Why It's Used:
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Why It's Used - Its Functions - What It Is
by Dr. Carole E. Scott
Copyright 1997-2001
With barter, the only alternative to using money to make transactions, if you want product A, and you don't have what the person who owns it wants in exchange for it, you either have to look for another seller or try to trade what you have for what this person wants. This is time consuming and costly.
If you produce concrete bird baths to earn a living, this is what you would trade to buy things. Hauling these around the mall to buy your children's back to school clothes would be a nuisance to say the least!
If the trade good you have is eggs, they will spoil unless you quickly find somebody with something you want to buy who wants eggs.
If you want to buy a shirt, but all you have to sell is a race horse, you probably have a problem because both you and the seller of the shirt probably think the horse is worth much more than the shirt. You can kill the horse and trade part of the meat for the shirt, but what you can trade the rest of the meat for plus the shirt isn't likely to be worth as much as what you can get for the live race horse.
You do not have problems like this if an appropriate form of money (durable, light in weight, etc.) is used instead. If, for example, as was once the case, everybody pays for the things they buy with specie (gold and silver), the problems outlined above are avoided. You do not have to buy something you do not need because someone who has something to sell that you want wants this thing. Specie is durable. A small amount of it is worth a lot. It can be divided without a loss in value.
Assuming a monetary system is properly operated, that is, severe deflation or inflation is avoided, it is more efficient to use money than barter. A medium of exchange must be used if a society is to practice the division of labor. A society's standard of living is enormously increased if it employs a division of labor, as otherwise everyone would have to be self sufficient--produce everything they consume. (If you specialize in producing one thing, then you must trade with others to get anything else.) Vastly less can be produced by a society in which each individual is self sufficient!
(Deflation is a persistent decline in the price level, while inflation is a persistent rise in it.)
| 1. commodity |
| 2. fiat |
The first monies were commodities, that is, they were such things as gold and silver which have a use value (jewelry, etc.) that practically everybody would always exchange for anything. As a result of how much easier using them made trade, people started selling whatever they had to sell for them and using them to make purchases. Therefore, they served as a medium of exchange, that is, people acquired them not to use as jewelry, etc. but to conduct trade.
All kinds of things have served as commodity monies. In Colonial Virginia tobacco was used because there wasn't enough gold and silver available to conduct trade with. Tobacco was not a good very money because it deteriorated quickly with use; all tobacco leaves did not have an equal value; and it had a relatively low value per pound, therefore, a large quantity of it had to be carried around in order to buy much. However, tobacco could be divided into small quantities without a reduction in value in order to make small purchases. Gold and silver lacked these flaws.
In the past, the issuers of paper money normally guaranteed to redeem it in gold or silver coins on demand. Therefore, assuming people trusted the issuerer to keep his promise, they would voluntarily accept this paper money. Today our paper money is NOT redeemable in specie. While some of our coins have silver in them, the value of this silver as a commodity is far below the denomination of the coin it is in. Our coins today are called token coins because the value of the metal in them is far below the denomination of the coins they are in. (In the past our coins were full bodied, that is, their value as specie was near their value as money.) Our money today is money because the government says it is. Therefore, it is called fiat money. (You must accept some of this money because it is required that you pay your taxes in it.)
Its Functions:
1. medium of exchange (what makes something money)
2. store of value (a function all assets serve)
3. unit of account (Any asset could serve, but using money is the most convenient.)
1. Medium of exchange: instead of swapping some of the cloth the company your work for produces for your groceries, you pay money for your groceries using money paid you by the company you work for.
2. Store of value: Instead of buying silverware and saving it to sell in order to pay your tuition next semester, you save money.
3. Unit of account: Instead of measuring the value of everything people own in terms of, say, automobile batteries, pencils, cans of white house paint, etc., money is used.
