Check Your Understanding

1. Question

   Suppose you hold a gift certificate, good for certain products at participating stores. Is this gift certificate money? Why or why not?

   The defining characteristic of money is its liquidity: how easily it can be used to purchase goods and services. Although a gift certificate can easily be used to purchase a very defined set of goods or services (the goods or services available at the store issuing the gift certificate), it cannot be used to purchase any other goods or services. A gift certificate is therefore not money since it cannot easily be used to purchase all goods or services.

2. Question

   Although most bank accounts pay some interest, depositors can get a higher interest rate by buying a certificate of deposit, or CD. The difference between a CD and a checking account is that the depositor pays a penalty for withdrawing the money before the CD comes due—a period of months or even years. Small CDs are counted in M2, but not in M1. Explain why they are not part of M1.

   Again, the important characteristic of money is its liquidity: how easily it can be used to purchase goods and services. M1, the narrowest definition of the money supply, consists only of currency in circulation, traveler’s checks, and checkable bank deposits. CDs aren’t checkable—and they can’t be made checkable without incurring a cost because there’s a penalty for early withdrawal. This makes them less liquid than the assets counted in M1.

3. Question

   Explain why a system of commodity-backed money uses resources more efficiently than a system of commodity money.

   Commodity-backed money uses resources more efficiently than simple commodity money, like gold and silver coins, because commodity-backed money ties up fewer valuable resources. Although a bank must keep some of the commodity—generally gold and silver—on hand, it has to keep only enough to satisfy demand for redemptions. It can then lend out the remaining gold and silver, which allows society to use these resources for other purposes, with no loss in the ability to achieve gains from trade.