Lecture Notes on Mishkin Chapter 3
("What is Money")
Econ 353: Money, Banking, and Financial Institutions

Last Updated: 10 September 2007

Latest Course Offering: Fall 2007

Course Instructor:

Professor Leigh Tesfatsion

tesfatsi AT iastate.edu

Econ 353 Homepage:

http://www.econ.iastate.edu/classes/econ353/tesfatsion/

• Economists' Meaning of Money
• Functions of Money
• Evolution of Payment Systems
• Measuring Money
• Reliability of Monetary Data
• Basic Concepts and Key Issues From Mishkin Chapter 3

Economists' Meaning of Money

1. Basic Definition

Money is anything that is generally accepted in payment for goods and services and for the repayment of debts, as a matter of social custom.

It follows that money is defined more by its function (what purposes it serves) than by its form (coin, paper, gold bars, etc.).

Moreover, the stress on "generally accepted" in this definition indicates that money is largely a social convention in the sense that what actually constitutes money in a society depends on what people in the society are generally willing to accept as money.

An interesting question is how this "general acceptance" comes to be established!

Note on Terminology:

Money must be distinguished from both "wealth" and "income."

The wealth of an agent at any given point in time is the current market value of the total collection of assets currently owned by that agent. Money holdings might constitute part of an agent's wealth, but the agent would presumably own other types of assets as well (e.g., land, equipment,...). On the other hand, income is a flow of value accrued over some specified period of time.

Example: A student works part time as a teaching assistant, earning $900 per month, and has a checking account balance of $400. He also owns a car worth $1100 and books worth $500. Consequently, ignoring for simplicity the student's "human capital" (e.g., his embodied labor skills, valued by estimating the capitalized stream of all of his potential future wage earnings), one has:

• Money holdings = $400

• Wealth = Market value of his asset holdings consisting of (money holdings, car, books) = ($400 + $1,100 + $500) = $2,000

• Income = $900 per month

As illustrated by this example, income is a flow variable in the sense that it measures an amount of value accrued over a specified period of time (e.g., a month). In contrast, money and wealth are both stock variables in the sense that they measure an amount of value at a given point in time.

2. Types of Money

• Commodity Money: Commodity money is any commodity (economic good) that is used as money, i.e., that is generally accepted as a means of payment for goods and services and for the repayment of debts.

  Commodity Money Examples from the Past:

  Cattle, skins, furs, corn, gold, silver, and copper.

• Fiat Money: Fiat money is any paper money that is "unbacked" and "legal tender." A money is unbacked if it is not collateralized by any valuable commodity. That is, no one is obliged by law to convert the money into coins, precious metals, or any other type of physical good or service. A money is legal tender for a country if, by law, the citizens of the country must accept the money for repayment of debts.

  Fiat Money Example:

  In the United States, the Federal reserve notes (dollar bills) issued by the Federal Reserve System (the central bank of the US) are paper money that is unbacked legal tender, hence fiat money. The general acceptance of dollar bills in the US as payment for goods and services depends upon the persistence of a widely shared trust among citizens that any person who accepts dollars now in exchange for goods or services will be able to exchange these dollars later for other goods and services.

  Note: Under the Coinage Act of 1965, legal tender in the United States consists of all currency (coins and paper money) issued by the U.S. government. This includes Federal reserve notes as well as other older paper money issued by the U.S. government, such as United States notes first authorized and issued in 1862 during the Civil War (1861-1866).

• Electronic Means of Payment (EMOP): A means of payment that permits payments to be transmitted using electronic telecommunications.

  EMOP Examples:

  One example is the Fed's use of Fedwire, a telecommunications system that permits all financial institutions that maintain accounts with the Fed to wire (transfer) funds to each other without having to send checks.

  Other examples include private EMOP systems such as CHIPS and SWIFT (used by banks, money market mutual funds, securities dealers, and corporations to wire funds) and ACHs (automatic clearing houses) used for smaller wire transfers, e.g., from employers to their employees.

  Interesting EMOP observation:

  As noted by Mishkin, in the United States, even though an EMOP is used by fewer than 1 percent of the number of payments made, over 80 percent of the dollar value of payments made is through EMOP transfers.

• Electronic Money (e-Money): E-money is money that is stored electronically rather than in paper or commodity form. Once established, e-money cuts way down on transactions costs; but it can be expensive to set up an e-money system, and concerns have been raised about record-keeping, security, and privacy (as well as the elimination of "float" for consumers!).

e-Money Examples:

• Debit Cards: Charged expenses are immediately deducted from some corresponding bank account -- there is no float (time between purchase and deduction) as with credit cards and paper checks;

• Stored-Value Cards: Charged expenses are immediately deducted from a fixed amount of digital cash stored on the card;

• Electronic Cash: A form of e-money that can be used to purchase goods and services on the Internet;

• Electronic Checks: A process by which users of the Internet can pay their bills directly over the Internet without having to send a paper check.

