Concept summary Chapter 10
Macroeconomics | © John Petroff; contributors: Komla Amega Source: PEOI |
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.
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.
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.
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).
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).
M1
M1 includes currency (paper notes and coins) and checkable deposits.
M1 is the most restrictive definition of money supply.
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.
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.
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.
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.
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).
Review Quiz available at end of next chapter.
[Your opinion is important to us. If you have a comment, correction or question pertaining to this chapter please send it to comments@peoi.org .]
Return to Chapter 10 MONEY Chapter :