. In Romania under Communist Party rule in the 1980s, for example, Kent cigarettes served as a medium of exchange; the fact that they could be exchanged for other goods and services made them money.
Money, ultimately, is defined by people and what they do. When people use something as a medium of exchange, it becomes money. If people were to begin accepting basketballs as payment for most goods and services, basketballs would be money. We will learn in this chapter that changes in the way people use money have created new types of money and changed the way money is measured in recent decades.
Functions of Money and Its Demand
Can you even imagine a world without money? How would we conduct everyday transactions? How would we price items? Money has great significance in an economy as it performs four important functions. Let us learn more about these functions of money as well as the demand for money.
Table of content
2.2 Browse more Topics under Money And Banking
2.5 Standard for Deferred Payment
Functions of Money
Economists define money via four of its basic functions. These functions will help us understand the importance and need of money as far as the economy is concerned.
Unit of Account
Say you went to a shop and started browsing around. You see the price of the products on display. They are all expressed in terms of money (rupees in this case). The cake is a hundred rupee, the pencil is ten rupees, the sneakers are a thousand rupees and so on. So as you can see, money is the basic unit of account or measurement of everything in an economy.
It is very important to have a uniform unit of account in an economy. The barter system does not work in all cases. So it is highly efficient and convenient to have a uniform base for all transactions, i.e. money. It is the foundation of every economic transaction happening anywhere around the world.
Browse more Topics under Money And Banking
· Instruments of Monetary Policy and the Reserve Bank of India
Medium of Exchange
This is what most economists consider the most important function of money. Money has the ability to satisfy all your unlimited needs and wants. You want the cake, or the pencil, or the sneakers, or all of them. The money will give you the ability to buy it all.
One can argue you can also barter for the goods. But then you would have to have some service or product that the shop owner wants. And it also has to be of equal value. Say the shop owner wants 5 pairs of socks in exchange for the sneakers but you do not possess them. Then you cannot buy the sneakers. The exchange can only take place if there is a double coincidence of wants. This is why money is of such essence, it makes these transactions possible with minimum effort and maximum ease.
Store Value
Money means liquidity, i.e. it is the most liquid asset. It is the most convenient way to store wealth since you can use to buy any goods or products directly. It requires no conversion. This is what we call the store value of money.
If one was to store their wealth in other commodities, like gold or shares, there is a risk. These commodities do not have a stable value. However, money does not fluctuate in value, it’s value/worth remains stable. This is one of the biggest advantages of storing the value in money or currency.
Standard for Deferred Payment
Deferred payment is any payment that is to be made in the future. Like if you have taken a loan or buy goods on credit. The payment of these transactions has to be made on some date in the future. So these amounts are measured in terms of money. And they are ultimately paid in money as well. This is because the value of money remains stable in any economy. And so one of the most important functions of money.
(Source: Money control)
Demand for Money
We will be seeing here the Keynesian approach for calculating the demand for money. Money is the most liquid asset in the world. We can exchange it for any commodity or service and so people prefer to hold on to their cash. But then there is also the opportunity cost of money. Instead of preferring liquidity if the money was invested it would earn interest. And so the demand for money is the balance between these two motives.
Transaction Motive
Money is a medium of exchange and this function of it’s gives rise to the transactional motive for demand for money. We regularly need money to pay for goods and services. And such financial transactions can be of two types – income motive and business motive.
The income motive is to bridge the gap between the receipt of the income and its eventual disbursement. And the business motive is to bridge the gap between the time when costs are incurred and the time when you receive the sale proceeds. If these time gaps are smaller, the person will hold less cash for his transactions and vice versa.
There may be other factors involved for the changes in transactional demand for money like the expectation of income, interest rate, business turnover etc. And from the above factors, we conclude that transactional demand for money is a directly proportional function to the level of income. We express this as
L1 = kY
Where L1 is transactional demand for money, k is the proportion of income kept for transactions and Y is income.
Speculative Motive
The other important function of money is that it is a store value of wealth, i.e. it is an asset. And the demand for any given asset depends on its opportunity cost and its rate of return. Now money does not have a rate of return but it has an opportunity cost. The opportunity cost of holding money is the interest it could earn by being invested in some bond.
The speculative motive for demand for money arises when investing the money in some asset or bond is considered riskier than simply holding the money. The speculative motive for demand for money is also affected by the expected rise or fall of the future interest rates and inflation of the economy.
If interest rates are expected to raise the opportunity cost of simply holding the money will also rise and reduce the speculative motive. And if inflation is expected to rise, money will lose its purchasing power and again speculative income will drop.
