Money is any item of value that can be exchanged and accepted as payment for goods, services, or debts. Historically, money had taken many forms, but today the most common types include paper and coin issued by a government and personal or bank checks that constitute a promise to pay and that can readily be converted into currency. Money makes it possible to bypass the practice known as bartering, in which a person trades either goods or services in order to receive other needed goods or services. Although its value may fluctuate on currency markets, money, unlike perishable or exhaustible commodities, also constitutes "stored value"; it can be acquired in the present expressly to be used in the future.
The Properties of Money
Good money is made of a material that is durable, easily stored, lacking in bulk, and light in weight. Small coins and paper are ideal for these purposes. Money is created by a government and also by private institutions under the direct supervision and control of a government. The Constitution of the United States, for instance, grants Congress the "power to coin money and regulate the value thereof." Congress has delegated this authority to the United States Treasury Department, the Federal Reserve System, and through it to privately owned commercial banks.
Some money also serves as legal tender. This money by law must be accepted as payment for debts. Currency and coin are considered legal tender because they are created by a government or by government authority and must be accepted in payment for all debts, public and private. Checks, however, are products of commercial banks and, although considered a form of money, they are not legal tender. A merchant or debtor has the legal right to refuse to accept a personal check and, instead, to demand payment in cash.
Money also has the ability to affect prices. Because money finances almost all economic activity, the total money supply in circulation at any given time exercises an impact not only on the price of goods and services but also on the price of money itself in the form of interest rates charged for borrowing. If for some reason the quantity of money doubles, it usually follows that prices will increase as well.
The Functions of Money
Money performs four basic functions. It is a medium of exchange, a measure or standard of value, a store of value, and a standard of deferred payment. As an instrument of exchange, money serves as an asset that enables consumers, whether they are individuals, corporations, or governments, to acquire goods and services. In this way, money facilitates both conversion and growth. If, for example, a farmer grows and then sells soybeans for money, that money can, in turn, be converted into other goods and services. A series of related transactions fuels the growth of the economy.
As a standard of value, money acts as what economists call the "unit of account." In this capacity, money serves as the common denominator of value because the price of all goods and services is stated in monetary terms, regardless of how the value of money changes or affects the price charged for goods and services.
Economists define money that is earned from services provided or labor completed as a store of value because it can be kept for future use as purchasing power rather than immediately expended. Money in a savings or checking account, however, is not the only store of value. Value can also be stored in stocks, bonds, real estate, and even such commodities as wheat or corn. In some cases, money, held in the form of cash, is actually inferior to interest- or dividend-bearing assets as a store of value, since cash by itself yields no return and is subject to its value being eroded by inflation. Money is easily stored, however, because it is not bulky and will not physically deteriorate.
As a standard of deferred payment, money in the form of credit permits consumers to acquire goods and services now and to pay for them over a specified period of time. The ability to access credit and defer full payment enhances purchasing power.
Coins, currency, and checking accounts are the only items that perform all four of these monetary functions. However, in recent years, some economists have extended their definition of money to include what they called "near money" or money substitutes. These items have become known simply as M1, M2, and M3 and refer to the different levels of the money supply.
The Money Supply
The debate over how to define the "money supply" of the United States centers primarily on the question of whether savings deposits should be included in it. To that end, economists have identified the following levels for the money supply. M1 is the traditional money supply consisting only of coin, currency, and checking accounts. M2 includes M1 plus deposits in commercial savings banks, both passbook accounts and certificates of deposit. However, negotiable certificates worth $100,000 or more are not part of M2. M3 consists of M2 plus savings deposits in savings and loan associations, banks, and credit unions. It also excludes certificates valued at $100,000 or more.
Once the money supply has been determined, the next question is who will manage it and to what end. In the United States the Federal Reserve oversees the money supply. It does so by controlling the dollar amount of commercial bank reserves and, through these reserves, the total supply of money available for circulation or borrowing. Among the objectives of the Federal Reserve is the maintenance of price stability and control of the rate of economic growth.
The Circulation of Money
The speed with which money circulates, or changes hands, is one of the most important factors determining economic health. Economists call this characteristic the "velocity of money." If a dollar changes hands five times per year, the velocity of money is five. Overall price levels are determined by the quantity of money multiplied by the velocity of its circulation. Increases in either the quantity or velocity of money will cause prices to rise. Decreases will bring a decline in prices. If the quantity of money in circulation or the velocity at which it circulates is such that one rises while the other falls, there is little or no impact on prices.
