Monetary system

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When you walk into a restaurant to buy a meal, you get something of value--a full stomach. To pay for this service, you might hand the restaurateur several worn-out pieces of greenish paper decorated with strange symbols, government buildings, and the portraits of famous dead Americans. Or you might hand him a single piece of paper with the name of a bank and your signature. Whether you pay by cash or check, the restaurateur is happy to work hard to satisfy your gastronomical desires in exchange for these pieces of paper which, in and of themselves, are worthless. To anyone who has lived in a modern economy, this social custom is not at all odd. Even though paper money has no intrinsic value, the restaurateur is confident that, in the future, some third person will accept it in exchange for something that the restaurateur does value. And that third person is confident that some fourth person will accept the money, with the knowledge that yet a fifth person will accept the money and so on. To the restaurateur and to other people in our society, your cash or check represents a claim to goods and services in the future. The social custom of using money for transactions is extraordinarily useful in a large, complex society. Imagine, for a moment, that there was no item in the economy widely accepted in exchange for goods and services. People would have to rely on barter--the exchange of one good or service for another--to obtain the things they need. To get your restaurant meal, for instance, you would have to offer the restaurateur something of immediate value. You could offer to wash some dishes, clean his car, or give him your family's secret recipe for meat loaf. An economy that relies on barter will have trouble allocating its scarce resources efficiently. In such an economy, trade is said to require the double coincidence of wants--the unlikely occurrence that two people each have a good or service that the other wants. The existence of money makes trade easier. The restaurateur does not care whether you can produce a valuable good or service for him. He is happy to accept your money, knowing that other people will do the same for him. Such a convention allows trade to be roundabout. The restaurateur accepts your money and uses it to pay his chef; the chef uses her paycheck to send her child to day care; the day care center uses this tuition to pay a teacher; and the teacher hires you to mow his lawn. As money flows from person to person in the economy, it facilitates production and trade, thereby allowing each person to specialize in what he or she does best and raising everyone's standard of living. In this chapter we begin to examine the role of money in the economy. We discuss what money is, the various forms that money takes, how the banking system helps create money, and how the government controls the quantity of money in circulation. Because money is so important in the economy, we devote much effort in the rest of this book to learning how changes in the quantity of money affect various economic variables, including inflation, interest rates, production, and employment. Consistent with our long-run focus in the previous three chapters, in the next chapter we will examine the long-run effects of changes in the quantity of money. The short-run effects of monetary changes are a more complex topic, which we will take up later in the book. This chapter provides the background for all of this further analysis.

THE MEANING OF MONEY

What is money? This might seem like an odd question. When you read that bil- lionaire Bill Gates has a lot of money, you know what that means: He is so rich that he can buy almost anything he wants. In this sense, the term money is used to mean wealth. Economists, however, use the word in a more specific sense: Money is the set of assets in the economy that people regularly use to buy goods and services from other people. The cash in your wallet is money because you can use it to buy a meal at a restaurant or a shirt at a clothing store. By contrast, if you happened to own most of Microsoft Corporation, as Bill Gates does, you would be wealthy, but this asset is not considered a form of money. You could not buy a meal or a shirt with this wealth without first obtaining some cash. According to the economist's definition, money includes only those few types of wealth that are regularly accepted by sellers in exchange for goods and services.

THE FUNCTIONS OF MONEY

Money has three functions in the economy: It is a medium of exchange, a unit of ac- count, and a store of value. These three functions together distinguish money from other assets, such as stocks, bonds, real estate, art, and even baseball cards. Let's examine each of these functions of money in turn. A medium of exchange is an item that buyers give to sellers when they purchase goods and services. When you buy a shirt at a clothing store, the store gives you the shirt, and you give the store your money. This transfer of money from buyer to seller allows the transaction to take place. When you walk into a store, you are confident that the store will accept your money for the items it is selling because money is the commonly accepted medium of exchange. A unit of account is the yardstick people use to post prices and record debts. When you go shopping, you might observe that a shirt costs $20 and a hamburger costs $2. Even though it would be accurate to say that the price of a shirt is 10 ham- burgers and the price of a hamburger is 1/10 of a shirt, prices are never quoted in this way. Similarly, if you take out a loan from a bank, the size of your future loan repayments will be measured in dollars, not in a quantity of goods and services.

When we want to measure and record economic value, we use money as the unit of account. A store of value is an item that people can use to transfer purchasing power from the present to the future. When a seller accepts money today in exchange for a good or service, that seller can hold the money and become a buyer of another good or service at another time. Of course, money is not the only store of value in the economy, for a person can also transfer purchasing power from the present to the future by holding other assets. The term wealth is used to refer to the total of all stores of value, including both money and nonmonetary assets. Economists use the term liquidity to describe the ease with which an asset can be converted into the economy's medium of exchange. Because money is the economy's medium of exchange, it is the most liquid asset available. Other assets vary widely in their liquidity. Most stocks and bonds can be sold easily with small cost, so they are relatively liquid assets. By contrast, selling a house, a Rembrandt painting, or a 1948 Joe DiMaggio baseball card requires more time and effort, so these assets are less liquid. When people decide in what form to hold their wealth, they have to balance the liquidity of each possible asset against the asset's usefulness as a store of value. Money is the most liquid asset, but it is far from perfect as a store of value. When prices rise, the value of money falls. In other words, when goods and services be- come more expensive, each dollar in your wallet can buy less. This link between the price level and the value of money will turn out to be important for understanding how money affects the economy.

money quantity exchange

THE KINDS OF MONEY

When money takes the form of a commodity with intrinsic value, it is called commodity money. The term intrinsic value means that the item would have value even if it were not used as money. One example of commodity money is gold. Gold has intrinsic value because it is used in industry and in the making of jewelry. Although today we no longer use gold as money, historically gold has been a common form of money because it is relatively easy to carry, measure, and verify for impurities. When an economy uses gold as money (or uses paper money that is convertible into gold on demand), it is said to be operating under a gold standard. Another example of commodity money is cigarettes. In prisoner-of-war camps during World War II, prisoners traded goods and services with one another using cigarettes as the store of value, unit of account, and medium of exchange. Similarly, as the Soviet Union was breaking up in the late 1980s, cigarettes started re- placing the ruble as the preferred currency in Moscow. In both cases, even nonsmokers were happy to accept cigarettes in an exchange, knowing that they could use the cigarettes to buy other goods and services. Money without intrinsic value is called fiat money.Afiat is simply an order or decree, and fiat money is established as money by government decree. For example, compare the paper dollars in your wallet and the paper dollars from a game of Monopoly (printed by the Parker Brothers game company). Why can you use the first to pay your bill at a restaurant but not the second? The answer is that the U.S. government has decreed its dollars to be valid money. Each paper dollar in your wallet reads: “This note is legal tender for all debts, public and private.” Although the government is central to establishing and regulating a system of fiat money (by prosecuting counterfeiters, for example), other factors are also required for the success of such a monetary system. To a large extent, the acceptanceof fiat money depends as much on expectations and social convention as on government decree. The Soviet government in the 1980s never abandoned the ruble as the official currency. Yet the people of Moscow preferred to accept cigarettes (or even American dollars) in exchange for goods and services, because they were more confident that these alternative monies would be accepted by others in the future.

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