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What’s it: Money is everything we use or accept widely as a means of payment for goods and services, including coins and banknotes. It also functions as a unit of account and a store of value. It replaces barter payments in the modern economy.
In ancient times, we used gold or silver as money. We all accept it as a medium of exchange because we think it is valuable.
However, in today’s economy, fiat money, such as banknotes and coins, replaced the gold standard even though they had no intrinsic value. This shift allowed governments to benefit from seigniorage, the profit earned from creating new money. Now, electronic money and cryptocurrency are starting to gain popularity and replace physical money for some transactions.
Importance of money in economics
Money solves problems in barter transactions. You rely on double coincidence. To exchange goods, you have to find another party who has the things you need and who needs your belongings. You also have to transport goods from one location to another just to exchange them.
Bartering is more problematic when it involves indivisible goods. You might have to break them down into smaller pieces just to trade them out. And, it’s hard.
In bartering, there is no common measure of value. You do not have a reference price for each item. If you want to exchange oranges for apples, how many apples must be exchanged for one orange? The answer will be subjective between individuals. It is even more difficult to service.
Money solves such problems. With money, you have freedom and choices about where and how you spend it.
You only need to carry it (physical or digital) to buy things. All sellers are willing to accept it.
We also use the money to determine the unit value of goods. That way, you don’t have to measure the value of the goods yourself. You just have to look at the price and exchange some money to get it.
Characteristics of money
Money facilitates transactions. To function effectively, it must have the following qualities:
- Widely accepted: Money must be readily accepted by all parties involved in a transaction. Conversely, some people may not accept goods as money in bartering because they don’t necessarily need those goods. This eliminates the challenge of finding someone who wants exactly what you have to offer in exchange for what you need.
- Known value: Money should have a clear and established value, allowing everyone to understand its worth and facilitate price comparisons across different goods and services. Money comes in all sizes, shapes, and values, but each unit should have a clearly defined purchasing power.
- Divisible: It should be easily divided into smaller units for precise transactions. This allows for the exchange of goods and services with varying prices, without needing to break down larger units into inconvenient fractions. Unlike a single cow, which can’t be easily divided for smaller purchases, money can be readily divided into smaller denominations to ensure accurate payments.
- Durable: Money should withstand wear and tear to retain value over time. This ensures that it can be used for multiple transactions without losing its purchasing power. Imagine using a bar of chocolate as money – it wouldn’t last long enough to function effectively!
- Portable: It should be easy for us to move from one location to another. This allows for transactions to take place conveniently, regardless of location. Carrying paper money or using a digital wallet is significantly easier than transporting bulky goods like furniture or livestock to barter with.
Types of money
In the economy, what counts as “money” tends to vary. In its narrow definition, it consists of banknotes and coins in circulation. In addition, there are deposits in banks and other financial institutions, which are liquid and quick to use as a means of payment.
Each monetary authority in different countries has a different measure. The most common measures are narrow money and broad money.
- Narrow money consists of banknotes and coins in circulation, plus other highly liquid deposits.
- Broad money consists of narrow money plus various liquid assets that can be used to make purchases.
Functions of money
The three main functions of money are:
- Medium of exchange
- Store of value
- Unit of account
Medium of exchange
Money acts as the universal translator in our economic world, smoothing the way for countless daily transactions. Imagine trying to barter for a new pair of shoes – you might need to offer several old books or a bag of groceries, depending on the perceived value of each item. This becomes cumbersome and inefficient. With money, however, the process is streamlined. You simply hand over cash (or use a digital form of money) in an amount that reflects the pre-established price of the shoes.
Money’s strength as a medium of exchange lies in its divisibility, meaning it can be easily broken down into smaller units. This allows for precise transactions, regardless of the item’s cost. For instance, you can use a single twenty-dollar bill to buy a movie ticket or break it down into five-dollar bills for smaller purchases like coffee or a newspaper.
Furthermore, money’s portability makes it incredibly convenient to carry around. Unlike bartering goods, which can be bulky or difficult to transport, cash or a debit card fits easily in your wallet or pocket, allowing you to make purchases on the go. This portability is crucial for a functioning economy, enabling people to buy and sell goods and services without logistical headaches.
Store of value
Money retains its value over time (acts as a store of value). By saving it, we can transfer our wealth today to the future.
However, the ability to maintain value varies with each type of money. Fiat money, like paper money, is vulnerable to inflation because it has no intrinsic value. When inflation is high, its purchasing power for various goods and services decreases.
It differs from gold, which is relatively resistant to inflation. From traditional economies to modern economies, people regard gold as a valuable item. Hence, like money, gold retains its value, even though the price of goods and services rises. For this reason, we consider gold a safe asset.
Units of account
Money provides a general measure of the value of the goods and services exchanged. With this function, we can compare the values of various products.
For example, if a bag costs $9 per unit and a pair of shoes costs $18, we can calculate the opportunity cost of buying a pair of shoes, two units of the bag. Comparisons are made easier when the value of the goods is expressed in money (price).
For this reason, money makes it easy to calculate the opportunity cost of consumption, facilitating efficient decision-making.