The Money Market
Institutions that bring the borrowers and lenders of short-term funds together on an impersonal basis are known collectively as the money market, a highly competitive arena in which borrowers pay whatever the going interest rate may be to access available funds. Commercial banks are the most important source of short-term funds in the money market. The Federal Reserve, working through member banks, also supplies funds. At times, life insurance companies, pension funds, savings and loan associations, credit unions, and mutual funds also supply funds in the money market.
Common borrowers in the money market include businesses looking to finance short-term expansion often in response to economic conditions, as well as the U.S. Treasury Department, which seeks funds to finance the federal deficit. Treasury bills are the major money market instrument used by the Treasury to finance the deficit. These T-bills, as they are known, represent short-term obligations sold at a discount and redeemed at face value upon maturity. The two major instruments that corporations use to satisfy short-term needs are commercial paper and bankers' acceptances. They, too, are sold at a discount and then appreciate to face value at maturity.
The Monetary System of the United States
The monetary system of the United States is made up of two government agencies, the United States Treasury and the Federal Reserve System (the Fed), along with 14,700 privately owned commercial banks. These institutions create the money supply. The U.S. Treasury and the Federal Reserve can strike coins, print paper money, or write checks as outlined in their duties by the United States Congress. Commercial banks can create bank money or checking accounts, but only under the close supervision of the Federal Reserve. Commercial banks must first have adequate reserves before they can make loans and set up new accounts for borrowers. The Federal Reserve controls the dollar amount of these reserves and, in that way, also controls the volume of money in circulation and the costs of borrowing.
The Fed implements monetary policy through this control and manipulation of the money supply. By increasing or decreasing the amount of money flowing through the economy, monetary policy can accelerate or slow the rate of economic growth. The object of monetary policy is, thus, to influence the performance of the economy as reflected in such factors as inflation, productivity, and employment. It works by affecting demand across the economy, that is, consumers' willingness or ability to pay for goods, services, and credit.
There are several methods by which the Fed implements monetary policy. The Fed adjusts bank reserve requirements by buying and selling U.S. government securities. By raising or lowering the reserve requirements, the Board of Governors at the Fed can either encourage or discourage the expansion of credit.
The most powerful and efficient entity within the Fed for shaping monetary policy, however, is the Federal Open Market Committee (FOMC). This group, headed by the Chairman of the Federal Reserve Board, who in 2002 was Alan Greenspan, sets interest rates either directly (by changing the discount rate) or through the use of "open market operations," the buying and selling of government securities to affect the federal funds rate. The discount rate is the rate the Federal Reserve Bank charges member banks for overnight loans. The Fed actually controls this rate directly, but adjustment tends to have little impact on the activities of banks because funds are available elsewhere. This rate is agreed upon during the FOMC meetings by the directors of the regional banks and the Federal Reserve Board.
The federal funds rate is the interest rate at which banks lend excess reserves to each other. Although the Fed cannot directly influence this rate, it effectively controls the rate through buying and selling Treasury bonds to banks. During the course of eight regularly scheduled meetings, the FOMC sets the federal funds rate by determining a plan of open market operations. The group also sets the discount rate, which technically is established by the regional banks and approved by the Board.
In the early twenty-first century, the FOMC began announcing its decisions at the end of every meeting. The committee can increase or decrease the discount rate, or leave it unchanged. Increasing the interest rates is called "tightening" the money supply because this action reduces the amount of money flowing through the economy. Lowering interest rates is called "easing" because this action increases the money supply. Generally, analysts believe that changes in the discount rate will have little direct effect on the economy because banks can get credit from outside sources with ease.
The Fed has the same three options with the federal funds rate. By carefully buying and selling government securities, the Fed can actually change what other banks charge each other for short-term loans. Over time, changes in the money supply will affect the economy as a whole. Most analysts believe that monetary policy takes at least six months to have an impact, and by that time the economic circumstances that the policy was designed to address may have changed. Consequently, the members of the FOMC must predict what the conditions will be when the rate changes begin to exercise an influence over the rate of economic growth. Needless to say, such foresight can be difficult.
As a consequence, the Fed also routinely announces it current "bias," indicating its present thinking about the future direction the economy will take. Such an announcement usually explains whether the Fed will continue to be concerned about inflation (a tightening bias), about slow growth (a loosening bias), or about neither (a neutral bias). In this way, the Federal Reserve tries to maintain a sustainable level of economic growth, without allowing growth to proceed too rapidly or, on the contrary, without allowing the economy to become sluggish and stagnant.
If growth is too fast, inflation will rise, prices will fluctuate upward, and, as wages also rise, unemployment will eventually ensue. These three factors, inflation, rising prices, and unemployment, will short-circuit economic growth. If, by contrast, economic growth is too slow, unemployment will also rise as workers are laid off, leaving growing numbers of consumers without adequate reserve capital to spend their way out of the recession. The Fed, therefore, tries to use monetary policy to maintain a sustainable level of growth for the economy that will keep inflation, prices, and unemployment at manageable levels.
