What Is Money?

Define money, discuss its functions, and describe how it is measured in the United States.

In economics the meaning of the term money is different from its everyday meaning. People often say money when they mean income or wealth, as in "that job pays good money" or "their family has a lot of money." In economics, how­ever, money refers specifically to assets that are widely used and accepted as payment.

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Money in a Prisoner-of-War Camp

Among the Allied soldiers liberated from German prisoner-of-war (POW) camps at the end of World War II was a young man named R. A. Radford. Radford had been trained in economics, and shortly after his return home he published an article titled "The Economic Organisation of a POW Camp."^[113] This article, a minor classic in the economics literature, is a fascinating account of the daily lives of sol­diers in several POW camps. It focuses particularly on the primitive "economies" that grew up spontaneously in the camps.

The scope for economic behavior in a POW camp might seem severely lim­ited, and to a degree that's so. There was little production of goods within the camps, although there was some trade in services, such as laundry or tailor­ing services and even portraiture. However, prisoners were allowed to move around freely within the compound, and they actively traded goods obtained from the Red Cross, the Germans, and other sources.

A key practical issue was how to organize the trading. At first, the camp economies used barter, but it proved to be slow and inefficient. Then the pris­oners hit on the idea of using cigarettes as money. Soon prices of all goods were quoted in terms of cigarettes, and cigarettes were accepted as payment for any good or service. Even nonsmoking prisoners would happily accept cigarettes as payment because they knew that they could easily trade the cigarettes for other things they wanted. The use of cigarette money greatly simplified the problem of making trades and helped the camp economy function much more smoothly.

Why were cigarettes, rather than some other commodity, used as money by the POWs? Cigarettes satisfied a number of criteria for a good money: A cigarette is a fairly standardized commodity whose value was easy for both buyers and sellers to ascertain. An individual cigarette is low enough in value that making "change" wasn't a problem. Cigarettes are portable, are easily passed from hand to hand, and don't spoil quickly.

A drawback was that, as a commodity money (a form of money with an alter­native use), cigarette money had a resource cost: Cigarettes that were being used as money could not simultaneously be smoked. In the same way, the traditional use of gold and silver as money was costly in that it diverted these metals from alternative uses.

The use of cigarettes as money isn't restricted to POW camps. Just before the collapse of communism in Eastern Europe, cigarette money reportedly was used in Romania and other countries instead of the nearly worthless official money.

The Functions of Money

Since the earliest times almost all societies—from the most primitive to the most sophisticated and with many types of political and economic systems—have used money.

Medium of Exchange. In an economy with no money, trading takes the form of barter, or the direct exchange of certain goods for other goods. Even today some people belong to barter clubs, in which members swap goods and services among themselves. Generally, though, barter is an inefficient way to trade because finding someone who has the item you want and is willing to exchange that item for some­thing you have is both difficult and time-consuming. In a barter system, if one of the authors of this book wanted a restaurant meal, he would first have to find a restaurateur willing to trade his blue-plate special for an economics lecture—which might not be easy to do.

Money makes searching for the perfect trading partner unnecessary. In an economy that uses money, the economics professor doesn't have to find a restau­rant owner who is hungry for knowledge. Instead, he can first exchange his eco­nomics lecture to students for money and then use the money to buy a meal. In functioning as a medium of exchange, or a device for making transactions, money permits people to trade at less cost in time and effort. Having a medium of exchange also raises productivity by allowing people to specialize in economic activities at which they are most skilled. In an economy with money, specialized producers have no problem trading their goods or services for the things they need. In a barter economy, though, the difficulty of trading would leave people no choice but to produce most of their own food, clothing, and shelter. Thus in a bar­ter economy the opportunity to specialize is greatly reduced.

Unit of Account. As a unit of account, money is the basic unit for measur­ing economic value. In the United States, for example, virtually all prices, wages, asset values, and debts are expressed in dollars. Having a single, uniform mea­sure of value is convenient. For example, pricing all goods in the United States in dollars—instead of some goods being priced in yen, some in gold, and some in Microsoft shares—simplifies comparison among different goods.

The medium-of-exchange and unit-of-account functions of money are closely linked. Because goods and services are most often exchanged for money (the medium-of-exchange function), expressing economic values in money terms (the unit-of-account function) is natural. Otherwise, we could just as well express eco­nomic values in terms of, say, bushels of wheat. However, the medium of exchange and the unit of account aren't always the same. In countries with high and erratic inflation, for example, fluctuating currency value makes money a poor unit of account because prices must be changed frequently. In such cases, economic val­ues are commonly stated in terms of a more stable unit of account, such as dollars or ounces of gold, even though transactions may continue to be carried out in the local currency.

Store of Value. As a store of value, money is a way of holding wealth. An extreme example is a miser who keeps his life's savings in cash under the mat­tress. But even someone who spends his cash wages 15 minutes after receiving them is using money as a store of value for that short period.

In most cases, only money functions as a medium of exchange or a unit of account, but any asset—for example, stocks, bonds, or real estate—can be a store of value. As these other types of assets normally pay the holder a higher return than money does, why do people use money as a store of value? The answer is that money's usefulness as a medium of exchange makes it worthwhile to hold, even though its return is relatively low.

Measuring Money: The Monetary Aggregates. Money is defined as those assets that are widely used and accepted in payment. This definition suggests a hard-and-fast line between assets that should be counted as money and those that should not. Actually, the distinction between monetary assets and nonmonetary assets isn't so clear.

Consider, for example, money-market mutual funds (MMMFs), which first became popular in the late 1970s. MMMFs are organizations that sell shares to the public and invest the proceeds in short-term government and corporate debt.

