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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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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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No Such Thing as a Free Lunch: Principles of Economics (Part 116)

Europe unified its monetary policy through the euro before it unified politically, therefore sustaining member countries' abilities to pursue the kind of independent fiscal policies that can strain a joint currency.

Amity Shlaes

The Government and Fiscal Policy

(Part D)

by

Charles Lamson

The Balanced-Budget Multiplier

We have now discussed (1) changing government spending with no change in taxes, and (2) changing taxes with no change in government spending. What if government spending and taxes are increased by the same amount? That is, what if the government decides to pay for its extra spending by increasing taxes by the same amount? The government's budget deficit would not change, because the increase in expenditures would be matched by an increase in tax income.

You might think in this case that equal increases in government spending and taxes have no effect on equilibrium income. After all, the extra government spending equals the extra amount of tax revenues collected by the government. This is not so. Take, for example, a government spending increase of $40 billion. We know from the preceding parts of this analysis that an increase in GDP of 40, with taxes (T) held constant, should increase the equilibrium level of income by 40 x the government spending multiplier. The multiplier is 1/MPS or in the case of the example we have been using, 1/.25 = 4. The equilibrium level of income should rise by 160 or (40 x 4).

Now suppose that instead of keeping tax revenues constant, we financed the 40 increase in government spending with an equal increase in taxes, so as to maintain a balanced budget. What happens to aggregate spending as a result of both the rise in G and the rise in T? There are two initial effects. First, government spending rises by 40. This effect is direct, immediate, and positive. Now the government also collects 40 more in taxes. The tax increase has a negative impact on overall spending in the economy, but it does not fully offset the increase in government spending.

The final impact of a tax increase on aggregate expenditure depends on how households respond to it. The only thing we know about household behavior so far (from the example numbers we have been using) is that households spend 75 percent of their added income and save 25 percent. We know that when disposable income falls, both consumption and saving are reduced. A tax increase of 40 reduces disposable income by 40, and that means consumption falls by 40 * MPC. Because MPC = .75, consumption falls by 30 or (40 * .75). The net result in the beginning is that government spending rises by 40 and consumption spending falls by 30. Aggregate expenditure increases by 10 right after the simultaneous balanced budget increases in G and T.

So, a balanced-budget increase in G and T will raise output, but by how much? How large is this balanced budget multiplier? The answer may surprise you:

balanced budget multiplier ≡ 1

Let us combine what we know about the tax multiplier and the government spending multiplier to explain this. To find the final effect of a simultaneous increase in government spending and increase in net taxes, we need to add the multiplier effect of the two. The government spending multiplier is 1/MPS. The tax multiplier is -MPC/MPS. Their sum is (1/MPS) + (-MPC/MPS) ≡ (1 - MPC)/MPS. Because MPC + MPS ≡ 1, then 1 - MPC is MPS. This means (1 - MPC)/MPS ≡ MPS/MPS ≡ 1. (We derive the balanced-budget multiplier in the next post.)

Back to our example, recall that by using the government spending multiplier, a 40 increase in G would raise output at equilibrium by 160 (40 * the government spending multiplier of 4). By using the tax multiplier, we know that a 40 tax hike will reduce the equilibrium level of output by 120 (40 * the tax multiplier, -3). The net effect is 160 - 120, or 40. It should be clear, then, that the effect on equilibrium Y is equal to the balanced increase in G and T. In other words, the net increase in the equilibrium level of Y resulting from the change in G and the change in T is exactly the size of the initial change in G or T itself.

If the president wanted to raise Y by 200 without increasing the deficit, a simultaneous increase in G and T of 200 would do it. To see why look at the numbers in Table 3. In Table 1 (from part 113), we saw an equilibrium level of output at 900. With both G and T up by 200, the new equilibrium is 1,100---higher by 200. At no other level of Y do we find (C + I + G) = Y.

TABLE 3

An increase in government spending has a direct initial effect on planned aggregate expenditure; a tax increase does not. The initial effect of the tax increase is that households cut consumption by the MPC times the change in taxes. This change in consumption is less than the change in taxes, because the MPC is less than 1. The positive stimulus from the government spending increase is thus greater than the negative stimulus from the tax increase. The net effect is that the balanced budget multiplier is 1.

Table 4 summarizes everything we have said about fiscal policy multipliers. If anything is still unclear, review the relevant discussions in the last several posts.

