Money, Monetary Policy, and the Economy
What is Money?
Money is more than just cash; it serves three key functions:
Store of Value: Holding money to spend later. This function allows individuals to save their earnings and defer consumption to the future. For money to be a good store of value, it should maintain its purchasing power over time, meaning it should resist depreciation due to inflation or other economic factors.
Cryptocurrencies like Bitcoin and Ethereum face challenges as reliable stores of value due to their price volatility. The high volatility can erode savings quickly, making people hesitant to rely on them for long-term savings.
Medium of Exchange: Using money to buy goods and services. Money facilitates transactions by eliminating the need for barter, which requires a double coincidence of wants (i.e., both parties must have something the other wants). As a medium of exchange, money lowers transaction costs, making it easier and more efficient to trade goods and services.
While Bitcoin has been used for some transactions (e.g., Richard Branson accepting it for spaceflight tickets), it represents a tiny fraction of overall transactions. Widespread acceptance is crucial for money to function effectively as a medium of exchange.
Unit of Account: A common measure for pricing goods and services. This function provides a standard way to measure the value of goods, services, and assets, enabling consistent and comparable pricing. A stable unit of account reduces confusion and uncertainty in economic transactions.
Bitcoin's volatility makes it difficult to price items consistently, creating confusion for buyers and sellers. It's like "measuring with a stretchy ruler." Stable currencies provide a reliable benchmark for valuation, which is essential for economic planning and decision-making.
Measuring Money Supply: M1 and M2
Economists focus on two main measures of money supply:
M1: The narrowest definition, including:
Physical cash:
Coins and paper money in circulation, which are the most liquid forms of money.
Traveler's checks (though rarely used now):
Preprinted, fixed-amount checks that were commonly used by travelers as a substitute for cash. Their usage has declined significantly with the advent of credit and debit cards.
Money in checking accounts (easily spendable funds):
Demand deposits that allow depositors to withdraw funds at any time without prior notice. These are highly liquid and readily available for transactions.
M2: A broader definition, including all of M1 plus:
Savings deposits:
Interest-bearing accounts that allow customers to save money while earning interest. These deposits are less liquid than checking accounts but can be easily converted to cash.
Small certificates of deposit (CDs) under :
Time deposits that hold a fixed amount of money for a specified period and pay a fixed interest rate. These are less liquid than savings accounts but typically offer higher interest rates.
Money market accounts:
Deposit accounts that offer interest rates competitive with money market funds. These accounts may have some restrictions on withdrawals but provide a mix of liquidity and interest earnings.
Data from 1960 to 2020 in the US shows that M1 and M2 have grown and changed over time, reflecting changes in saving and spending habits. These changes reflect innovations in banking and financial technology, shifting consumer preferences, and monetary policy decisions.
Demand for Money
General Price Level:
The amount of money people need is directly related to prices. If prices double, you'll likely need double the money to buy the same goods. This relationship is fundamental to understanding how inflation affects the demand for money.
Example: If apples cost per pound, you need for pounds. If they cost per pound, you need . The relationship between nominal money demand and the price level illustrates the transactionary demand for money.
Real Income:
As people earn more (adjusted for prices), they spend more and need more money on hand for transactions. Higher real income leads to increased consumption and investment, which in turn increases the demand for money to facilitate these transactions.
Interest Rates:
Holding cash or basic checking accounts typically earns zero interest. This represents an opportunity cost since that money could be invested to earn a return.
If interest rates on bonds or high-yield savings accounts rise, holding non-interest-bearing money becomes more expensive (opportunity cost). Individuals and businesses may choose to hold less cash and more interest-bearing assets when interest rates are high.
Example: If you need a day, you might keep cash, withdrawing every two days (average cash holding = ). If interest rates rise, you might withdraw daily, keeping an average of cash and earning interest on the other . This example shows how higher interest rates incentivize economizing on cash holdings.
Economists' Equation/Function for Money Demand:
Money demand depends positively on the price level and real income and negatively depends on the nominal interest rate. This function captures the key determinants of money demand and is essential for understanding macroeconomic equilibrium.
Nominal interest rate = Real interest rate + Expected inflation
Velocity of Money
Velocity measures how many times a unit of currency is used for transactions in a given period (e.g., a year). It indicates the rate at which money circulates in the economy.
It indicates how quickly money is circulating or "how hard the money is working". A higher velocity means that each unit of currency is used more frequently, supporting a greater volume of transactions.
Total income = . Starting amount = . The velocity is . This example illustrates how velocity is calculated and interpreted.
Example:
You earn per month and spend it all on rent, food, etc.
Total spending = per month.
Total spending per year = .
Velocity = Total spending () / Money supply () = . The same money changed hands 12 times over the year. This simple example illustrates the basic concept of velocity.
