Money

Money plays a central role in our lives, yet no one can be totally free of misconceptions about it. This article deals with only a few basic ideas, but it should help to gain an overall understanding of what money is and how it works.

Money is a token that is widely accepted as a medium of exchange. The token can be tangible like a coin or note, or intangible like a bank deposit. If the token is convertible on demand into a valuable commodity like gold, the token is known as commodity money. The exchange value of commodity money varies, but is normally greater than its value as a commodity. A precious metal coin is simply a token potentially convertible into the bullion that comprises it.

If the tokens are intrinsically worthless and inconvertible, the government must endow them with a special status to make them viable as money. Such tokens are known as fiat money. Except for collector’s items, all government-issued tokens today are fiat money. One must therefore avoid thinking in terms of commodity money to understand modern money.

In the era of commodity money, the issuer was constrained by the need to hold a sufficient supply of the underlying commodity. There is no such constraint in the case of fiat money. The value of fiat money therefore depends on the policies and actions of the issuer, normally the central bank of a country. The remainder of this essay applies to the monetary system of the U.S. and not necessarily to other countries.

The general acceptance of the government’s fiat money derives from its status as legal tender and from the fact that it is required in payment of federal taxes. Those who have no tax liability have reason to acquire fiat money because it is of value to those who do. Thus fiat money can be viewed as a tax credit, which will be used as a medium of exchange as long as the government widely enforces tax collection.

Fiat money held by the private sector is known as the monetary base, which we will refer to as base money. The Fed issues base money when it buys securities from the public for its own portfolio, mainly Treasury debt. It pays by simply creating a deposit at the Federal Reserve Bank for the seller’s own bank. This is known as monetizing the debt.

Banks create deposits, known as bank money, when they issue loans by simply crediting the borrower’s account with a new deposit. The total amount of bank money increases when a bank issues a loan. When a loan is paid off, that amount of bank money vanishes.

The value of bank money is based on the promise that it can be converted on demand into base money at par. Current rules require a bank to hold reserves of base money equal to at least 10% of its transaction deposits. Reserves can be held in any combination of vault cash and deposit at the Fed. There is no required reserve for other bank liabilities, such as savings accounts or certificates of deposit.


Another important question is what limits the bank money supply from growing excessively? Banks are in the business of selling credit. If a creditworthy borrower is willing to pay the bank’s rate, the bank will normally make the loan even if it must borrow the required reserves after the fact. The only defense against the creation of an excessive supply of bank money is for the Fed to increase the price of reserves to the point that it slows net demand.

The Fed’s basic monetary policy challenge is to keep the supply of bank money in reasonable balance with the needs of producers and the availability of goods and services. That calls for a great deal of knowledge about the economy as well as skill in interpreting the data. Mismanagement of the price of reserves can readily drive the economy off track towards inflation or recession. This is a difficult task, and the Fed has made its share of mistakes over the years that are usually obvious only in retrospect.


What is meant by the money supply? The term itself implies that a certain amount of money exists at any given time, even though the quantity may be unknown. In truth there can be no meaningful measure of the quantity because it is continually varying as a function of demand.

The Fed has its own arbitrary measures of the money supply which it once used to help guide its monetary policy decisions. It defines money as the total of cash in circulation and deposit liabilities of banks and thrifts. At one time it set targets for the growth of the money supply. Now it largely ignores its own measures because it has found little correlation between them and its major policy objectives – limiting inflation and unemployment.

Monetary Aggregates

The Fed has defined three monetary aggregates M1, M2, and M3. The narrowest definition, M1, includes the transaction deposits of banks and cash in circulation. M2 adds savings accounts, small time deposits at banks, and retail money market funds. M3 adds large time deposits, repurchase agreements, Eurodollars, and institutional money market funds. In March 2006 the Fed discontinued tracking M3 because it does not convey information about economic activity that is not already embodied in M2.

Note that the Fed's definition of the money supply includes only what the non-bank sector holds. Thus the reserves of banks, i.e. vault cash and deposits at the Fed, though a part of the monetary base, are not included in the monetary aggregates. That means when a bank spends for itself, it increases the money supply. When it receives payments from the public such as interest on loans, the money supply decreases.

Bank Lines of Credit as a Money Equivalent

An important shortcoming of the Fed's definition is that it ignores lines of credit which can be exercised at the discretion of the borrower. Firms often hold substantial lines of credit from their banks, which they can use on short notice. Likewise consumers hold lines of credit in their credit card accounts that are just as useful for purchases as checking accounts or the currency in their wallets. Lines of credit increase liquidity, which is ultimately what counts in terms of enhancing aggregate demand.

When someone uses a credit card in a purchase, he automatically expands the money supply. The seller receives a new deposit in his account, which increases the total of demand deposits in the banking system -- until the buyer pays off the loan. The result is that consumers who roll over their credit card loans rather than paying them off have increased the money supply on their own initiative by hundreds of billions of dollars. In effect, the money supply is substantially larger and less measurable than the Fed's definition.

The Quantity Theory of Money

Economists regularly use the term money supply without defining it. A notable example is the equation of exchange in the quantity theory of money.

MV = PT

This relates the money supply, M, and the velocity of money, V, to the average price level, P, and the total number of transactions, T, in a given time period. The equation is simply an identity, meaning it is true by definition. Yet it is often used to "prove" that the average price level increases with the quantity of money. An identity says nothing about causal relations. The only thing we know is the product MV, which equals the national income, PT, which itself is only roughly measurable. The quantity of money, M, remains undefined and unknowable.