Demand and supply of money
The equilibrium interest rate in the economy is determined by the demand for money and the supply of money. The money demand curve slopes downward, showing a negative relationship between the interest rate and the amount of money demanded. Meanwhile, the money supply curve is a vertical line, telling you that the central bank determines the amount of money supplied to the economy.
Money supply
The central bank determines the money supply. It can be done in several ways and instruments. The policy to change the money supply is what we call monetary policy. The instrument can be via:
- Policy rate: the interest rate set for central bank loans to commercial banks.
- Open market operations: sale or purchase of government securities by a central bank
- Reserve requirements: the portion of deposits held by commercial banks as reserves and can not be lent.
Changes in the money supply affect interest rates in the economy. It affects consumption and investment behavior, where the real sector relies on loans. Ultimately, it affects aggregate demand.
An increasing money supply causes interest rates to fall. Conversely, a decrease in the money supply causes interest rates to rise.
Money demand
Money demand reflects the amount of financial assets that households choose to hold in money, not bonds or stocks. Why is money being asked for? Economists share three motives for asking for money:
- Transaction motives. Economic actors need money to finance transactions. The larger the transactions involved, the greater the demand for money. In general, it depends on the average transaction size and the overall GDP. GDP represents the monetary value of goods and services transacted in the economy.
- Precautionary motives. Economic actors save money for use in unforeseen circumstances. It may be to take advantage of opportunities or prevent unexpected or immediate expenses.
- Speculative motives relate to the perceived returns and risks from holding other financial instruments. When the returns on other financial instruments increase, the speculative demand for money decreases. People prefer to hold financial instruments rather than money. Conversely, if the risk of other financial instruments increases, speculative demand falls.
Money neutrality and real money
The concept of money neutrality suggests that changes in the money supply only affect nominal variables like prices and wages, not real variables like economic growth or unemployment. However, most economists believe this is an unrealistic ideal.
- Sticky wages and prices: Prices and wages may not adjust immediately to changes in the money supply, causing temporary imbalances in the real economy.
- Debt levels and expectations: Businesses and consumers with high debt burdens might be more sensitive to interest rate changes, which can impact their spending and investment decisions.
- Asset markets: Changes in the money supply can influence asset prices, which can indirectly affect economic activity through wealth effects and investment decisions.
Real money vs. nominal money
The concept of money neutrality is also intertwined with the distinction between real money and nominal money:
- Real money: Represents the purchasing power of money. It reflects the amount of goods and services a unit of money can buy. For instance, if a loaf of bread costs $2 today, the real money value of $2 is one loaf of bread.
- Nominal money: Refers to the face value of the currency itself. It’s the amount printed on a bill or coin.
Changes in the money supply can primarily impact nominal money (the amount of currency in circulation). However, the effect on real money (purchasing power) depends on how quickly prices adjust. In the long run, if the money supply persistently increases faster than the production of goods and services, inflation will erode the real value of money.
Money multiplier and money creation
Money creation is the process by which the money supply in an economy grows. It’s not just about printing more bills! The money multiplier plays a crucial role in this process, influencing how much new money is created based on initial changes in the monetary base.
Understanding money creation
Commercial banks, not just central banks, are the primary creators of money. Here’s how it works:
- Deposits: When you deposit cash into your bank account, you’re not simply storing it. The bank keeps a portion (reserve requirement) as reserves but lends out the remaining amount. This creates new money in the form of a deposit for someone else.
- Fractional reserve banking: Banks don’t lend out all deposits. They keep a reserve to maintain liquidity and meet withdrawal demands. This reserve requirement sets a limit on money creation.
- The money multiplier: This concept explains how a single dollar of new reserves can lead to a multiplied increase in the money supply. Let’s say the reserve requirement is 10%. A bank receives a $100 deposit. It keeps $10 as reserves (10%) and lends out $90. The borrower spends that $90, which might end up deposited in another bank.
- The cycle continues: The second bank keeps its 10% reserve ($9) and lends out $81. This lending and depositing cycle continues throughout the banking system, gradually creating new money based on the initial deposit.
The money multiplier formula
The money multiplier is calculated as the reciprocal of the reserve requirement (RR):
- Money multiplier = 1 / Reserve Requirement (RR)
For example, with a 10% reserve requirement, the money multiplier would be 1 / 0.1 = 10. This means that a single dollar of new reserves can potentially be multiplied into $10 of new money circulating in the economy.
Factors affecting money creation
The money multiplier isn’t a fixed number. Several factors can influence how much new money is created:
- Reserve requirement: A higher reserve requirement reduces the amount banks can lend, lowering the money multiplier effect.
- Excess reserves: If banks hold more reserves than required, it limits the amount they can lend and slows money creation.
- Demand for loans: Businesses and consumers needing loans drive money creation. If loan demand is low, banks may have excess reserves, reducing the multiplier effect.
Central Bank’s role
While commercial banks create most new money, the central bank can influence the process through monetary policy tools:
- Open market operations: By buying government bonds, the central bank injects reserves into the banking system, potentially increasing the money multiplier effect. Conversely, selling bonds can withdraw reserves and slow money creation.
- Discount rate: This is the interest rate the central bank charges on loans to commercial banks. A lower discount rate encourages banks to borrow more reserves, potentially leading to higher money creation.