What it is:
Money is anything that is used as a medium of exchange. The use of a medium of exchange is an alternative to barter. With barter, in order to buy, say, a pair of socks, you give the seller a belt in exchange for them. When money is used, the producer of belts sells them for money and uses the money to buy the socks he or she wants.
The money supply consists of all the money in circulation. Money held in banks' vaults, therefore, is not part of the money supply.
In the U.S. today the following things serve as money:
cash (paper money issued by the Fed which is its liability and coin issued by the Fed but is a U.S. Treasury liability)
checking deposits (or accounts) which are liabilities of commercial banks and thrifts that are provided both depositors of cash and borrowers, namely:
a. demand deposits
b. negotiable orders of withdrawal (NOW accounts)
c. share-draft accounts
d. automatic transfer system (ATS)
e. cashier's checks
f. money orders
g. travelers checks
Paper money is a liability of the Federal Reserve System (Fed), our central bank. It is an independent agency of the Federal government. Coins are also put into circulation by the Fed, but they are liabilities of the U.S. Treasury, a branch of the Executive Department (President) of the Federal government.
Assets (things owned) are financed by = Liabilities (creditors' money) + Equity (owners' money)
a. Demand deposits are liabilities of commercial banks. Federal law prohibits interest being paid on this type of checking deposit. In the past, this was the only kind of deposit (account) on which checks could be drawn. Federal law forbids interest being paid on demand deposits..
b. NOW Accounts (Negotiable Orders of Withdrawal) are liabilities of commercial banks and thrift institutions. Interest can be paid on this type of checking account. Corporations are not allowed to have a NOW account.
c. Share-draft-accounts are offered by one type of thrift institution, credit unions, and are like NOW accounts. (Their name arises from the fact that legally, the depositor of funds in a mutual is a share holder, and virtually all credit unions are mutuals. All used to be.)
d. ATS: Money in a time deposit can be used to cover a check drawn for more than is on deposit (an over draft) in a checking account if the writer of the check has this service (Automatic Transfer System). If you have this service, your bank will automatically transfer funds from a time deposit to cover a check.
e. Cashier's checks are checks drawn on a bank by itself which you can buy with cash or by authorizing the transfer of enough money from an account you have at this bank to the bank to cover the amount it is written for.
f. Money orders can be purchased from the Postal Service. They are liabilities of the Postal Service, that is, they promise to pay whomever you pay for something with one of these.
g. Travelers' Checks: Various companies, such as American Express, Visa, and Mastercharge, will sell you these. They come in fixed denominations like paper money.
"Cards" may or may not be substitutes for money:
A few years ago banks started offering debit cards. Debit cards are a substitute for checks. Instead of giving a merchant a check, you hand him or her your debit card. He or she sticks it into a machine which transmits a message which results in your bank account being reduced and his or hers increased. (This is what giving him or her a check also accomplishes, but it takes more time.)
A debit card should NOT be confused with a credit card. A credit card replaces the old system whereby a merchant noted in a book that he or she had sold you merchandise on a credit basis. Unlike a debit card, a credit card is NOT a substitute for money. Unlike a debit card, presenting a credit card does not provide payment to the merchant. He or she receives payment by presenting the resulting charge slip to the credit card company. You then pay the credit card company for having done this--normally by writing a check.
Some cards issued today can be used either as a debit card or a credit card. Only in the former case are you paying for the merchandise.
Newer than the debit card is the cash card. In exchange for cash, an amount of money is electronically "printed" on the card. To buy something, you put it in a machine which subtracts from this amount the value of the purchase.
Liquidity:
1. The more rapidly a non-cash asset can be converted into cash without loss, the more liquid it is.
2. The smaller is the relative loss experienced upon converting a non-cash asset into cash, the more liquid it is.
Liquid assests consist of all paper assets such as money, which is perfectly liquid, and less liquid assets such as savings deposits, bonds, and corporate stocks. Paper assets are intangible assets. Other assets, such as furniture, automobiles, and houses are tangible assets.Tangible assets are less liquid than intangible assets.
