What Everybody Should Know about Money

Economics Corner: What Everybody Should Know about Money

Money is nothing more than an economic tool. For anything that money is used for, the money itself is a tool for achieving something else.

I think the best way to understand money’s role in the economy is to contrast an economy that uses money with a barter economy.

If there were no monetary system, how would anybody acquire anything? Everybody could just try to take what they wanted. Such a system would be a true survival-of-the-fittest based on instincts and greed. Civilization as we know it would not exist. A better way would be to develop a society in which people learn to barter for what they want. If person A has something that person B wants, then person B could offer something that person A wants, and they could simply exchange the two items. It isn’t too difficult to see that even if each person is willing to give something up in an exchange, they won’t be able to agree to an even swap. A sense of relative value will factor into any exchange. Perhaps one person will have to throw something else into the exchange in order to reach an agreement.

Such an economy would be extremely primitive. The only economic transactions would be between two individuals, each having something that the other wants and each able to agree on some idea of relative value of what is given and what is received. More likely, if person A has something that person B wants, person B won’t have something that person A wants. But maybe person C does, and in return person C wants something that person B has. So they can complete a three-way swap.

That would still be a very primitive system. In order to make it more likely for each person to find something they agree to give up in exchange for something they want, they would need to involve a fourth person – and a fifth, and a sixth, and so on. People would be so busy exchanging things and negotiating terms that they would have little time left for enjoying things – or amassing things to offer to others. Perhaps the only things worth exchanging would be the things that people need for survival. The need to find somebody who wants what you have in order to be able to get what you want is called a coincidence of wants.

What about economic production? How would anything get made in a barter system? Each person could use his imagination, come up with some ideas on something to create, and then work on creating things to offer for exchange. That too, would be a primitive system. What if somebody came up with a great idea that required more than just his own labor to build? Perhaps he could hire somebody to help do the work. Well, that could be one way for people to get what they want. Instead of offering an item in exchange, they could offer their labor. All they would need would be to find an employer who is capable of giving all employees everything they need to make it worthwhile to spend their time being employed. Good luck with that. On payday, an employer would have to pay each employee an individualized package of goods – because everybody has different needs and different tastes. And what if somebody wants a big-ticket item, something that costs more than the value of the work they do within one pay period?

Exchanges would sometimes involve perishable items. People would require that goods be delivered when they want or need to use them. They wouldn’t want to receive items on payday if the items would spoil before they needed to use them.

And if multiple persons are involved in an exchange, or in an employment relationship, how could they know they weren’t getting cheated? They would have to have some idea of the relative value of all goods involved. The more complex the exchange and the more complex the economy, the more items that people would need to know the relative values of.

It should be easy to see that an economy as complex as the one we have in the United States could not exist in such a system. But from this description of a barter system, we should be able to see the functions that money serves in society:

Functions of money

  1. Medium of exchange: Money serves as a means of payment. It eliminates the necessity of a coincidence of wants present in a barter economy.
  2. 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.
  3. 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 finance expenditures.

Money is an economic tool which performs these functions in society: medium of exchange, unit of account, and store of value.


Now that we know the functions of money, what things count as being money?

Money is defined as anything that is widely accepted as payment in exchange for goods and services. Many people think of money as coins and paper currency. But people don’t always use coins and paper currency to make purchases. Money clearly includes other items.

Funds from checking accounts can be immediately accessed. They are money. Travelers’ checks are money.

In terms of whether assets meet the definition of money, many items are not as clear-cut as cash, checking accounts, and travelers’ checks. For example, if you put money into a savings account at a bank, is that money? It is an asset that you can access easily when you want to buy something. But it isn’t widely accepted as a form of payment until you transfer it into something else. You could make arrangements with the bank to transfer these funds to a checking account. You could go to the bank and have the funds converted into currency. You can’t actually “spend” a savings account. But you can, fairly easily, convert it into something that you can spend.

Because of such vagueness in determining which assets count as money, economists have come up with different measures of the money supply. See the Money page of my Economics Online Tutor website for a list of these measures as well as the assets included in each measure. The distinctions among the different measures are largely based on relative ease of access or liquidity. M-1 (mostly coins, paper currency, checking accounts) and M-2 (the same as M-1 except that items such as savings accounts are added in) are the two most frequently used measures of money.

The Nation’s Money Supply

Economists sometimes make inferences about the relationship between the money supply and economic activity by using this mathematical concept: the supply of money (measured in dollars) multiplied by the average number of times each dollar circulates throughout the economy (known as the velocity of money) is equal to nominal GDP. You should be wary of claims that specific conclusions about money can be reached from this formula because “it has to be true because it is a mathematical fact.” Mathematical identities are often used to justify economic conclusions when in fact the formulas are flawed. In this case,

  1. Each term in the formula is vaguely defined. You can’t have mathematical accuracy in the results of a formula if the variables are vaguely defined.
  2. The terms are fluid. GDP is measurement of a years’ worth of economic activity. But the money supply – no matter which of the various measures of money is used – continually changes.
  3. The formula works backwards in order to place a fixed value on variables.

