Macroeconomics monetary policy/Money creation

The purpose of this topic is to explain what is money. Demand and supply of money are analyzed. The importance of monetary policy is outlined. The structure and function of the Federal Reserve System is investigated.

Money
Money is any asset unconditionally accepted by all in all transactions. At different times in history, different items have been used as money, such as stones, salt, cattle or shells. Metals, gold in particular, have extensively been used. The modern paper form of money dates back to the Middle Ages when it was first used by Venetian merchants.

In some parts of the world, salt is used as money even today. Salt is obviously not an official currency of any nation, but it is the people who accept it in any transaction, who make it money. These people accept salt in exchange for other commodities because they know that they will be able to offer that salt when they want to acquire something else. Salt is convenient because it is easily divisible and because it does not deteriorate.

Functions of money
Money is the medium of exchange. It is used as a standard of value in which all prices are expressed. It is also a store of value for future consumption. Various characteristics of money are desirable, such as divisibility and durability.

If no money were used, people would revert to barter, that is, exchange of items for other items. A farmer who would have an extra cow could exchange it for a horse, or two sheep, or a ton of apples, or a ton of eggs, for instance. Matching needs would have to exist: the one who had the eggs would have to want a cow. But the farmer may want a pound of eggs instead of a ton of eggs. Thus, without some asset chosen as money, transactions are difficult.

Demand for money
Demand for money stems from the need to enter into transactions. In addition, there is an asset demand for money: for precautionary and for speculative reasons. The transactions demand for money is not interest rate sensitive. The asset demand for money is inversely related to the interest rate because money does not earn any return (and loses purchasing power with inflation): thus a smaller quantity would be held if the interest foregone is large. Demand for money is shown graphically as a downsloping curve.



While the purpose of holding money is to be able to buy something, it is also common to hold some amount of money as money just in case it is needed. Such need may arise out of an unexpected accident or unforeseen bargain opportunity, both of which require the ability to make immediate payments. This is also true when going out of the house: it is unwise not to have a few dollars for emergency.

Money supply
Different definitions of money supply exist because various forms of money may be used to make payments. The monetary authorities in the United States recognize 4 different types: M1, M2, M3 and L (for liquidity). Supply of money is shown graphically as a vertical line because it is determined by forces exogenous to the money market; these forces are policy tools of monetary policy (which are studied in next two chapters).



Any asset which allows one to make a payment, qualifies as a form of money, and is, thus, part of money supply. Careful analysis reveals that many different assets qualify as money, and differ only in the time it takes to complete the desired payment: this is their liquidity.

Currency
Coins and bank notes are known as currency. Compared to other means of payment such as checks, currency represents only a very small portion of money supply. Currency is a liability of the Federal Reserve Banks because the token value it represents (see below).

Currency is used to make small payments. For instance, for the purchase of groceries, gasoline or newspapers. It would be indeed inconvenient to write a check for small amounts. But all the large payments are completed with the help of checks. It would be unsafe and time consuming to purchase furniture, appliances or an automobile by paying with bank notes.

M1
M1 includes currency (paper notes and coins) and checkable deposits. M1 is the most restrictive definition of money supply.

Only the most liquid forms of money are included in M1. Payments with coins and bank notes are naturally completed immediately. Payments by check are normally recognized on the day of receipt of the check, but in reality the recipient does not have access to the amount received until the check clears, which may take a day or more.

Token money
Currency and coins are said to be token money because their intrinsic value (the value of paper and metal content) is but a small fraction of the value they represent. They are also called convenience money because they are necessary for small purchases.

The metal or paper content of coins and bank notes could not possibly come even close to the value it represents. If it did, the coin or bank note would disappear as a form of money. It is exactly what happened in the 1960's. Increases in the price of silver encouraged people to hoard quarters or even convert them into jewelry. The U.S. government had to mint new quarters which had but a trace of silver in them.

Checkable deposits
Checkable or demand deposits represent money deposits in a commercial bank with the right of the owner to withdrawal upon demand. Various forms of equivalent arrangement are now possible at savings banks, credit unions and even securities dealers. They bear different names such as NOW, SDA and ATS.

The bulk of the transactions in any modern economy is completed by check writing. In businesses in particular, the use of coins and bank notes is often referred to as petty cash and is reserved for miscellaneous minor expenses (such as buying a present for the birthday of an employee).

M2
M2 includes M1 and various forms of small time deposits. These deposits include savings accounts and certificates of deposits. Withdrawal or redemption of these deposits often leads to some penalty in lost interest.

Holding money in a checking account earns very little interest or none at all. That is why it is preferable not to leave funds in excess of daily needs in checking accounts. The most convenient placement of such funds is in a savings account or a certificate of deposit. These can be redeemed on short notice, usually within a few hours: the time it takes to get to the bank.

M3
M3 includes M2 plus large time deposits (those larger than $100,000). An even broader definition of money supply is L, which includes government securities.

Beyond the savings accounts and the certificates of deposits, a large variety of financial instruments are available. They usually offer a higher return but may take a little more time to redeem.

Near money
All forms of money other than those in M1 are referred to as near money because, although readily available, they must be converted into checkable deposits before they can be used. Up to now credit cards have not been considered as money because the use of a credit card is assumed to be conditional on a loan by the issuer. Reserves of banks are not part of money because that would be double counting. With high interest rates of the 1980's, several new forms of financial instruments have emerged. Mutual funds offered money market accounts with return much higher than normal bank certificates of deposit. Recent decreases in inflation and interest rates took away some of the appeal of money market account. Still, they are a good alternative to holding money in a checking account.

Backing of money
Money is no longer convertible into gold (because the supply of gold is too unstable). The pronouncement of legal tender does not assure that a currency will be accepted. The acceptance of money rests in the mutual trust of people of acceptance by others and in the trust that the value of money will be preserved. Preserving the money value depends entirely on its relative scarcity and the control of money supply (which is the purpose of monetary policy).

The value of money does not come from any weight of precious metal, but from the amount of goods or services a dollar can buy: it is the purchasing power of money. For instance, in the late 18th century, the French assignat had to be discontinued because it never caught on as a form of money (i.e. people did not accept it as money), in spite of all the official pronouncements by the French government at the time.