Unit 8: Money, Banking, and Financial Markets
Lesson 8.1: Money
What You Will Learn!
 Money is anything that can be used to buy goods and services. SS.912.E.1.13.
 The functions of money are medium of exchange, store of value, and unit of
account. SS.912.E.1.13.
 Money has six characteristics: durability, portability, uniformity, acceptability,
divisibility, and limited supply. SS.912.E.1.13.
 The three types of money are commodity money, representative money, and
fiat money. SS.912.E.1.13.
 The amount of money in the U.S. money supply is measured by M1 and M2,
which focus on liquidity and illiquidity of money. SS.912.E.1.13.
Key Point #1.
services.
Money is anything that can be used to buy goods and
Now it’s time to look at something we all know and love in great detail: money. If
you were to define money off the top of your head, what is the first thing that comes to
mind? Paper and coins? What we use to buy stuff? Maybe the term “currency”? In
fact, the concept of money is much broader than all of that. Money is anything that can
be used to buy goods and services. Anything? Yes, anything. Before we get into what
we can use as money, we should take a look first at what the purpose of money is, that
is, the functions of money.
Key Point #2. The functions of money are medium of exchange, store of
value, and unit of account.
Money has three functions: medium of exchange, store of value, and unit of
account. When we talk about “functions,” what we mean is how money is used, its
purpose in the economy.
Medium of Exchange. First off, money is a medium of exchange. What do we
mean by this? Well, let’s start off by defining “medium”? An artist will tell you that a
medium is the method you use to create art, like paper and charcoal, paint and canvas,
or clay and kilns. That same concept applies to money. Money as a medium of
exchange is the method by which we pay for goods and services. In other words,
money is how we pay for goods and services. For example, when you go to Toys R Us
to buy a Tickle Me Elmo for $30.00, you will provide $30.00 in cash or credit, plus tax, to
the cashier. The exchange of $30.00 for the Tickle Me Elmo between you and Toys R
Us demonstrates the concept of money as a medium of exchange.
Store of Value. Second, money must have store of value. What do we mean by
this? Money must be able to maintain its value over time. $1.00 today must be worth
$1.00 tomorrow, next week, next year, and so on. If the money can’t hold its value, then
that makes it difficult to buy goods and services. For example, today, Tickle Me Elmo
costs $30.00. Tomorrow the value of the dollar is cut in half, so you have to use twice
as much as before to buy the same good. Now Tickle Me Elmo costs $60.00 because
the dollar couldn’t maintain its value. What we’re talking about here is a decline
purchasing power, and it’s something we looked at when we talked about demand. To
remind you, purchasing power is the ability to buy a certain amount of goods and
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Unit 8: Money, Banking, and Financial Markets
Lesson 8.1: Money
service with the value of your money. Take a look at the income effect for review. This
concept will come back to us again when we look at inflation in a few lessons.
Unit of Account. Finally, money has to have a unit of account. What do we
mean by this? Money needs to be measurable in such a way that we can compare the
price of one good to another. In this case, we’re talking about how much money. For
example, when we say a Tickle Me Elmo doll costs $30.00, the unit is 30, the actual
numerical value, and the account is the dollar, the currency in which we’re counting the
value of Elmo. Currency is the actual paper and coins used to buy goods and services,
and comes in a variety of national flavors: dollars, pounds, pesos, euros, yen. With
Elmo, we can compare his price to a more intelligent and worthy adversary, the Cookie
Monster, priced at healthy $40.00. Both are priced in numbers and currency we can
understand, so we can make a comparison for prices. Cookie Monster is more
expensive than Tickle Me Elmo, in fact, he’s $10.00 more in price.
Key Point #3.
Money has six characteristics:
durability, portability,
uniformity, acceptability, divisibility, and limited supply.
So money is anything that can be used to buy goods and services. Anything?
Anything.
What about chickens?
Technically, yes, in a bartering system, you could trade a certain number of
chickens to get your Tickle Me Elmo fix. In the modern world, however, well, let’s just
say that we’ve come to think of money having certain characteristics.
