money and its how to use it

Chapter 2: Money and How We Use it

Money and How We Use It
To put it simply, money is anything commonly accepted in exchange for goods or services. Throughout the history of the world, many things have served as money: gold, silver, cows, horses, cigarettes, and more.
However, before we begin taking a closer look at money it is important to distinguish between some terms. We often use "money", "income," and "wealth" to mean the same things. However, these terms, though related, are different, and their differences are important in understanding financial markets.

• Money refers to what is actually accepted as payment for goods, services, and debts.
• Income refers to earnings during a period of time, such as a year.
• Wealth refers to the accumulated assets/property at a point is time.

What's this difference? Well, both money and wealth are stock variables. They are the amount at a point in time. Income is a flow. It is an amount occurring during a set time period. Consider these examples:

• If I own $2 million worth of diamonds but no cash or bank accounts, I am wealthy but I do not have any money.
• Suppose you win a $25 million lottery prize which you take as a lump sum, put the cash under your bed, and then quit your job. You would be wealthy, you would have a lot of money, but your income will be zero.
• Suppose a computer genius in Silicon Valley blows all of his income every year on food, parties, vacations even though he earning $250,000 per year. He has a high income, but is not wealthy if he has accumulated no assets.

These examples illustrate the importance of being clear about what financial variables are appropriate in a given situation.
Money has several functions in a society:
Money is a means of payment or a medium of exchange. Money is accepted in exchange for goods and services. This is the main function of money. In the absence of a medium of exchange we would be stuck bartering for stuff we want. This is inefficient because it requires a double coincidence of wants. I have to want what you are trading, and you have to want what I am trading. In our large and complex economy, that is pretty unlikely. So without money, the transaction costs associated with bartering for everything you want would be huge. This function is so important that it is the motivation for the development of money in the earlier cultures and civilizations on the planet. If money is to function well this way, then the form that money takes must

• be easily measured to determine its actual value
• be easily divisible to pay for both "cheap" and "expensive" items
• be widely accepted by buyers and sellers
• not deteriorate quickly.

Looking at this list we note that precious metals would satisfy much of these criteria, but a piece of fruit would not.
Money is a unit of account (or standard of value). Money is the benchmark used to measure value. If I tell you the price of a product, you immediately know how cheap/expensive it is, and can compare that value to other products. If I tell you the price of something is $500, you immediately form a very different impression about its value than if the price is $5.
Money is a store of value. Money can be used to accumulate wealth; i.e., to save your income today to purchase something in the future. Money is not the only store of value. Precious metals, gems, real estate, stocks, and bonds could also perform this function. The big advantage money has over these other assets is liquidity. Money can be used immediately to purchase goods and services while converting gold, diamonds, or a house to cash takes time and effort. In times of high inflation or political instability, money may not be a good store of value. The U.S. dollar is considered to be an excellent store of value, but the Russian ruble is a lousy one.
The Payments System
Money has evolved to take different forms, and the way that monetary payments are made continue to evolve at a rapid rate.
Originally money took the form of commodity money. Commodity money is money with its own value as a good. Gold coins are commodity money because the gold is worth something as a metal, not just as a unit of money. Commodity money has an opportunity cost: the gold in a gold coin could be used for something else, like jewelry. It also gets really heavy.
It is only within the last 100 years of world history that we have seen paper money successfully circulate. (Your book gives you a little history about some failures.) At first, paper money consisted of certificates redeemable for precious metal. The U.S. dollar was convertible to gold until 1934. Later money evolved into fiat money, where paper currency is not linked to a commodity. Fiat money has no value other than that given to it as money. The U.S. dollar today is fiat money. A $10 bill is worth something because the federal government says so, and because we accept it in exchange for goods and services. Fiat money is more efficient because it does not involve the same opportunity cost as does commodity money.
Both checks and electronic payments (such as debit and credit cards) are alternative forms of payments. They have the convenience and safety of not requiring buyers to carry a lot of cash. These alternative payment methods also leave a record of transactions, which may be good or bad. A cancelled check to prove payment of taxes is a good thing. However, it is hard to imagine a drug dealer accepting Visa.
Keep in mind that checks, debit cards or credit cards are NOT money. They are both payment mechanisms by which we access money in a more convenient way.
Measuring Money
One key indicator of our economy is the rate of inflation, i.e. the rate of increase in the general price level. Inflation is closely related to money growth. In order to measure money growth, we have to first measure money.
Money is broader than just cash, and different kinds of money differ in terms of how easily they convert to cash. The U.S. has four measures of its money supply:

• M1 = currency in circulation + demand deposits + other checkable deposits + traveler's checks
• M2 = M1 + savings deposits + small time deposits (CDs < $100,000) + money market deposits + other stuff
• M3 = M2 + large time deposits + other stuff
• L = M3 + other stuff

These measures get larger and larger because they include the measure below it. M1 contains the most liquid assets, i.e. assets easily converted to cash. We add assets less and less liquid assets for the broader measures of money.
The various components of M1, M2 and M3 vary in their importance:



Cash makes up almost half of M1, savings deposits are the largest component of M2, and over 2/3 of M3 components are those already included in M1 and M2.
The three monetary aggregates may move together or in opposite directions. Note, for example, the differences in the behavior of M1 vs. M2 and M3 in the 1990s:

Given these differences, the monetary aggregate that policymakers choose to watch could make a difference in the direction of monetary policy. Today policy makers place more emphasis on M2 and M3 since these measure include money market accounts.
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