Economics Online Tutor
As noted above, money is divided into different categories, or measures. Perhaps it would be helpful to
list the measures of money at this time. This might help with understanding the brief discussion that
MEASURES OF MONEY:
||CURRENCY AND COINS (CASH MONEY) HELD BY THE PUBLIC, DEMAND DEPOSITS (CHECKING
ACCOUNTS), TRAVELER'S CHECKS, AND OTHER CHECKABLE DEPOSITS SUCH AS NOW
ACCOUNTS, ATS ACCOUNTS, CREDIT-UNION SHARE-DRAFT BALANCES.
||EVERYTHING DEFINED AS M-1, PLUS OVERNIGHT RPs ISSUED BY COMMERCIAL BANKS,
OVERNIGHT EURODOLLAR DEPOSITS, MONEY MARKET MUTUAL FUND SHARES (GENERAL
PURPOSE), SAVINGS DEPOSITS AT ALL DEPOSITORY INSTITUTIONS, SMALL TIME DEPOSITS
(LESS THAN $100,000) AT ALL DEPOSITORY INSTITUTIONS, MONEY MARKET DEPOSIT
||EVERYTHING DEFINED AS M-2, PLUS LARGE TIME DEPOSITS AT ALL DEPOSITORY
INSTITUTIONS ($100,000 OR MORE), TERM RPs, TERM EURODOLLAR DEPOSITS, MONEY
MARKET MUTUAL FUND SHARES (INSTITUTIONS).
||EVERYTHING DEFINED AS M-3, PLUS BANKER'S ACCEPTANCES, COMMERCIAL PAPER,
SAVINGS BONDS, SHORT-TERM TREASURY SECURITIES.
A few notes concerning money:
The distinctions made with these various measures can be somewhat arbitrary; they are mostly based on
the relative liquidity of the different classifications of money. Liquidity means the relative ease with
which something can be converted to cash.
Many people think of money in terms of only currency and coins. Currency and coins issued by the
government are considered legal tender, meaning that no seller can legally refuse to accept currency
and coins as payment for goods and services.
Currency (paper money) at one point in time could be legally exchanged for a specific amount of a
commodity such as gold or silver. This was called the gold standard (or the silver standard). Coins were
made of these commodities, and were called commodity money. This means that the coins had a value
based on the material that they were composed of, separate from the face value of the coins. This meant
that if the value of the gold or silver that the coins were made of exceeded the face value of the coins,
people would tend to hoard them. This would reduce the amount of money in circulation, and reduce
economic activity. This tendency to hoard commodity money is called Gresham's Law. Supply and
demand forces, including hoarding, would tend to keep the values of the commodity in line with the face
value of the coins. Inflation would be low, but economic growth could be limited.
Currency and coins no longer have value based on commodity prices. The value of cash money is based
on the faith that people put in it. This is closely related to the stability of the government. Money that is
not backed by commodities is called fiduciary, or fiat, money. One advantage of using fiduciary money is
that it is much less expensive for the government to issue it. The government does not have to use or
pledge valuable resources such as gold and silver. One disadvantage is that with fiduciary money, the
government may tend to issue too much of it, which creates inflation.
I won't go into detail to describe everything listed in the table above. Many of these items rarely need
additional explanations for economics class. M-1 is called transaction money. It includes forms of money
that are generally used to finance transactions. By far the largest form of money is demand deposits, not
currency and coins. Currency and coins held at financial institutions (such as banks) and by the
government are not part of the money supply. Only currency and coins held by the public (in circulation)
are counted as money.
M-1 is the most widely-used measure of money, especially by those who want to emphasize the medium of
exchange function of money.
The definitions that different people use for money are somewhat arbitrary. Economists classify money
into different categories, or measures. These measures are: M-1, M-2, M-3, and L; they are described
below. The distinction between these measures can be somewhat unclear. However, a simple definition
of money would look something like this:
Money: anything that is widely accepted as payment in exchange for goods
In order to understand the functions that money serve, consider the alternative, which is a barter
economy. A barter economy depends on what is called a coincidence of wants. This means that if you
want something that someone else has to offer, in order to get it, you must give that person something
that they want. Usually, that person is not going to want whatever it is that you have to offer. You will
have to find a third person, and probably involve many more people, before you can find an equilibrium
where everybody involved will get something that they want in exchange for something that they have to
If you want or have something that is perishable or decreases in value over time, finding someone to
trade with becomes a very urgent process. This entire process is very cumbersome and
time-consuming. People would end up spending so much of their time just making exchanges that they
would have little time left to actually be producing something. It is very difficult to imagine a barter
economy that has any kind of economic growth, let alone any advances in technology, or even education.
Involving many people in the many transactions that would be required so that everybody gets what they
want can involve thousands of different goods and services. This would require some sort of exchange
rate between all of the goods and services in order to know what the relative values are. It would be
very difficult for anybody to keep track of all of the different exchange rates for all of the different
combinations of goods and services that can be traded for each other.
In addition, you have to consider the source of the goods or services that you have to offer. You could
work for someone, and use whatever they pay you. But they won't likely pay you in whatever it is that you
want. They would have to have everything that each and every employee wants in order to do that. And
they won't pay you with what you want at exactly the same time that you want it. You would want to spread
your earnings out between pay days, even save some to increase your wealth and make larger purchases
in the future.
Functions of money:
Economists have identified three functions that money serves to distinguish a money economy from a
Medium of exchange: Money serves as a means of payment. It eliminates the necessity of a coincidence
of wants present in a barter economy.
Unit of account: This is a standard of value, or a common denominator, to measure the material worth of
all goods and services available in the economy against each other. This gives people a general idea of
the relative values of the items that they frequently purchase. This keeps people from having to know
what the exchange rates are between thousands, or potentially millions, of goods and services.
Store of value: Money allows people to store purchasing power. This is necessary because the time that
income is received will not always coincide with the time that people will want to use the money to
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