Money
From Encyclopædia
Money is one of the most important inventions of humankind. Without it a complex, modern economy based on the division of labor, and the consequent widespread exchange of goods and services, would be impossible.Functions of MoneyBecause many things, ranging from gold to entries on computer tape, have been used as money, it cannot be defined as some particular object but must instead be defined by the functions it serves--to act as a medium of exchange and a standard of value. A third function of money--as a store of wealth--is something money shares with many other types of objects.A medium of exchange is simply an item used to make it easy to exchange things. In a very primitive economy, and in a few isolated
cases in a complex economy, people directly barter goods and services. Direct barter is extremely inefficient, however, because it requires that one locate someone who wants the particular good one provides, and just by coincidence happens to have available for exchange a particular good one wants. In a modern economy with millions of products it would require an extensive search to locate such a person, but the use of money as a medium of exchange allows one to
Split this barter process into two parts. All one has to do is locate a person who wants one's particular good, receive money in exchange for it, and then locate another person who has available the good one wants and who is sure to take money in payment for it.Another function of money is to serve as a standard of value or unit of account--so that economic values in terms of money can be measured; in this respect, money serves as an
abstract unit. This standard-of-value function is overwhelmingly important because a modern economy requires numerous comparisons of values.In principle, this standard of value need not be the same as the medium of exchange. In colonial
America, for example, merchants kept their financial records in British
pounds, but most of the medium of exchange they received consisted of Spanish coins. Obviously, however, it is convenient to use the same item both as a medium of exchange and as a standard of value, and modern money normally fulfills both roles.The third function of money is to serve as a store of wealth. This is not a distinctive function of money, but money has certain peculiarities as a store of wealth. Unlike other forms of wealth, it has no transactions costs. Someone who decides to hold wealth in, for example, corporate stock has to undergo a certain amount of trouble and cost--first to buy stock and then to sell it again in order to buy another item. All of these costs and inconveniences can be avoided by holding one's wealth in the form of money. Economists term this ease of using money, as opposed to other forms of wealth, as a medium of exchange liquidity.How well does money fulfill its functions? The medium of exchange function is fulfilled very well. The occasional inconveniences of being unable to cash a check, or to pay a bus fare with a $10 bill, are trivial when looked at in a larger context. Money does not perform well, however, as a standard of value or a store of wealth because the value of money itself is not stable or predictable. For example, someone who currently lends $100 at 15%
interest does not know whether the purchasing power received back, both as repayment of principle and as
interest, will be more or less than the purchasing power of the $100
Lent because of the effect of
inflation or deflation.It is convenient to classify the numerous moneys that exist into three types. One is full-bodied commodity money--money that has a value as a commodity (gold or silver, for instance) fully equal to its value as money. Because coins can be awkward to carry, representative full-bodied money was developed, which consists of paper money that is freely convertible into full-bodied money. (In the late 19th and early 20th centuries most Western countries based their currencies on gold; see
gold standard.) Neither of these types of money, however, now exists in the
United States or in most other countries. All U.S. money is credit money, or fiat money--money that does not have a value as a commodity equal to its face value and that cannot be exchanged for full-bodied commodity money.One might well ask why people are willing to exchange valuable goods and services for pieces of paper called $10 bills. The answer is that these pieces of paper are valuable because we know that other people are willing to take them in exchange for their goods. The same is ultimately true of gold--it is considered valuable because we know that other people treat it as valuable. Hence, many of those who advocate a return to the
gold standard do so primarily because this would limit the government's ability to create money rather than because of any inherent value attached to gold.HistoryMuch dispute exists about the origin of money and its role in primitive society. One school of thought argues that in primitive s?cieties money was used not for everyday trade but only for certain ceremonial and public transfers, such as tribute, bride price, and blood money. Particular moneys could be used only for particular purposes, or for payments to certain social classes, such as gold and silver for aristocrats and
Copper for common people.As economies developed, money was used more and more for ordinary trade and tended to consist of
metals, although cowrie
shells were used for a long time in
Africa. Coinage was probably invented in ancient China and reinvented (c. 700 BC) by the Lydians in what is now Turkey. Paper currency was also invented in China, at least as early as the 11th century. Ancient Babylon had a highly developed monetary system with banks and credit, as did ancient Greece and Rome. For reasons not well understood, in early medieval
Europe the money economy went into a decline and barter reemerged. During the 9th century, however, the European economy started to become monetized again.It is tempting to sketch monetary history as an evolution from a system of concrete objects--such as ounces of precious
metals--to more and more
abstract units, such as checking deposits. But this evolutionary explanation is an oversimplification. For example, the stone money used on the Pacific island of Yap was more
abstract than modern money because the large stones that served as money could still be used as such even if they had been lost at sea.Definitions of MoneyWhat items should be counted as money in the modern U.S. economy? It is clear that one component of money is currency. But the definition of money must include more than just currency because the great bulk of the dollar value of payments is made by transferring bank deposits and not by currency. Currency is merely the small change of the U.S. system. Obviously, checking accounts must be included in the definition of money.Beyond this basic definition, however, there is disagreement. Some economists prefer to define money by its essence--the fact that it is a medium of exchange and is liquid. According to this criterion, money is narrowly defined as currency plus checkable deposits.Other economists, however, notably Milton FRIEDMAN and Anna Schwartz, prefer a broader approach. Economists and policymakers are primarily interested in the supply of money because changes in the supply of money bring about changes in prices and output, and hence in income (see
MONETARY POLICY;
MONETARY THEORY). They therefore define money as that total which gives the best explanation and prediction of changes in income, rather than by money's inherent characteristics. In addition, they believe that the total should be subject to
Control because policymakers not only want to predict income but to change it if necessary. This approach to the definition of money and the previously discussed approach are not in fundamental conflict; essentially, it is a disagreement about whether to use the word money for one thing or the other.On a more practical level, what specific items should be included in money? Until recently, the
Federal Reserve System used the following rule. So-called narrow money, or M-1, was defined to include currency and checking deposits, and broad money, M-2, was defined as M-1 plus time and savings deposits in banks. M-3 included, in addition, deposits held in savings and loan associations and savings banks.This set of definitions had to be changed in 1980, when all savings and loan associations and mutual savings banks were allowed to offer checkable deposits to their customers in the form of NOW (Negotiable Order of Withdrawal) accounts, which are
interest-bearing
demand deposits. (Commercial banks may also offer NOW accounts.) First, there is M-1A, which is essentially the old M-1. (Federal government deposits are excluded from both the old and the new measures.) This measure of money will probably be phased out. A more important one is M-1B, which adds in checkable deposits in savings and loan associations and savings banks and credit unions. Then?there is M-2, which adds to M-1B savings and time deposits below $100,000, shares in money-market
mutual funds, and some other very liquid items. M-3 then adds to M-2 all savings and time deposits of more than $100,000 plus a few minor items.