Functions of Money

Money performs three basic functions in an economy: (1) It serves as a unit of account; (2) it serves as a medium of exchange; and (3) it serves as a store of value.

• Unit of Account: A unit in terms of which a single price for each good and service can be quoted.

  Example:

  In the US, the price of an apple is given as dollars per apple, the price of a gallon of milk is given as dollars per gallon of milk, etc. That is, each good or service on sale at an outlet is generally offered at a single quoted "dollar price" -- that is, a price quoted in terms of dollars.

  In reality, however, any particular good or service (e.g., apples) has a huge array of different prices that could be quoted for it, one for each other good or service in the economy (e.g., pounds of bread per apple, cans of beer per apple, hours of doctor visits per apple, etc.)

  Without a money unit to provide a single accepted unit of account, sellers would have to quote prices of items in terms of whichever goods or services they were willing to accept in return at the time the items were purchased. That is, as clarified further below, the payment system would be a "barter" payment system.

• Medium of Exchange: An accepted means of payment for trade of goods and services.

  As noted above, the existence of a money unit permits each item for sale to have a single price quoted for it in terms of the money unit. But this is not enough to ensure the item will actually be sold to buyers for money units.

  Sellers have to be willing to accept the money units from buyers in return for giving up the item, which requires a trust on the part of sellers that others will in turn be willing to accept these money units from them at a later time in return for goods and services. That is, the money units have to act as a medium of exchange in the economy before one can conclude that they indeed constitute money in the economy.

• Store of Value: A repository of purchasing power for future use.

  Money can be held for future use, allowing for the ability to save (store value) over time. All assets act as stores of value to some extent, but money by definition is the most liquid, i.e., the most easily converted into a medium of exchange, since by definition it already is a medium of exchange!

  On the other hand, money is by no means a risk-free store of value. The real purchasing power of money depends on the inflation rate, that is, on the rate at which the general price level is changing. If the inflation rate is positive (prices are increasing), any money held loses purchasing power over time. If the inflation rate is negative (prices are decreasing), any money held gains purchasing power over time.

  To the extent that the inflation rate is unpredictable, inflation reduces the ability of money to act as a reliable store of value and as a method of deferred payment in borrowing-lending transactions. A positive inflation rate is bad for lenders and good for borrowers since the dollars lent out are worth more than the dollars later paid back. Conversely, a negative inflation rate is good for lenders and bad for borrowers.

  In extreme cases in which the inflation rate exceeds 50 percent per month -- a situation referred to as hyperinflation -- the entire monetary system generally breaks down and is replaced by barter. This has devastating effects on an economy.

  Mishkin notes that Post-WWI Germany suffered a hyperinflation in which the inflation rate at times exceeded 1000 percent per month. More recently, various Latin American economies experienced hyperinflations during the 1980s. For example, as discussed by Mishkin in Chapter 28, in the first half of 1985 Bolivia's inflation rate was running at 20,000 percent and rising.

Evolution of Payment Systems

Tracing the historical evolution of payment systems in various economies is a fascinating and complex task. Although highly simplified, the following three-stage process captures the general way in which this evolution has occurred in many parts of the world.

• Autarky: Each family or tribal group produces all of what they consume, with the outputs of production being shared in accordance with some kind of group distribution rule determining who gets what and in what amount. No trade takes place and there is no use of money.

• Barter Payment System: Within family or tribal groups, and possibly between such groups, people trade goods and services for other goods and services. There is no use of money.

• Monetary Payment System: People trade goods and services in return for money.

A barter payment system has several problems that make it extremely inefficient relative to a monetary payment system if a large number of goods and services are produced in an economy:

• Double Coincidence of Wants: Under a barter payment system, a double coincidence of wants is needed before any trade can take place. That is, two individuals seeking to trade must have exactly the goods or services that each other wants. The requirement of having a double coincidence of wants before exchange can take place discourages both specialization in labor (generally referred to as "division of labor") and specialization in production; for the fewer the types of goods and services one produces for sale, the fewer the types of goods and services one can expect to be able to trade for. The need for double coincidence of wants in barter payments systems thus tends to reduce productive efficiency.

• Multiple Prices for Each Good or Service: Under a barter payment system, many different prices must be maintained for each good and service, making informed decisions about what to buy (and from whom to buy it) extremely difficult. Specifically, an exchange ratio ("goods price") is needed for every distinct pair of items to be traded.
  
