No Such Thing as a Free Lunch: Principles of Economics (Part 117)

A fool and his money are soon parted.

Thomas Tusser

The Money Supply and the Federal Reserve System (Part A)

by

Charles Lamson

In the last several posts, we explored how consumers, firms, and the government interact in the goods market. The next several posts show how money markets work in the macroeconomy. We begin with what money is and the role it plays in the U.S. economy. We then discuss the forces that determine the supply of money and show how banks create money. Finally, we discuss the workings of the nation's central bank, the Federal Reserve (the Fed), and the tools at its disposal to control the money supply.

Microeconomics has little to say about money. Microeconomic theories and models are concerned primarily with real quantities (apples, oranges, hours of labor) and relative prices (the price of apples relative to the price of oranges, or the price of labor relative to the prices of other goods). Most of the key ideas in microeconomics do not require that we know anything about money. As we shall see, this is not the case in macroeconomics.

An Overview of Money

You often hear people say things like, "He makes a lot of money" (in other words, "He has a high-income") or "She's worth a lot of money" (meaning "She is very wealthy"). It is true that your employer uses money to pay you your income, and your wealth may be accumulated in the form of money. However, money is not income, and money is not wealth.

To see that money and income are not the same, think of a $20 bill. That bill may pass through a thousand hands in a year, yet never be used to pay anyone a salary. Suppose I get a $20 bill from an automatic teller machine, and I spend it on dinner. The restaurant puts that $20 bill in a bank in the next day's deposit. The bank gives it to a woman cashing a check the following day; she spends it at a baseball game that night. The bill has been through many hands but not as part of anyone's income.

What is Money? 

We will soon get to a formal definition of money, but let us start out with the basic idea of what money is.

Money is anything that is widely accepted as a medium of exchange.

Most people take the ability to obtain and use money for granted. When the whole monetary system works well, as it generally does in the United States, the basic mechanics of the system are virtually invisible. People take for granted that they can walk into any store, restaurant, boutique, or gas station and buy whatever they want, as long as they have enough green pieces of paper.

The idea that you can buy things with money is so natural and obvious that it seems absurd to mention it, but stop and ask yourself: "How is it that a shop owner is willing to part with a steak and a loaf of bread that I can eat in exchange for some pieces of paper that are intrinsically worthless?" Why, on the other hand are there times and places where it takes a shopping cart full of money to purchase a dozen eggs? The answers to these questions lie in what money is: a means of payment, a store of value, and a unit of account.

A Means of Payment, or Medium of Exchange Money is vital to the working of a market economy. Imagine what life would be like without it. The alternative to a monetary economy is barter, people exchanging goods and services for other goods and services directly instead of exchanging via the medium of money.

How does a barter system work? Suppose you want bacon, eggs, and orange juice for breakfast. Instead of going to the store and buying these things with money, you would have to find someone who has these items and is willing to trade them. You would also have to have something the bacon seller, the orange juice purveyor, and the egg vendor want. Having pencils to trade will do you no good if the bacon, orange juice, and egg sellers do not want pencils.

A barter system requires a double coincidence of wants for trade to take place. That is, to affect the trade, I have to find someone who has what I want, and that person must also want what I have. Where the range of goods traded is small, as it is in relatively unsophisticated economies, it is not difficult to find someone to trade with, and barter is often used. In a complex society with many goods, barter exchanges involve an intolerable amount of effort. Imagine trying to find people who offer for sale all the things you buy in a typical trip to the grocery store, and who are willing to accept goods that you have to offer in exchange for their goods.

Some agreed-to medium of exchange (or, means of payment) neatly eliminates the double-coincidence-of-wants problem. Under a monetary system, money is exchanged when people buy things; goods or services are exchanged for money when people sell things. No one ever has to trade goods for other goods directly. Money is a lubricant in the functioning of a market economy.

A Store of Value Economists have identified other roles for money aside from its primary function as a medium of exchange. Money also serves as a store of value---an asset that can be used to transport purchasing power from one time period to another. If you raise chickens and at the end of the month sell them for more than you want to spend and consume immediately, you may keep some of your earnings in the form of money until the time you want to spend it.

There are many other stores of value besides money. You could have decided to hold your "surplus" earnings by buying such things as antique paintings, baseball cards, or diamonds, which you could sell later when you want to spend your earnings. Money has several advantages over these other stores of value. First, it comes in convenient denominations and is easily portable. You do not have to worry about making change for a Renoir painting to buy a gallon of gasoline. The second, because money is also a means of payment, it is easily exchanged for goods at all times. (A Renoir is not easily exchanged for other goods.) These two factors compose the liquidity property of money. Money is easily spent, flowing out of your hands like liquid. Renoirs and ancient Aztec statues are neither convenient nor portable and are not readily accepted as a means of payment.

The main disadvantage of money as a store of value is that the value of money falls when the prices of goods and services rise. If the price of potato chips rises from $1 per bag to $2 per bag, the value of a dollar bill, in terms of potato chips, falls from one bag to half a bag. When this happens, it may be better to use potato chips (or antiques or real estate) as a store of value.

A Unit of Account Money also serves as a unit of account---a consistent way of quoting prices. All prices are quoted in monetary units. A textbook is quoted as costing $90, not 150 bananas, and a banana is quoted as costing $0.60, not 1.4 apples.

Obviously a standard unit of account is extremely useful when quoting prices. This function of money may have escaped your notice---what else would people quote prices in except money? 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 475-477*

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