Whichever method you use to determine the relative liquidity of non-cash assets will produce the same rating. Cash, of course, is perfectly liquid. Securities, which are intangible assets, are more liquid than tangible assets like inventories, equipment, and buildings.
Economists sometimes refer to cash as M1. By adding the next most liquid assets to M1, you get M2. Cash plus savings deposits are called M2. By adding the next most liquid to M2 you get M3. Liquid assets as a whole are called ML. These (the Ms) are called monetary aggregates.
The equation of exchange:
MV = PY
M (money supply) times V (velocity of money or rate of turnover) has to equal P (average price per unit) times Y (number of units sold)
Two versions of the equation of exchange:
1. transactions: MV = PT, which includes ALL sales
2. income: MV = PY or MV = (nominal) GDP (Gross Domestic Product) which ONLY
includes those sales which are included in GDP.
Velocity is computed thusly: V = GDP/M
If the nation is at full employment, it doesn't take much of an increase in M to cause prices to rise. Because the value of money varies inversely with the price level, the velocity of money may rise as prices rise. If this happens, we have what is called hyperinflation, that is, self-generated inflation. That is, the money supply increasing more rapidly than can the level of output causes inflation. This inflation then becomes self-generating because it induces people to spend money faster than they used to because, otherwise, it would lose too much value while they held it. The highest rates of inflation experienced in the world have been accompanied by a rise in the velocity of money.
If a nation is operating at well below full employment, an increase in the money supply may, at least eventually, cause output, rather than prices, to rise. (Higher profits generated by higher prices may induce an increase in output and a lowering of prices.)
Because the Fed can control the supply of bank reserves and set the legal minimum ratio of reserves to deposits, over the long run it can control the supply of money. (Recall that: bank reserves consist of deposits at the Fed (Fed liabilities) and cash, nearly all cash is a liability of the Fed, and it puts the rest (coins) into circulation.) The public, however, controls the composition of the money supply. This is because, say, 60% of the money supply is currently in the form of checkbook money, and the other 40% is in the form of cash. If the public decides it wants a larger share in the form of cash, it has only to withdraw cash from the banks; thus increasing the amount of cash in circulation while reducing the amount of checkbook money. By depositing some of the cash it holds, the public can do the reverse: increase the percent held in the form of checkbook money while reducing the percent held in the form of cash.
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What They Are:
Deposit-type institutions and the types of deposits they offer:
There are two types of deposit institutions: commercial banks and thrift institutions
Today thrift institutions differ little from commercial banks. Originally the law only allowed them to offer savings accounts. Commercial banks and thrift institutions today offer three types of deposits:
a. checking b. savings c. time
Banks must honor checks drawn on them when they are presented.
Checks cannot be written on savings accounts (deposits); therefore, they are NOT part of the money supply as are checking accounts. Interest is paid on savings accounts. This rate exceeds what is paid on NOW accounts because savings accounts are inferior to checking accounts because they cannot be used as money. The higher interest rate offsets this disadvantage. Money can be withdrawn from them whenever a bank is open without any penalty.
Time deposits have a maturity date. The most common form is the certificate of deposit (CD). To get your money from a negotiable CD, you must either wait until it matures or sell it. If it is non-negotiable, you must either wait until it matures or be penalized via a reduction in the rate of interest paid on it. The interest rate paid on time deposits is greater than that paid on savings accounts because you cannot withdraw the money from them at any time without penalty or cannot withdraw it until it matures; thus they are inferior to savings accounts.
There are three types of thrift institutions:
1. savings and loan associations (few of these are left)
2. savings banks
3. credit unions
All thrift institutions were originally mutuals, that is, customer owned. Today thirifts can be incorporated institutions like commercial banks which have, by law, always had to be corporations, that is, investor owned.