A Warning Although we have added government, the story we have told about the multiplier is still incomplete and oversimplified. For example, we have been treating net taxes (T) as a lump sum, fixed amount, whereas in practice, taxes depend on income. The next post shows that the size of the multiplier is reduced when we make the more realistic assumption that taxes depend on income. We continue to add more realism and difficulty to our analysis in the posts that follow.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 462-463*

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No Such Thing as a Free Lunch: Principles of Economics (Part 115)

The fact that we are here today to debate raising America's debt limit is a sign of leadership failure... It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government's reckless fiscal policies.

Barack Obama

The Government and Fiscal Policy

(Part D)

by

Charles Lamson

The Tax Multiplier

Remember that fiscal policy comprises policies concerning government spending and policies concerning taxation. To see what effect a change in tax policy has on the economy, imagine the following. Just like in the last post, you are still chief economic advisor to the president, but now you are instructed to devise a plan to reduce unemployment to an acceptable level without increasing the level of government spending. In your plan, instead of increasing government spending (G), you decide to cut taxes and maintain the current level of spending. A tax cut increases disposable income, which is likely to lead to added consumption spending. (Remember our general rule that increased income leads to increased consumption.) Would the decrease in taxes affect aggregate output (income) the same as an increase in G?

A decrease in taxes would increase income. The government spends no less than it did before the tax cut, and households find they have a larger after-tax, or disposable, income than they had before. This leads to an increase in consumption. Planned aggregate expenditure will increase, which will lead to inventories being lower than planned, which will lead to a rise in output. When output rises, more workers will be employed and more income will be generated, causing a second-round increase in consumption, and so on. Thus, income will increase by a multitude of the decrease in taxes, but there is a "wrinkle."

Why does the tax multiplier---the ratio of change in the equilibrium level of output to a change in taxes---differ from the spending multiplier? To answer this, we need to compare the ways in which a tax cut and a spending increase work their way through the economy.

Look at Figure 1. When the government increases spending, there is an immediate and direct impact on the economy's total spending. Because G is a component of planned aggregate expenditure, an increase in G leads to a dollar-for-dollar increase in planned aggregate expenditure. When taxes are cut, there is no direct impact on spending. Taxes enter the picture only because they have an effect on the household's disposable income, which influences our household consumption (which is part of total spending). As Figure 1 shows, the tax cut flows through households before affecting aggregate expenditure.

Let us assume the government decides to cut taxes buy $1. By how much would spending increase? We already know the answer. The marginal propensity to consume (MPC) tells us how much consumption spending changes when disposable income changes. In the example running through the last several posts, the marginal propensity to consume out of disposable income is .75. This means that if households after-tax incomes rise by $1, they will increase consumption not by the full $1, but by only $0.75.

In summary, When government spending increases by $1, planned aggregate expenditure increases initially by the full amount of the rise in G, or $1. When taxes are cut, however, the initial increase in planned aggregate expenditure is only the MPC times the change in taxes. Because the initial increase in planned aggregate expenditure is smaller for a tax cut than for our government spending increase, the final effect on the equilibrium level of income will be smaller.

We figure the size of the tax multiplier in the same way we derived the multiplier for an increase in investment and an increase in government purchases. The final change in the equilibrium level of output (income) (Y) is:

△Y = (initial increase in aggregate expenditure) x (1/MPS)

Because the initial change in aggregate expenditure caused by a tax change of △T is (-△T * MPC), we can solve for the tax multiplier by substitution:

△Y = (△T * MPC) * (1/MPS) = -△T x (MPC/MPS)

Because a tax cut will cause an increase in consumption expenditures and output and a tax increase will cause a reduction in consumption expenditures and output, the tax multiplier is a negative multiplier:

tax multiplier ≡ -(MPC/MPS)

Again, note that the triple equal sign means this is an identity, or something that is always true.

We derive the tax multiplier algebraically not in the next post, which will cover the balanced-budget multiplier, but in the post after that.

If the MPC is .75, as in our example, the multiplier is .75/.25 = -3. A tax cut of 100 will increase the equilibrium level of output by -100 x -3 = 300. This is very different than the effect of our government spending multiplier of 4. Under these same conditions, a 100 increase in G will increase the equilibrium level of output by 400 or (100 x 4).

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 461-462*

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