No Such Thing as a Free Lunch: Principles of Economics (Part 118)

That money talks, I'll not deny, I heard it once: It said, 'Goodbye'.

Richard Armour

The Money Supply and the Federal Reserve System

(Part B)

by

Charles Lamson

Commodity and Fiat Monies

Introductory economics textbooks are full of stories about the various items that have been used as money by various cultures---candy bars, cigarettes (in World War II prisoner of war camps), huge wheels of carved stone (on the island of Yap in the South Pacific), cowrie shells (in West Africa), beads (among North American Indians), cattle (in southern Africa), and small green scraps of paper (in contemporary North America). The list goes on. These various kinds of money are generally divided into two groups, commodity monies and fiat money.

Some of Yap's stone money wheels are so large that they are never moved.

Commodity monies are those items used as money that also have an intrinsic value in some other use. For example, prisoners of war made purchases with cigarettes, quoted prices in terms of cigarettes, and held their wealth in the form of accumulated cigarettes. Of course, cigarettes could also be smoked---they had an alternative use apart from serving as money. Gold represents another form of commodity money. For hundreds of years gold could be used directly to buy things, but it also had other uses, ranging from jewelry to dental fillings.

By contrast, money in the United States today is mostly fiat money. Fiat money, sometimes called token money, is money that is intrinsically worthless. The actual value of a 1-, 10-, or 50-dollar bill is basically zero; what other uses are there for a small piece of paper with some green ink on it?

Why would anyone accept worthless scraps of paper as money instead of something that has some value such as gold, cigarettes, or cattle? If your answer is "Because the paper money is backed by gold or silver," you are wrong. There was a time when dollar bills were convertible directly into gold. The government backed each dollar bill in circulation by holding a certain amount of gold in its vaults. If the price of gold were $35 per ounce, for example, the government agreed to sell one ounce of gold for 35 dollar bills. However, dollar bills are no longer backed by any commodity---gold, silver, or anything else. They are exchangeable only for dimes, nickels, pennies, other dollars, and so on.

The public accepts paper money as a means of payment and a store of value because the government has taken steps to ensure that its money is accepted. The government declares its paper money to be legal tender. That is, the government declares that its money must be accepted in settlement of debts. It does this by Fiat (hence, fiat money). It passes laws defining certain pieces of paper printed in certain inks on certain plates to be legal tender, and that is that. Printed on every Federal Reserve Note in the United States is "This note is legal tender for all debts, public and private." Often, the government can get a start on gaining acceptance for its paper money by requiring that it be used to pay taxes. (Note that you cannot use chickens, baseball cards, or Renoir paintings to pay your taxes, only checks or currency.)

Aside from declaring its currency legal tender, the government usually does one other thing to ensure that paper money will be accepted: It promises the public that it will not print paper money so fast that it loses its value. Expanding the supply of currency so rapidly that it loses much of its value has been a problem throughout history and is known as currency debasement. Debasement of the currency has been a special problem of governments that lack the strength to take the politically unpopular step of raising taxes. Printing money to be used on government expenditures of goods and services can serve as a substitute for tax increases, and weak governments have often relied on the printing press to finance their expenditures. We will discuss money and inflation at great length in later posts.

Measuring the Supply of Money in the United States

We now turn to the various kinds of money in the United States. Recall from last post that money is used: to buy things (means of payment); to hold wealth (a store of value); and to quote prices (a unit of account). Unfortunately, these characteristics apply to a broad range of assets in the U.S. economy. As we will see, it is not at all clear where we should draw the line and say, "Up to this is money, beyond this is something else."

To solve the problem of multiple monies, economists have given different names to different measures of money. The two most common measures of money are transactions money, also called M1, and broad money, also called M2.

M1: Transactions Money What should be counted as money? Coins and dollar bills, as well as higher denominations of currency, must be counted as money---they fit all the requirements. What about checking accounts? Checks, too, can be used to buy things and can serve as a store of value. In fact, bankers call checking accounts demand deposits, because depositors have the right to go to the bank and cash in (demand) their entire checking account balances at any time. That makes your checking account balance virtually equivalent to bills in your wallet, and it should be included as part of the amount of money you hold.

If we take the value of all currency (including coins) held outside of bank vaults and add to it the value of all demand deposits, traveler's checks, and other checkable deposits, we have defined M1, or transactions money. As its name suggests, this is the money that can be directly used for transactions to buy things.

M1 ≡ currency held outside banks + demand deposits + traveler's checks + other checkable accounts deposits

A checkable deposit is any deposit account with a bank or other financial institution on which a check can be written. Checkable deposits include demand deposits; negotiable order of withdrawal (NOW) accounts, which are like checking accounts that pay interest; and automatic-transfer savings (ATS) account which automatically transfer funds from savings to checking (or vice versa) when the balance on one of those accounts reaches a predetermined level.

M1 in the United States increased to $18,935.20 billion in April from 18,682.90 billion in March of 2021 (federalreserve.gov). M1 is a stock measure---it is measured at a point in time. It is the total amount of coins and currency outside of banks and the total dollar amount in checking accounts on a specific day. Until now, we have considered supply as a flow---variable with a time dimension: the quantity of wheat supplied per year, the quantity of automobiles supplied to the market per year, and so forth. However, M1 is a stock variable.

M2: Broad Money Although M1 is the most widely used measure of the money supply, there are others. Should savings accounts be considered money? Many of these accounts cannot be used for transactions directly, but it is easy to convert them into cash or to transfer funds from a savings account into a checking account. What about money market accounts (which allow only a few checks per month but pay market-determined interest rates) and money market mutual funds (which sell shares and use the proceeds to purchase short-term securities)? These can be used to write checks and make purchases, although only over a certain amount.

If we add near monies, close substitutes for transactions money, to M1, we get M2, called broad money because it includes not-quite-money monies such as savings accounts, money market accounts, and other near monies.

M2 ≡ M1 + savings accounts + money market accounts + other near monies

M2 in the United States increased to $20,108.60 billion in April from $19,896.20 billion in March of 2021 (federalreserve.gov), a little larger than the total M1 of $18,935.20 billion. The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable. For instance, when banks introduced new forms of interest-bearing checking accounts in the early 1980s, M1 shot up as people switched their funds from savings accounts to checking accounts. However, M2 remained fairly constant because the fall in savings account deposits and the rise in checking account balances were both part of M2, canceling each other out.

Beyond M2 Because a wide variety of financial instruments bear some resemblance to money some economists have advocated including almost all of them as part of the money supply. In recent years, for example, credit cards have come to be used extensively in exchange. Everyone who has a credit card has a credit limit---you can charge only a certain amount on your card before you have to pay it off. Usually we pay our credit card bills with a check or through online banking. One of the very broad definitions of money includes the amount of available credit on credit cards (your charge limit minus what you have charged but not paid) as part of the money supply.

There are no rules for deciding what is money and what is not. This poses problems for economists and those in charge of economic policy. However, for our purposes here, "money" will always refer to transactions money, or M1. For simplicity, we will say that M1 is the sum of two general categories: currency in circulation and deposits. Keep in mind, however, that M1 has four specific components: currency held outside banks, demand deposits, traveler's checks, and other checkable deposits.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 477-479* 

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