  For example, given two items (say apples and beer), one needs one goods price (apples per beer or beer per apples, either one will do). For three items (say apples, beer, and cars), one needs three goods prices (e.g., apples per beer, apples per car, and beer per cars). But for four items one needs six prices, for five items one needs ten prices, and so it goes. As the number of items keeps increasing, the number of needed goods prices increases dramatically.
  More precisely, given a barter economy with n goods, the number of needed goods prices is n[n-1]/2, which is the number of distinct ways that n items can be selected 2 at a time without consideration of order. An equivalent formula for calculating the needed number of goods prices in a barter economy with n goods is the sum of numbers between 1 and n-1, inclusive; i.e., (n-1) + (n-2) + ... + 1. Can you explain why?

  High Transactions Costs: Under a barter payment system, the above two problems result in high transaction costs, that is, large amounts of resources (time, effort, shoe leather,...) being spent on trying to exchange goods and services.

As previously discussed, the use of money dramatically cuts down on the transactions costs arising from barter, so it is not surprising that barter payment systems have tended to evolve into monetary payment systems.

The nature of the monies used in monetary payment systems continues to evolve over time.

The first monies were commodities, that is, they were economic goods such as cattle, tobacco, and gold which had a direct use value (e.g., for eating, smoking, jewelry). Their direct use value made them useful as mediums of exchange because people were willing to accept them as means of payment even if they, themselves, had no direct use for them.

Different types of commodities have different kinds of drawbacks for use as commodity money. For example, gold and silver are durable and can be molded into portable coins of standard size for ease of use in trade, but they tend to lose commodity value when subdivided into very small quantities for everyday transactions. On the other hand, tobacco is not very durable and its quality is highly variable, but it can be subdivided into small amounts without loss of commodity value.

To avoid various difficulties associated with the direct use of commodity monies in trade, private banks along with governments began to issue paper notes (claims against themselves) that were backed (collateralized) by the commodity money they replaced, usually gold or silver coin. That is, the issuers of these paper notes normally promised to redeem their notes in gold or silver coins on demand. This paper form of money was therefore simply a way to cut down on the transactions costs associated with the use of commodity monies without actually eliminating these commodity monies.

As trade continued to expand, however, the power to issue notes was increasingly transferred to governments and the link with commodity monies became increasingly tenuous. Eventually paper notes evolved into fiat monies, i.e., unbacked paper monies officially designated as legal tender. Moreover, the link between the precious metal content of coins and the face value of coins also became tenuous. Indeed, coins in use today are often referred to as token coins because the amounts of silver and other precious metals they contain are far below their face values.

As Mishkin details, the use of fiat money in trade is itself subject to several difficulties: in particular, expense of transport, and risk of theft. Attempts to combat these difficulties led to the invention of checkable demand deposits. More recent innovations include electronic means of payments (EMOPs), which permit value to be transmitted electronically, and electronic monies (e-monies), which permit value to be stored electronically.

In summary, the nature of monies used in monetary payment systems has tended to evolve over time from commodity money, to fiat money, to checkable demand deposits, to EMOPs, and most recently to e-monies. At this point in time, all of these forms of money are used to varying extents in different parts of the world. Whether the earlier forms of money will ever be entirely eliminated by the later forms remains to be seen.

Measuring Money

In the U.S. today, dollar bills and coins are together referred to as currency. As will be clarified later in the course, dollar bills (Federal Reserve notes) are issued by each of the twelve banks constituting the Federal Reserve System (Fed), the central bank of the US. Coins are also put into circulation by the Fed, but they are minted by the U.S. Treasury (part of the Executive Branch of the U.S. Federal government).

In value terms, however, currency represents only a small part of what is used in the U.S. today as money. For this reason, the Fed makes use of various broader measures of the money supply.

Accurate measurement of the money supply is important for the following reasons:

• Changes in the money supply are thought to have rather immediate effects on short-term interest rates (e.g., the Federal funds rate), intermediate-run effects on key macro variables such as real GDP, and longer-run effects on other key macro variables such as the aggregate price level and the inflation rate.

• The Fed has some ability to manipulate and control the money supply (hence short-term interest rates) through open-market operations, i.e., sales and purchases of government bonds to and from the private sector. Thus, by appropriately managing the money supply (and short-term interest rates), the Fed can exert some longer-run control over key macro variables.
  NOTE: Monetary policy refers to the efforts of central banks such as the Fed to control key macro variables through the management of the money supply and (short-term) interest rates.

  Without an accurate measurement of the money supply, however, it is difficult for the Fed to judge the effectiveness of its monetary policy. To judge this effectiveness, the Fed must first be able to measure the extent to which it has succeeded in changing the money supply in accordance with its plans. Second, the Fed must be able to measure the extent to which these changes in the money supply have had intended effects on key macro variables.

There are two basic ways of measuring money: the "theoretical approach" and the "empirical approach."

The Theoretical Approach to Money Measurement:

The theoretical approach to money measurement tries to use economic theory to decide which assets should be included in the measure of money. In particular, the theoretical approach focuses on the relative "moneyness" of assets -- in particular, the degree to which assets function as mediums of exchange.