Banks' reserves consist of vault cash plus their deposits with the Federal Reserve System's (Fed) twelve, regional banks These deposits can be acquired by banks with cash and can be withdrawn on demand. They can also be acquired by banks borrowing from the Fed or selling securities they own to the Fed. Banks are required to hold reserves. They are required to avoid the ratio of their reserves to fall below a certain ratio to their deposits.
The monetary base = currency in circulation plus bank reserves.
Banks are able to create money because ours is a fractional reserve system of banking.
The easiest way to understand this is to assume all a bank's reserves are held in the form of cash and consider only three bank accounts: cash (an asset), loans (an asset), and checking deposits (a liability). Assume that the reserve requirement is 20 percent, that is, the ratio of cash (reserves) to deposits (checking deposits) cannot exceed .20 (20 perecent).
If a banks collectively had $1 billion in cash, no loans, and checking deposits of $1 billion (issued to the customers who deposited the cash), they could make loans of up to $4 billion by issuing borrowers $4 billion in checking deposits.
| ASSETS | LIABILITIES |
| Cash - - $1 billion | Checking deposits - $5 billion |
| Loans - $4 billion |
This could be done because the ratio of reserves to deposits is $1 billion to $5 billion, which equals the minimum legal level, 20 percent. So, until and unless more reserves are obtained, $4 billion is the most additional money the banking system can create. Due to lack of borrowers or borrowers of sufficiently low risk, banks are likely not to create this much additional money.
Note that the above refers to the all banks collectively. This is important because an individual bank can safely create only an amount of additional money equal to its excess reserves. This is because, say a bank has $100 deposited into one of its checking accounts, and the reserve requirement is 20 percent (.20). Say it lends out $400. $100 is enough reserves to meet the reserve requirement on this $400 in deposits plus the $100 deposit provided the depositor of the $100 in cash. It is, however, possible that all the borrowers write checks that are deposited in other banks. Therefore, other banks will demand have to be paid $400--four times the $100! If, however, the bank has confined itself to lending out its excess reserves of $80 [$100 - .2($100)], it would have no problem. The $400 of borrowers' deposits would be gone--drawn upon, leaving only the depositors' $100--and the $20 left would be adequate to meet the reserve requirement on the $100 deposit issued to the person who deposited the $100. Therefore, this bank would create only $80 of the $400 that could ultimately be created by other banks as they obtain varying-sides shares of the $80 of excess reserves.
Because vault cash is not part of the money supply, which is defined as equaling money in circulation, but checking deposits are, when people deposited $1 in cash in the banks in checking deposits, the size of the money supply did not change because, although there was thereafter $1 billion less in circulation, there was a $1 billion more checkbook money in circulation. When the banks then issued $4 billion more checkbook money in exchange for borrowers' I.O.U.s, the money supply increased by $4 billion!
The deposit multiplier is the inverse of the reserve requirement, that is: 1/.2. In this case it is one divided by 20 percent (.2), which equals five (5). Note that 5 times $1 billion equals $5 billion.
Total reserves times the reserve requrement equals required reserves. Before the banking system in this case made any loans, it was forbidden from holding less than $200 million in cash (reserves) because 20 percent of $1 billion is $200 million. These are called required reserves.
Total reserves less required reserves equals excess reserves. In this case this is $1 billion less $200 million, which equals $800 million.
Excess reserves times the deposit multiplier equals the maximum amount of new loans that can be made. In this case this is 5 times $800 million, which equals $4 billion.
Free reserves are excess reserves less borrowed reserves. Banks can borrow reserves from other banks. What they borrow is part of other banks' reserve deposits at their district Federal Reserve Bank. These are called Federal Funds. It is risky for banks to extend additional loans in excess of their free reserves because these loans ar for very short periods of time; therefore, they are highly likely to be lost well before the new loans mature.
Click to review this section: How They Create Money
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| Barter | Required Reserves | Liquidity | Equation of Exchange |
| Types of Money | Thrifts | Deposit Multiplier | Types of Deposits |
| Forms of Money | Bank Reserves | Excess Reserves | Creating Money |