Still, in the aggregate, economists often find this formula useful. But keep in mind that it yields results that are historically volatile and increasingly so.

How is money created?

No, the Fed doesn’t simply turn on printing presses, although the printing press is often used as a metaphor for increasing government debt. When you see this metaphor, don’t take it literally. Printing presses and mints are controlled by the Treasury, and are used largely for replacing old money with new money. The creation of additional money in the money supply is largely accomplished through electronic deposits in bank accounts.

Most money that is added to the money supply is created in one of two ways. Commercial banks create money whenever they make loans. The Fed creates money whenever it buys U.S. Treasury securities from the public for the purpose of stimulating the economy through quantitative easing.

Students of macroeconomics are taught early in their studies that commercial banks create money when they make loans. The method is fairly easy to understand, but you have to separate traditional banking activity from investment banking activity and focus on traditional banking. The assets of commercial banks are also the liabilities of commercial banks. The assets are deposits of other people’s money, and their liabilities are the same – they have to give these deposits back to their rightful owners on demand. But commercial banks exist in order to make a profit. Banks don’t just hold the money and wait for depositors to ask for the money back. There is no profit in doing that. So they loan this money out to other customers. In essence, depositors finance borrowers and the bank acts as a middle-man.

But what happens when a commercial bank makes a loan? Typically, it will credit the money as a deposit in the account of the borrower. The borrower has money that he didn’t have before. But what about the depositor whose money was used for a loan? His money is still his money. It is also part of the money supply. Suddenly, there are two deposits when there used to be only one deposit. The bank has created money “out of thin air.” Of course, when the borrower pays back the loan, his payments are deducted from his account, and the money that was created disappears from circulation.

Banks can’t loan out all of the money on deposit, of course. They need enough money in reserve to meet depositors’ demands for withdrawal. But they know from experience that on any given day, they will only need so much money to meet that day’s obligations. In addition to what the bank expects to need for withdrawals, the Fed imposes a reserve requirement on banks. The Fed can raise or lower this reserve requirement as one method of controlling the money supply. The current reserve requirement is 10% of deposits. This means that each bank can loan out up to 90% of money on deposit. If you have heard of a fractional reserve system, this is what it means. A bank can loan out a fraction of its reserves.

Econ students typically learn to calculate the theoretical maximum amount that a bank can increase the money supply through bank loans. With a 10% reserve requirement, a bank can loan out $90 for every new $100 on deposit. But this $90 in new money through one bank potentially can multiply to $1000 throughout the banking system. This multiplier effect assumes that each bank will always loan out the maximum amount possible under the reserve requirement; that each borrower will deposit the loan proceeds into an account at that bank rather than take the loan proceeds in cash; that each borrower turns around and spends the money in the economy; that each party receiving the money from the borrower turns around and deposits all of it into a different commercial bank; that each additional commercial bank starts the process all over by loaning out the maximum amount possible according to the reserve requirements; and that no loan proceeds are repaid to banks during this process. If all of these assumptions are met, then one loan can eventually increase the nation’s money supply by ten times the amount of the original loan. Of course, in the real world, all of these assumptions are never met. This doesn’t prevent people from claiming that a bank loan multiplies the money supply tenfold, however.

When the Fed buys U.S. Treasury securities from the public, the Fed typically arranges the purchases through investment brokers. The securities are taken out of circulation and become property of the Fed. The amount of the sales proceeds becomes new money in circulation when it is deposited into the brokers’ accounts. In order for these transactions to occur, the brokers will either have to have these securities already in their portfolio or they will have to buy them from investors.

Money is debt

A lot of people warn that our monetary system, indeed our entire economic system, is doomed to collapse because it is based entirely on debt. Some of these same people also claim that new money is always inflationary. It is true that when new money is injected into the economy, debt is usually involved. Actually, it is the debt aspect of issuing money that prevents it from being 100% inflationary. Debt prevents all new money from being “free money” with no obligation from the recipients. The debt obligation associated with the creation of money adds a stabilizing effect on the economy.

For more on the relationship between the money supply and inflation, see “Economics Corner: What Everybody Should Know About Inflation”.

Money is only a tool for facilitating economic activities. The only things that are important when evaluating the merits of any monetary policy are the types and volume of such economic activities, relative to alternative policy options.

We are not all economists, so why does the news media keep bombarding us with economic statistics and terminology we don’t understand? Should the average American even care about such news stories? When politicians talk about the economy, how do we separate the relevant from the rhetorical? More to the point, you might be asking yourself, “How does this affect me?”

Perhaps talk about the economy sounds like a bunch of gibberish to you. But if you had a basic understanding of the terminology being used – not the dictionary definitions, but what the words in their context should mean to a layman – free of misleading political implications, then such talk would mean more to you than just gibberish. The good news is that you don’t have to be an economist or even a student of economics in order to understand the terminology.

“Economics Corner: What Everybody Should Know About…” series is designed as a layman-friendly explanation of important economics terms and concepts. Created by Jerry Wyant.

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Jerry Wyant