Center for Distance and Independent Study
Economics 3229: Money, Banking, and Financial Markets

Commentary

Why Study Money?

We do not often think about the money supply, and we think even less about its growth rate. However, these concepts influence our everyday life in many ways. Strictly speaking, money simply helps us to carry on transactions in a more efficient way. In a barter economy, if an individual wants to eat, he will have to find another individual who wants to trade a meal for whatever this individual is able to produce, let's say, a sword. If every time this person wants to eat he has to find a farmer who wants a sword, he will probably spend too much time looking for farmers willing to trade food for swords and not enough time producing better swords.

Money helps individuals by avoiding the necessary "double coincidence" of needs of a barter economy and by allowing individuals to specialize. However, the amount of money in an economy (the money supply) has a number of consequences for the well being of its citizens. For example, suppose there is an economy in which there are only two goods produced, let's say, two swords. Now suppose the money supply amounts to 20 units of currency. If the money supply is divided amongst the whole economy's production, then 20 units of currency would be allotted to two swords. Although any distribution would be fine, let's assume 15 units of currency for one sword and 5 units for the other.

What happens if the individuals of this economy are able to produce only two swords, but the money supply increases to 30 units of currency? We can say that the price of one sword will increase as a result of the increase in the money supply. As we will see later in this course, if the money supply increases at a rate that is too fast, we could end up with inflation (an increase in prices).

This simple example illustrates that the amount of money outstanding in an economy turns out to be quite an important variable.

Economists also know that changes in the rate of money growth are linked to the business cycle. Negative rates of money growth are thought to create depressions (a negative rate of growth in GDP, gross domestic product). Although the evidence only shows that there is a relationship between these two events, many economists think that rates of money growth affect GDP. However, by what means this happens is a matter of intense debate.

The amount of money and its growth rate are linked to inflation and to the business cycle, but how do these concepts affect our daily decisions? Most people sign contracts by which they agree to get paid a fixed amount of currency units per hour. Most of these contracts are valid for a year. What happens if, in the course of that year, prices increase by 20%? When comparing how many groceries you were able to buy with your paycheck in January and then in December, you would realize you can buy less at the end of the year. You just experienced a loss in your purchasing power. So, in the presence of inflation, people will ask for higher wages to be able, at least, to buy the same amounts of goods over the course of a year.

An increase in the rate of money growth can cause your paycheck to be less valuable, but a decrease in the rate of money growth can create a depression. In the latter case, it is much more difficult to get a job. During a recession, companies do not create as many jobs and sometimes layoff workers. If you are in your senior year and just entering the job market, you might find harsh competition during a recession, and your years of education might not be compensated by the wages you earn.

Another way the money supply affects us is through interest rates. The interest rate is the price of money. If the money supply is shrinking, its price (the interest rate) will go up. This is the same principle that when a good is scarce, its price increases. The effects of interest rates in our everyday decisions are quite straightforward: should we buy a house and look for a fixed-rate mortgage? What about a variable-rate mortgage? Should we refinance? It is not the same to buy a car and pay 5% interest compared to buying the same car at 8% interest. If 8% interest is too much and the company does not sell the car, it does not increase the size of its plant; therefore, there are not as many jobs created that year!

Why Study Financial Markets and Banks?

Financial markets along with financial intermediaries and other market participants (savers and borrowers) constitute the financial system. Financial markets and financial intermediaries perform the essential task of channeling funds from savers (people who have no immediate use for their funds) to spenders or borrowers (people who need funds to undertake projects). This process is not trivial.

The more efficiently this process is carried out, the better the welfare of the economy as a whole. If it is very difficult for a company to get funds to build a factory or to develop a new product, it will become increasingly difficult for an economy to grow. Financial intermediaries and financial markets deal with the problems associated with financial transactions so that funds are allocated most efficiently.

A well functioning financial system also allows small savers to have more options. These options translate into the ability to purchase something now and pay for it later (like buying a car) or into the multiple choices we have to save our extra earnings (savings accounts, bonds, stocks, etc.) Developed countries' economies have much more efficient financial systems than do developing countries.

Financial intermediaries, or institutions that borrow from people and lend these funds to other individuals, are a key element of the financial system. Banks are the most important financial intermediaries; we will study banks in Lesson 5.

Measuring Money: Definition and Monetary Aggregates

Now that we have learned that the money supply plays an important role in the well being of an economy, let's try to be more specific about what the money supply is. First we need to answer the important question: what constitutes money?

There are at least two ways to define money. The textbook defines money as "anything that is generally accepted in payment for goods or services or in the repayment of debts" (8).

This definition emphasizes that an individual will accept money as payment because she knows that somebody else will accept it later. In that sense, it is not important what money is physically. According to this definition, if everybody accepts tobacco leaves as a form of payment, then tobacco leaves constitute money (as was true in the United States in the 1700s). Tobacco is example of, what today is called, commodity money. Another example is cigarettes in prison. Since most inmates are ready to accept cigarettes as a means of payment, they constitute money in that environment.

Another way to define money is to list its functions. For example, money is anything that can perform all the functions listed in Table 1.1.