Durability. Money has to maintain some kind of durability, that is, it has to last
through all the wear and tear of exchanging hands, being counted by money machines,
processed through ATMs and more. Chickens, unfortunately, are not all that durable.
Besides a limited lifespan, exchanging chickens from place to place would likely cause
the death of the chicken. Paper, on the other hand, works just fine. Actually, we say
paper, but paper isn’t actually all that durable either. The U.S. dollar is actually made
from 75% cotton and 25% linen. Our coins are made mostly from zinc and nickel.
These materials give the American currency the ability to last over time.
Portability. Money has to be easily portable. You should be able to carry it
around with little problem. For the most part, even if you keep them in cages, chickens
are not all that portable. A $20.00 and $10.00 bill, on the other hand, can easily be kept
in your wallet. We need our money to be portable not just for ease of carrying it around,
but also for ease of exchange. Buying something with cash is a momentary transaction.
Buying something with chickens might take a while.
Uniformity. Money must be uniform in that one $20.00 bill and another $20.00
bill must be able to buy the same thing. This allows us to count and measure money—
unit of account. No two chickens are alike. Besides different sizes, you also have
different types of chickens: Rhode Island Red, Iowa Blue, American Bantam. Also,
there’s a subjective element here. How do you decide if a chicken is big or small in
terms of exchanging it for goods and services? The dollar, on the other hand, has the
same size: 6.14 inches length by 2.61 inches in height and 0.0043 inches in width. The
only thing that changes is the unit and that can be easily countable.
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Unit 8: Money, Banking, and Financial Markets
Lesson 8.1: Money
Acceptability. Money must be accepted in order to exchange it for goods and
services. This sounds obvious, but actually, some countries issue currency that has
little value and is not accepted, even inside its own country. For the most part, chickens
are accepted by everybody. Except, for of course, vegetarians. For them, chickens
would not be an acceptable method of payment. However, vegetarians, like with all
things that are green, do like dollar bills.
Divisibility. Money must be easily divisible, if for no other reason than to make
change. For example, let’s say that with tax, Tickle Me Elmo costs $32.37. You’ve
decided to pay with chickens. First off, it’s pretty clear that dividing up a chicken will not
be an easy task, and certainly one filled with lots and lots of mess. Second, how do you
cut up a chicken to be 37/100 of a chicken? On the other hand, a dollar bill equals 100
cents, and can be broken up between pennies, nickels, dimes, and quarters to get you
the right amount of change, and without all the chicken blood and feathers.
Limited Supply. Money must be in limited supply. Why? Let’s skip chickens for
a second, and use leaves as money. In this case, our money is literally growing on
trees. A single oak tree can produce hundreds of thousands of leaves, although if
you’re raking them in the fall, it feels like millions. Thing about this is that leaves, and
therefore money, is everywhere. There’s so much of it, in fact, that money has lost its
value. If everybody is a millionaire, nobody is rich. Going back to chickens, they are
not in limited supply. Why? Because chickens produce eggs, which in turn produce
little chickens. In other words, counterfeit chickens. This causes problems if you need
money to be in limited supply.
When we talk about money being in limited supply, we are ultimately talking
about controlling the supply of money. In the United States, control of the money supply
is handled by the Federal Reserve, the central bank of the United States. We’ll talk
more about the Federal Reserve when we get to monetary policy, but for now,
understand that this is one of the jobs of the Federal Reserve. Controlling the money
supply, and that includes printing and destroying currency, comes under the authority of
governments. We joked about counterfeit chickens, but counterfeiting is a federal crime
punishable by heavy fines and 20 years in prison. At one point, counterfeiting was
considered an offense punishable by death.
Why such serious penalties? It must be understood that controlling the money
supply is a right of the government. When someone counterfeits money, they are
infringing on that right. At the same time, because maintaining a limited supply of
money is an important characteristic of money—ultimately it allows money to keep its
value—by counterfeiting, the person is producing “money” that expands that money
supply, and lowers the value of that money as a result.
Key Point #4.
The three types of money are commodity money,
representative money, and fiat money.
Finally, the answer to the question what exactly is money can be looked at in
terms of the types of money: commodity money, representative money, and fiat money.