Because assets differ in their "moneyness," no single measure of the amount of money in the economy—or the money stock, as it is often called—is likely to be completely satisfactory. For this reason, in most countries economists and policy­makers use several different measures of the money stock. These official measures are known as monetary aggregates. The various monetary aggregates differ in how narrowly they define the concept of money. In the United States the two mon­etary aggregates are called M1 and M2. Summary definitions and data for these two aggregates are given in Table 7.1. Information about where to find data on the monetary aggregates is presented in "In Touch with Data and Research: The Monetary Aggregates."

TABLE 7.1

U.S. Monetary Aggregates (December 2021)

The M1 Monetary Aggregate.

In Touch with Data and Research

The Monetary Aggregates

The official monetary aggregates—M1 and M2—are compiled and reported by the Board of Governors of the Federal Reserve System (Fed) in Washington. Only data for M1 were reported until 1971, when the Fed introduced M2 and M3. Since then the definitions of the monetary aggregates have changed several times, reflecting the evolution of the financial system. In 2006, the Fed stopped reporting M3. In early 2021, the Fed moved savings deposits from M2 into M1, retroactive to May 2020, which resulted in a break in the M1 series.

The Fed reports estimates of the aggregates both weekly and monthly, using data supplied by banks, the Treasury, money-market mutual funds, foreign central banks, and other sources. Each Thursday at 4:30 p.m. Eastern time the Fed announces figures for M1 and M2 for the week ending the Monday of the previous week. Historical data are available in the Federal Reserve Bulletin, the Federal Reserve Bank of St. Louis FRED database atfred.stlouisfed.org, the Economic Report of the President, and on the Federal Reserve System's website at www.federalreserve.gov/releases/h6/current/default.htm. Monetary data are revised frequently, reflecting the receipt of new data by the Federal Reserve or changes in the definitions of monetary aggregates.

Publication of the monetary aggregates helps keep the public and Congress informed about how the Fed is changing the nation's money supply.

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Where Have All the Dollars Gone?

In December 2021 the stock of U.S. currency was $2225.3 billion, or almost $6700 for every man, woman, and child in the United States. This figure is surprisingly high. After all, how many people actually have $6700 of cash on hand at any given time, and how many families of four hold $26,800 in cash?

Businesses, especially retailers, hold currency for making transactions, but the amount of currency held by U.S. businesses appears to account for a small fraction of the "missing" dollars. Currency also is extensively used in the underground economy, either to conduct illegal transactions (such as trade in illegal drugs) or to hide legal transactions from tax collectors. Studies have found that a substantial portion of the "missing" U.S. currency—amounting to 50% or more of currency outstanding—is held abroad.^[114]

Why would people in other countries want to hold U.S. dollars? Even though the dollar may not serve as the medium of exchange or as a unit of account in a country, it can be a relatively attractive store of value, especially in countries that are economically or politically unstable. For example, in countries with high rates of inflation, the local currency is a particularly poor store of value because the real value (purchasing power) of the local currency decreases at the rate of inflation. In high-inflation countries the dollar, which has had a relatively stable purchasing power, may be much more attractive than local currency as a means of holding wealth. Political instability in a country might also induce residents to demand U.S. dollars because, if political upheaval forces people to flee the coun­try, carrying dollars out may be the easiest way for them to take some of their wealth with them. About half the U.S. currency sent overseas between 1988 and 1995 went to Europe, much of it to Russia and other nations of Eastern Europe, which experienced substantial economic and political instability during that time (see the Application "Money Growth and Inflation in European Countries in Transition").

Because much currency is held abroad, events abroad that change the foreign demand for U.S. dollars can cause substantial changes in measured U.S. monetary aggregates. Since 1947, many of the months with the fastest growth in U.S. cur­rency holdings were months in which a foreign crisis occurred. For example, U.S. currency growth was rapid in the months after Iraq invaded Kuwait in 1990. And several of the months with the fastest growth occurred in late 2008 and early 2009 during the worldwide financial crisis, where many foreigners traded their own currency for the safety of U.S. dollars.^[115] These large increases in U.S. currency out­standing were driven by foreign concerns about political, military, and financial instability rather than by domestic factors determining money demand in the U.S. economy.

Although foreign holdings of U.S. dollars reduce the reliability of measured monetary aggregates as indicators of conditions in the U.S. economy, the United States gets an important benefit from the foreign holdings of its currency. U.S. cur­rency is a liability of the Federal Reserve System and thus represents a loan to the Federal Reserve System (and ultimately to the U.S. government, to which most Federal Reserve profits go). However, currency pays no interest, so this loan being provided by foreign holders of U.S. currency to the United States is interest-free! The interest savings associated with this interest-free loan to the U.S. government amount to many billions of dollars each year.

is lower. When the central bank sells government bonds to the public to reduce the money supply, the transaction is an open-market sale. Open-market purchases and sales together are called open-market operations.

In addition to buying government bonds from the public, the central bank can also increase the money supply by buying newly issued government bonds directly from the government itself. For example, if a country's treasury needs $1 billion to pay for some new fighter planes, it might give an IOU for $1 billion (government bonds) to the central bank in exchange for $1 billion in newly printed currency. The treasury then gives the $1 billion of currency to the manufacturer of the fighter planes. After the treasury has distributed this currency, the amount of money in circulation—the money supply—will be higher by $1 billion. Effectively, this sec­ond way of increasing the money supply amounts to the government financing its expenditures by printing money.⁵ This practice is most common in poor countries or in countries wracked by war or natural disaster, in which government spending often greatly exceeds the amount that can be raised through taxes.⁶

For the rest of this chapter, we assume that the economy has a money supply of M dollars, which is determined by the central bank. The term M may represent M1, M2, or some other measure of money. For the purpose of developing the theo­retical model, which measure of money M refers to doesn't matter.

7.2