By the 1700s, tobacco leaves performed all these functions (although some functions better than others). Although most people accepted tobacco leaves as a medium of exchange and used them to set the prices of goods and services, they were not a good choice as a store of value since the leaves became worthless as they aged. To overcome these limitations, silver and gold coins were introduced. Coins have two advantages: they can be easily divided and their quality can be standardized.

Individuals have continually tried to reduce the problems associated with handling money (or different types of it). This process gave rise to the evolution of the payment system. After realizing that silver and gold coins were an improvement over tobacco leaves, individuals realized that coins were quite heavy to carry! That's why fiat money was created. Fiat money is simply a piece of paper that is considered to be a country's currency and is backed by the government. Of course, you do not buy a house with a stack of bills anymore; you will probably use a cashier's check. This is another step in the evolution of the payment system. This process continues today with the system of online purchases and bill payments.

Therefore, if a check (that represents a checking account) is a type of money, a dollar bill is another and a certificate of deposit is yet another. How do we define what money is today?

Money Aggregates

Central banks all over the world solve the problem of defining money by classifying different assets into categories known as monetary aggregates. Each of these categories holds similar assets that can be considered money, according to our definition. The criterion used to classify these assets is liquidity. By definition, the most liquid asset is cash. How easily and quickly you can convert an asset into cash determines that asset's degree of liquidity.

If someone wants to check the degree of liquidity of a given asset, he or she will have to answer this question: how quickly can I convert this asset into cash? A house might be a good way of storing your wealth, but it is not a very liquid asset. To convert your house into cash, you will have to sell it, after spending a considerable amount of time looking for a buyer. You will also have to pay commission fees to a real estate agent. Economists refer to the time and money spent to carry out a financial transaction as transaction costs. The higher the transaction costs incurred in converting an asset into cash, the lower the degree of liquidity of that asset.

Although the previous example is pretty straightforward, sometimes it is not easy to determine the liquidity of an asset. Are traveler's checks, for example, more or less liquid than checks? It only takes a couple of signatures to cash a traveler's check at a bank. How many places accept checks as a form of payment compared to how many places accept traveler's checks? Today, only a few businesses accept traveler's checks, which makes checks more liquid than traveler's checks. It also provides a reason to distinguish between checks and cash. Stores can refuse to accept personal checks. It's likely you have seen signs that say, "No personal checks, please". Of course, it is unlikely you will see a sign that says, "No cash, please." This and other factors (like the fact that most banks charge for checkbooks) lead to the conclusion that checks are, in fact, less liquid than cash.

If a check is less liquid than cash, isn't the difference small when compared to the liquidity of a house? This is how monetary aggregates are constructed. Assets with similar degrees of liquidity are grouped in categories: M1, M2, M3, and so on. The most liquid assets are grouped in M1, the not-so-liquid assets in M2, and so on. By definition, M1 holds the most liquid assets. Table 1 on page 57 in your textbook illustrates the measures of monetary aggregates. An example is also provided in Table 1.2. For current statistics go to the Federal Reserve Web site (Series H.6).

Monetary aggregates serve the purpose of providing a practical definition of money. When central bank authorities are pursuing a specific goal, like a given money growth rate, it is critical that all agents in the economy (banks, corporations, even other governments) know exactly which monetary aggregate the central bank is talking about. Conducting a policy that increases M1 might have different affects than a procedure that seeks to expand M2. Also, it is often the case that the choice of policy instrument is related to the monetary aggregate targeted. For example, if an economic policy induces individuals to move their money from their checking accounts into savings accounts, this will decrease M1 but will leave M2 unaffected.

To see this more clearly, consider Figure 1.1. A transfer from checkable deposits (a component of M1 and M2) into a savings account (a component of M2 only) will decrease M1 but leave M2 unaffected. If the goal is to reduce M1, this transfer might be a good idea. However, if policymakers want to influence M2, this transfer might not be a good choice.

Figure 1.1. Monetary Aggregates

Alternative Measures of Money

Although M1 and M2 are useful ways of measuring the money supply, researchers have proposed other means of measuring money. Researchers at the Federal Reserve (the central bank of the United States) for example, proposed a weighted average of the components of M1, M2, and M3. This type of measure is called "divisia monetary aggregate."

A weighted average is simply an average that places more or less importance (weights) on each of the components of the average.

Specifically, researchers proposed that the weights on each component should depend on the interest rate that each component yields. The main idea is that, as interest rates on the different components change, liquidity also changes; thus a measure of the money supply should reflect this relationship. The approach, which was developed in the 1980s, was not very popular, despite its ability to reflect changes in the money supply better than M1 or M2.

Another way of measuring money was proposed by the economist William Pole in 1991. Pole thought that the money supply should consist of any asset that can be spent immediately. Therefore, he suggested the concept of "money with zero maturity," or MZM. All components of M2 qualify as components of MZM, except small time deposits. However, a component of M3, institutional money market mutual funds (MMMF), can be spent immediately and should therefore be added to the MZM aggregate. Thus, MZM can be calculated as follows:

Research is ongoing, and the staff of the Federal Reserve is always looking for improved ways of measuring money. The issue is complicated by the rapid pace of financial innovation and the creation of new payment instruments. These new types of money have to be classified and measured in order to have an indication of their evolution and affects on the overall economy.