The monetary policy of the United States affects the kinds of economic decisions people make, from obtaining a loan to buying a new home to starting a business. Because the U.S. economy is the largest and most prosperous in the world, American monetary policy also has a significant impact on economies around the world. As economic circumstances change at home and around the world, the Fed adjusts its policies to stimulate, sustain, or slow growth. When the Japanese economy began to fall apart in the mid-1990s, for example, it greatly diminished the volume of American exports to Japanese markets and threatened to short-circuit the unprecedented economic boom that the United States was then experiencing. To counteract this development, the Fed cut interest rates to stimulate economic growth or at least to slow decline and to execute what economists call "soft landing."
Monetary Theory: the Prevailing Models
There are two predominant theories about how best to manage the money supply. One of these is associated with Supply-Side Economics. According to the basic principles of supply-side economics, the growth and operation of the economy depends almost entirely on factors affecting supply rather than demand. In terms of monetary theory and policy, supply-side economists embrace such measures as cuts in the interest and tax rates to encourage investment and, at the same time, favor restricting the growth of the money supply to dampen inflation.
Supply-side economists generally hold that if people had more cash in hand, they would spend more on goods and services, thereby increasing the aggregate demand for those goods and services and stimulating economic growth. Since there are natural limits to the amount of goods and services people require, they would invest their surplus assets in interest- or dividend-bearing securities, thus making additional capital available for investment and further driving down interest rates. Lower interest rates, coupled with higher aggregate demand, would prompt businesses to borrow to fund expansion, a development that also quickens economic growth. According to monetarist theory, even a small reduction in taxes and interest rates would increase consumer spending, aggregate demand, and capital investment and, as a consequence, ensure economic growth.
An alternative to the monetary theory of supply-side economies emerged when economist James Tobin criticized the narrow emphasis on money. Tobin argued that there was a range of financial assets that investors might be willing to hold in their portfolios besides money, including bonds and equities. Their preferences were rationally determined by calculating potential gains against potential risks. Tobin, following John Maynard Keynes, showed how government economic and fiscal policy could impinge on productivity and employment.
Keynes had argued that a drop in prices would increase the value of money in real terms. Simply put, without raising wages, falling prices would mean that consumers enjoyed greater purchasing power. An increase in the real value of money would also make available a greater surplus of capital for investment and bring about a consequent decline in interest rates, thus prompting additional investment and stimulating economic growth. In the Keynesian system, the quantity of money determined prices. Interest rates brought savings and investment into balance, while the interest rate itself was set by the quality of money people desired to hold (liquidity preference) in relation to the money supply. Government monetary policy, therefore, ought to aim at keeping money in the hands of consumers and investors, either through increasing wages to counter the effects of inflation or by lowering prices if wages remained stable. Lowering wages to cut business costs, increase profit margins, and stimulate employment, Keynes suggested, was counterproductive. Lower wages only served to decrease income, depress aggregate demand, and retard consumption, all of which would more than offset any benefits that accrued to business from a reduction in wages. During economic hard times, when the private sector could not absorb the costs of labor, the government could take over the role of business by spending money on public works projects to reduce unemployment.
The Future of Money
By the 1990s, Americans were already becoming immersed in the technology of the digital economy. The idea of digital money, e-cash, is simple. Instead of storing value in paper, e-cash saves it in a series of digits and codes that are as portable and exchangeable as paper, but more secure and even "smarter." If e-cash is lost or stolen, its proponents maintain, the card can easily be canceled via computer and its value transferred to another card. E-cash is also more mutable and controllable than paper money. It enables individuals to send funds over the Internet, encoded in an e-mail message rather than sending cash, checks, or wire transfers. Digital currency can also be programmed so that it can be spent only in specific ways; money budgeted for food cannot be used to go to the movies or visit the local pub. Finally, e-cash, unlike paper money when withdrawn from an account, continues to earn interest until it is used.
This characteristic of e-cash gave rise to another extraordinary aspect of the digital financial revolution: the dissolution of the government monopoly on money. Digital cash has no boundaries. Cardholders are free to acquire e-cash from worldwide lenders willing to pay higher interest rates than banks in the United States. As long as e-cash is easily convertible and widely accepted, customers will find that there is no reason to limit themselves to the currency of a single government. Government-issued money will not cease to exist, but it will have to compete with dozens of other currencies, each tailored to meet specific needs of customers. "In the electronic city, the final step in the evolution of money is being taken," explained Howard M. Greenspan, president of Heraclitus Corporation, a management consulting firm. "Money is being demonetized. Money is being eliminated."
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