Traditionally, advocates of this theoretical approach have argued that only those assets that clearly function as a medium of exchange should be counted in the measure of money. Unfortunately, however, many assets function as a medium of exchange to some degree and the appropriate cut-off point is not clear.

More recently, however, economists have argued for a "weighted aggregate" approach to the measure of money.

In the latter approach, all assets functioning to some degree as a medium of exchange are included in the measure of money. However, each of these assets is weighted, with assets that function more as a medium of exchange receiving a relatively larger weight. This eliminates the need to specify a sharp threshhold determining which assets are included or excluded from consideration. However, one is still left with the problem of how to select specific weight magnitudes for the included assets.

The verdict on the reliability and usefulness of these newer weighted-aggregate measures is still out.

The Empirical Approach to Money Measurement:

The empirical approach to the measurement of money takes a more pragmatic view and argues that the decision about what to call money should be based on which measure of money works best in helping to predict the movements of key macro variables.

Unfortunately for the empirical approach, experience has shown that different measures may work better for predicting different variables at any given point in time. For example, the measure that works best for predicting recessions may not be the measure that works best for predicting exchange rates. Morever, the usefulness of any one measure for predicting any one variable tends to vary over time. What works in one period may not work well in the next.

Actual Practice in the United States:

Over the years the Fed has devised a range of different measures of money that combine aspects of the theoretical and empirical points of view. The three measures of money most commonly used by the Fed -- M1, M2, and M3 -- are explained by Mishkin in Table 1.

These measures, generally referred to as monetary aggregates, are "nested" in the sense that each aggregate is broader than its predecessor. For example, M2 includes all assets in M1 together with several additional assets not included in M1.

The narrowest monetary aggregate, M1, conforms to the theoretical point of view in that it only contains highly liquid assets that are directly usable as mediums of exchange (currency, traveler's checks, demand deposits, and other checkable deposits). However, the continual introduction of new forms of money-like instruments has driven the Fed to make additional use of broader monetary aggregates such as M2 and M3 in order to improve its prediction of and control over key macro variables.

Question: Why might you guess that, the narrower the measure of money, the more "unstable" will be its relationship to key macro variables such as GDP and inflation?

As seen in Mishkin's Figure 1, the monetary aggregates M1 and M2 have tended to move together over time, but there have been occasions in which they have moved in substantially different directions. These differences in movement underscore the difficulty of obtaining useful empirical measures of money.

Reliability of Monetary Data

Estimates of the various monetary aggregates are frequently revised by large amounts for two reasons.

• First, small depository institutions are only required to report the amount of their deposits infrequently, forcing the Fed to estimate these amounts between the reporting dates.

• Second, the monetary aggregates are based on "seasonally adjusted" data, meaning that corrections are made for systematic peaks and dips in money use due to such time-dependent events as regular holidays and seasonal changes in weather. The appropriate extent of these seasonal adjustments often only becomes clear after the fact, requiring revisions to the adjustments made at the time of the event.

The revisions made in monetary aggregate estimates can be considerable from one month to the next. However, when averaged over time, these revisions tend to average out to zero.

For example, for the initial and revised monthy estimates of the growth rate of M2 depicted in Mishkin's Table 2, in some months the initial rate estimates are too high and need to be revised downward, and in other months the initial rate estimates are too low and need to be revised upwards. However, the average of the initial rate estimates across all 12 months is approximately the same as the average of the revised rate estimates across all 12 months, implying that the revisions (error corrections) made in the initial rate estimates tend to average out to zero.

A useful conclusion to draw from these observations is that one should probably not pay too much attention to reported monthy movements in monetary aggregates. It is far more meaningful and useful to consider the trends in these monetary aggregates, i.e., to consider the average movements in these monetary aggregates over longer periods of time.

Basic Concepts and Key Issues From Mishkin Chapter 3

Basic Concepts:

Money

Wealth

Income

Stock Variable

Flow Variable

Commodity Money

Paper Money (Backed or Unbacked)

Legal Tender

Fiat Money

U.S. Federal Reserve System

Electronic Means of Payment

Electronic Money

Unit of Account

Medium of Exchange

Store of Value

Hyperinflation

Payment System

Autarky

Barter Payment System

Monetary Payment System

Double Coincidence of Wants

Monetary Policy

Currency

Monetary Aggregates (M1, M2)

Key Issues:

The Definition (Abstract Meaning) of Money

Types of Money

Functions of Money

Evolution of Payment Systems

Efficiency of Barter vs. Monetary Payment Systems

Difficulties Encountered in Attempts to Measure the Money Supply

Measuring the Money Supply: Actual Practice in the U.S.

Reliability of U.S. Monetary Data

Copyright © 2007 Leigh Tesfatsion. All Rights Reserved.