Real-World Velocity in the US:
M1 velocity increased significantly from the 1960s until the 2008 financial crisis (more than doubled). This increase reflected the growing use of electronic payments and other financial innovations.
M2 velocity was generally more stable. The relative stability of M2 velocity suggests that broader measures of money supply are less affected by short-term fluctuations in economic activity.
Reasons for M1 Velocity Increase:
Technology and Fintech: Online banking, payment apps, credit/debit cards, online transfers, and mobile payments make transactions faster without needing physical cash. These innovations have streamlined payment processes and reduced the need for physical cash.
The same amount of M1 can support more transactions because it moves faster (money works harder). This increased efficiency has significant implications for monetary policy and economic stability.
Monetary Equilibrium
Occurs when the real amount of money people want to hold equals the real amount of money available. This is a state of balance in the money market.
This balance affects prices. Monetary equilibrium is crucial for maintaining price stability and controlling inflation.
Equation:
= Overall price level
= Nominal money supply (created by the central bank)
= Demand for real money balances, depending on real income and nominal interest rate
Prices depend on the money supply relative to the demand for it. This relationship is a cornerstone of monetary economics.
Link to Inflation:
If the money supply grows faster than the demand for money, prices tend to rise (inflation). This is a fundamental principle of monetary policy.
Inflation rate ≈ Growth rate of money supply - Growth rate of money demand
Money demand growth is influenced by income growth and changes in interest rates. Understanding these influences is essential for forecasting inflation.
Expectations matter: Higher expected money growth can lead to higher expected inflation, pushing up nominal interest rates (I = r + π, where π is expected inflation). Inflation expectations can become self-fulfilling prophecies, making it crucial for central banks to manage these expectations effectively.
Example Calculation:
Money supply grows by 6%.
Real income (y) grows by 3%.
Income elasticity of money demand is 0.7 (1% income rise increases money demand by 0.7%).
Money demand growth = 0.7 * 3% = 2.1%.
Inflation rate ≈ 6% - 2.1% = 3.9%.
If the nominal interest rate is 7.9%, the real interest rate ≈ 7.9% - 3.9% = 4%. This example illustrates how these concepts are applied in practice.
Money, Business Cycles, and Economic Growth
Short-Term Business Cycles:
Monetary policy (central bank actions) significantly influences short-term economic fluctuations. Central banks use monetary policy tools to stabilize the economy.
By changing interest rates or money supply, central banks affect borrowing costs, business investment, and consumer spending, driving overall economic activity. These actions can either stimulate or restrain economic growth.
Monetary policy can "heat up" or "cool down" the economy. Central banks aim to achieve a balance between promoting growth and controlling inflation.
Money also plays a role in those dynamics, as GDP, unemployment and investment behave in certain ways. The relationship between money and these macroeconomic variables is complex and multifaceted.
Long-Term Economic Growth:
Driven by fundamental factors: capital accumulation, infrastructure, new technologies, and productivity improvements. These factors determine the long-run potential of an economy.
Stable monetary system and low inflation are helpful, but monetary policy isn't the primary engine for long-term growth; real factors are more important. While monetary policy can support long-term growth, it cannot substitute for fundamental drivers of productivity and innovation.
Money and the Global Economy
Countries are connected through exchange rates (how much one currency buys of another) and capital flows. These linkages create interdependencies among national economies.
Exchange rates affect import/export prices and investment decisions. Fluctuations in exchange rates can have significant effects on international trade and investment.
Purchasing Power Parity: The idea that goods should cost the same everywhere once exchange rates are considered (in the long run). PPP is a theoretical concept that provides a benchmark for assessing exchange rate misalignments.
Central banks intervene in currency markets to influence their currency's value. These interventions can be controversial and may have limited effectiveness.
Domestic monetary conditions have international impacts. Monetary policy decisions in one country can affect interest rates, exchange rates, and economic activity in other countries.
Key Takeaways
Understanding the three functions of money: store of value, medium of exchange, unit of account. These functions are essential for a well-functioning economy.
Knowing how money is measured: M1 and M2. These measures provide insights into the liquidity and availability of money in the economy.
Understanding the drivers of money demand: prices, income, interest rates. These factors influence the amount of money individuals and businesses want to hold.
Understanding the relationship between money growth, demand growth, and inflation. This relationship is crucial for maintaining price stability.
Appreciating how money fits into the broader economic picture: short-term cycles, long-term growth, and the global economy. Money plays a central role in macroeconomic dynamics.
Fintech and digital payments are speeding up velocity. These innovations are transforming the way money is used and exchanged.
With the rising of cryptocurrencies, stablecoins, central bank digital currencies, how might our whole undestanding and measurement of money need to evolve in the coming years? The digital revolution is challenging traditional notions of money and monetary policy.