Commodity money. Commodity money is money made up from a commodity
that is valuable in and of itself. Remember, a commodity is a product that is the same
no matter who sells it. We’ve talked about milk and oil as commodities in previous
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Unit 8: Money, Banking, and Financial Markets
Lesson 8.1: Money
lessons. Here, commodities used for money, not surprisingly, are gold, silver, and
copper. These are precious metals that have value in and of themselves. Ultimately,
though, there’s a problem with using precious metals; they may be worth more than the
currency. For example, let’s say the U.S. makes a $1.00 coin made out of 1 ounce of
gold. Currently, 1 ounce of gold trades for more than $1,300.00 on the New York
Mercantile Market. It’s a good bet that owners of these $1.00 gold coins will melt them
down for something more valuable. Alternatively, they could just simply hold on to the
money, rather than exchange it for goods and services, which would cause the
economy to stagnate.
Representive money. A solution was found in representative money, bills and
coins that represent a specific commodity like gold, silver, and oil. The bills and coins
didn’t have that much value themselves, but represented the value of the commodity.
Representative money is sometimes called commodity-backed money for this reason.
Representative money bases its value in the commodity it represents, and that is
actually a problem. If the value of the commodity decreases, then so does the value of
the money. If the value of the money drops, then you need more money to buy goods
and services. For example, the U.S. dollar was once based on the gold standard,
money backed by the value of gold. When the price of gold dropped, so did the value of
the dollar.
Fiat money. Fiat money is the modern form of currency, and it is money that
has value because the government says it has value. The word “fiat” in Latin means
“legal order” or “decree.” In other words, the government has declared the currency to
be acceptable as money and the money is backed by the word of the government. The
U.S. dollar is no longer backed by gold, but by the full faith and credit of the U.S.
government and the citizens who elect it. The words “This note is legal tender for all
debts, public and private,” are printed on every dollar. The expectation from these
words is that buyers and sellers can use the dollar as a medium of exchange. At the
same time, fiat money helps the government with controlling the money supply by
allowing it to declare what is and what is not money.
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Unit 8: Money, Banking, and Financial Markets
Lesson 8.1: Money
Key Point #5. The amount of money in the money supply is measured by M1
and M2, which focus on liquidity and illiquidity of money.
So if we were to ask how much money is in the U.S. economy today, we would
need to first take a look at another characteristic of money—liquidity. Liquidity refers to
any asset that can be used as cash or converted easily into cash. Liquidity is measured
in a monetary aggregate called M1. A monetary aggregate is a measurement of the
money supply. M1 specifically measures liquidity.
Okay, so what types of things do we use as money that are liquid—that can be
used as cash or converted easily into cash? Well, cash itself would certainly qualify.
So would any kind of checking account, called demand deposits or checking deposits.
A check is readily accepted as cash in most places, and you can certainly write out a
check and cash it out at a bank or check-cashing business. Checks are essentially
notes from a bank tied to your account, instructing the bank to pay a certain amount of
money to whom the check is written out. Travelers’ checks are the last category of M1.
Travelers’ checks work like normal checks, but are used by travelers’ to buy goods and
services, and can be listed in different currencies. In short, M1 is made up of cash,
checking deposits, and travelers’ checks.
The second monetary aggregate is M2, and it measures both liquidity and what is
called near-money. Near-money is accounts and deposits that can be converted into
cash easily, but are not used to directly buy goods and services. Savings deposits
constitute near-money, because you can withdraw the savings out directly or redeposit
them in a checking account. However, you can’t write a check tied to a savings
account. You have to convert the savings into cash or something that can be used as
cash, that is convert to something more liquid. CDs or small short-term deposits would
also count. CD stands for certificate of deposit, and generally they pay a higher rate of
interest than a normal savings account, and are harder to pull money out of. Money
market mutual funds also belong to M2. These are funds that pool money from small
investors to purchase stocks and bonds, and can be converted into cash. In short, M2
is made up of all of M1, savings deposits, CDs, and money market mutual funds. In late
2013, M1 consisted of $2.5 trillion dollars, and M2, which includes M1, consisted of
$10.8 trillion.
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