Solved Question for You
Q: Transactional demand for money is ______ proportional to the level of income
a. Directly
b. Inversely
c. Depends on the situation
d. Not proportional
Ans: The correct option is A. Transactional demand for money is a directly proportional function to the level of income. It is expressed as L1 = kY.
Money Supply Definition
Investopedia / Madelyn Goodnight
What Is the Money Supply?
The money supply is all the currency and other liquid instruments in a country's economy on the date measured. The money supply roughly includes both cash and deposits that can be used almost as easily as cash.
Governments issue paper currency and coin through some combination of their central banks and treasuries. Bank regulators influence the money supply available to the public through the requirements placed on banks to hold reserves, how to extend credit, and other money matters.
KEY TAKEAWAYS
The money supply refers to the amount of cash or currency circulating in an economy.
Different measures of money supply take into account non-cash items like credit and loans as well.
Monetarists believe that increasing the money supply, all else equal, leads to inflation.
Money Supply
Understanding Money Supply
Economists analyze the money supply and develop policies revolving around it through controlling interest rates and increasing or decreasing the amount of money flowing in the economy. Public and private sector analysis is performed because of the money supply's possible impacts on price levels, inflation, and the business cycle. In the United States, the Federal Reserve policy is the most important deciding factor in the money supply. The money supply is also known as the money stock.
$20.55 TRILLION
As of December 2021, the Federal Reserve reports the M1 money supply was a record $20.55 trillion.1
Effect of Money Supply on the Economy
An increase in the supply of money typically lowers interest rates, which in turn, generates more investment and puts more money in the hands of consumers, thereby stimulating spending. Businesses respond by ordering more raw materials and increasing production. The increased business activity raises the demand for labor. The opposite can occur if the money supply falls or when its growth rate declines.
Change in the money supply has long been considered to be a key factor in driving macroeconomic performance and business cycles. Macroeconomic schools of thought that focus heavily on the role of money supply include Irving Fisher's Quantity Theory of Money, Monetarism, and Austrian Business Cycle Theory.
Historically, measuring the money supply has shown that relationships exist between it and inflation and price levels. However, since 2000, these relationships have become unstable, reducing their reliability as a guide for monetary policy. Although money supply measures are still widely used, they are one of a wide array of economic data that economists and the Federal Reserve collect and review.2
How Money Supply Is Measured
The various types of money in the money supply are generally classified as Ms, such as M0, M1, M2, and M3, according to the type and size of the account in which the instrument is kept. Not all of the classifications are widely used, and each country may use different classifications. The money supply reflects the different types of liquidity each type of money has in the economy.
M1, for example, is also called narrow money and includes coins and notes that are in circulation and other money equivalents that can be converted easily to cash. M2 includes M1 and, in addition, short-term time deposits in banks and certain money market funds.2 M3 includes M2 in addition to long-term deposits. However, M3 is no longer included in the reporting by the Federal Reserve.3
Money supply data is collected, recorded, and published periodically, typically by the country's government or central bank. The Federal Reserve in the United States measures and publishes the total amount of M1 and M2 money supplies on a weekly and monthly basis. They can be found online and are also published in newspapers.
What Happens When the Federal Reserve Limits the Money Supply?
A country’s money supply has a significant effect on a country’s macroeconomic profile, particularly in relation to interest rates, inflation, and the business cycle. In America, the Federal Reserve determines the level of monetary supply.2 When the Fed limits the money supply via contractionary or hawkish monetary policy, interest rates rise and the cost of borrowing increases. This can dampen inflationary pressures, but also risk slowing down economic growth.
How Is Money Supply Determined?
A central bank regulates the level of money supply within a country. Through monetary policy, a central bank can undertake actions that follow an expansionary or contractionary policy. Expansionary policies involve the increase in money supply through measures such as open market operations, where the central bank purchases short-term Treasuries with newly created money, thus injecting money into circulation. Conversely, a contractionary policy would involve the selling of Treasuries, removing money from circulating in the economy.
What's the Difference Between M0, M1, and M2?
In the United States, the money supply is categorized by various monetary aggregates including M0, M1, and M2. These are used by the Federal Reserve to measure how open market operations impact the economy. The monetary base, or M0, is equal to coin currency, physical paper, and central bank reserves. M1, typically the most commonly used aggregate, covers M0 in addition to demand deposits and travelers' cheques. Meanwhile, M2, which may be used as an indicator for inflation when compared to GDP, covers M1 in addition to savings deposits and money market shares.1
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