Module 4.3 Money
Module 4.3: Definition, Measurement, and Functions of Money
Introduction
Discussion of Module 4.3 covering the definitions, measurements, and functions of money.
Emphasis on the complexity of defining money from an economic perspective.
Goal: Understand what constitutes money, how economists measure it, and the distinction between money and credit cards.
What is Money?
Definition: Money is an abstract concept that is based on collective agreement about value.
In economics, money is defined as any asset that serves three specific functions:
Medium of Exchange
The primary function of money.
Enables the purchase of goods and services easily.
Example: Using a $5 bill to buy apples at a grocery store is straightforward, whereas bartering would require a trading partner who wants what you offer (e.g., a goat).
Double Coincidence of Wants Problem: Evolved from barter systems, where both parties must agree on the trade, which is simplified by the use of money.
Store of Value
Money holds its purchasing power over time, allowing saving and future expenditure.
Example: A $20 bill kept in a drawer retains its value; however, a peanut butter and jelly sandwich does not retain its value over time due to spoilage.
The effectiveness of money as a store of value is affected by price stability; for instance, hyperinflation reduces this function.
Unit of Account
Provides a standard measure for valuing goods and services.
Example: If Caleb trades his hamster habitat for three pizzas, and Caddell wants movie tickets for pizzas, it complicates fair value assessment.
Money simplifies this by providing a common standard (e.g., a hamster habitat costs $30, a pizza costs $10, movie tickets cost $15).
Collective Agreement: If participants in an economy decided that bubble gum wrappers served the three functions of money, they could be treated as money.
Types of Money
Fiat Money:
Definition: Money without intrinsic value, valued by government decree and collective acceptance.
Example: Dollar bills; their worth is based on public trust rather than the material itself.
Commodity Money:
Definition: Money with intrinsic value; it has worth beyond functioning as money.
Examples: Gold and silver can function as currency but are also used for jewelry or manufacturing.
Commodity-Backed Money:
Definition: Money without inherent value, but convertible to something of value (e.g., gold).
Historical example: US dollars backed by gold, allowing individuals to exchange notes for gold at banks.
Measuring Money Supply
Liquidity
Liquidity: Refers to how easily and quickly an asset can be converted into cash without losing value.
Cash: Perfectly liquid.
Checking Accounts: Very liquid (transferable instantly).
Savings Accounts: Less liquid (may have restrictions on withdrawals).
Certificates of Deposit: Least liquid (money locked for a specific timeframe).
M1
Definition: Represents the most restrictive measure of money, including only the most liquid assets.
Components of M1:
Cash in circulation
Checkable deposits (e.g., funds in checking accounts).
Example: As of August 2025, M1 in the United States was approximately $18,900,000,000,000.
M2
Definition: A broader measure than M1, classified as "near money."
Components of M2:
Everything in M1
Savings accounts
Small time deposits (e.g., certificates of deposit under $100,000)
Money market deposit accounts
Money market mutual funds.
Labelled as "near money" because although not directly spendable, these assets can quickly be converted to cash.
Key relationship: M2 is always greater than M1, as it includes all of M1 plus additional assets.
Formula: M2 = M1 + ext{savings accounts} + ext{small CDs} + ext{money market funds}
Monetary Base
Also known as M0 or high-powered money.
Distinct from the money supply: it includes currency in circulation and bank reserves.
Clarification: Currency in circulation contributes to M1, but reserves are not immediately available for transactions and therefore do not count.
Example: US banks hold approximately $3,300,000,000,000 in reserves, which cannot be used until converted into M1.
Role of the Federal Reserve
Structure: Consists of 12 regional banks that offer services to financial institutions and the U.S. government.
Acts as a "banker's bank" by holding reserves, clearing checks, providing cash, and facilitating fund transfers for commercial banks.
The Federal Reserve maintains a checking account for the US Treasury.
Responsibilities include regulating member banks to ensure compliance and financial health.
Monetary Policy Objectives:
Aim for full employment, stable prices, and moderate long-term interest rates.
Historical tools include:
Reserve Requirements: Specifies minimum reserves each bank must hold.
Discount Rates: Rates charged to commercial banks for borrowing funds from the Fed.
Open Market Operations: Frequent tool that involves buying/selling government securities to influence money supply.
In response to economic crises (e.g., the Great Recession), the Federal Reserve adopted new tools like Quantitative Easing (2008-2014, and again in 2020) to inject liquidity into the economy.
Introduction of interest on reserves, becoming a vital monetary policy tool.
Summary of Key Points
Functions of Money: Medium of exchange, Store of value, Unit of account.
M1 is more liquid than M2 due to immediate availability for transactions. M1 decreases when cash is deposited into savings (not affecting M2).
Credit cards are not classified as money; they are forms of loans, facilitating borrowing rather than spending cash directly.
Conclusion
The complexities and roles of money in the economy are foundational for understanding economic systems. Understanding different types of money and their functions is crucial for financial literacy and economic comprehension.
Final Note: Importance of grasping monetary supply definitions, their implications for economic policy, and the distinction between various forms of money.