When we say that a person has a lot of money, we usually mean that he or she is wealthy. By contrast, economists use the term “money” in a more specialized way. To an economist, money does not refer to all wealth but only to one type of it: money is the stock of assets that can be readily used to make transactions. Roughly speaking, the dollars (or, in other countries, for example, pounds or yen) in the hands of the public make up the nation’s stock of money.

Money has three purposes: it is a store of value, a unit of account, and a medium of exchange.

As a store of value, money is a way to transfer purchasing power from the present to the future. If I work today and earn $100, I can hold the money and spend it tomorrow, next week, or next month. Money is not a perfect store of value: if prices are rising, the amount you can buy with any given quantity of money is falling. Even so, people hold money because they can trade it for goods and services at some time in the future.

As a unit of account, money provides the terms in which prices are quoted and debts are recorded. Microeconomics teaches us that resources are allocated according to relative prices—the prices of goods relative to other goods—yet stores post their prices in dollars and cents. A car dealer tells you that a car costs $20,000, not 400 shirts (even though it may amount to the same thing). Similarly, most debts require the debtor to deliver a specified number of dollars in the future, not a specified amount of some commodity. Money is the yardstick with which we measure economic transactions.

As a medium of exchange, money is what we use to buy goods and services. “This note is legal tender for all debts, public and private” is printed on the U.S. dollar. When we walk into stores, we are confident that the shopkeepers will accept our money in exchange for the items they are selling. The ease with which an asset can be converted into the medium of exchange and used to buy other things—goods and services—is sometimes called the asset’s liquidity. Because money is the medium of exchange, it is the economy’s most liquid asset.

To better understand the functions of money, try to imagine an economy without it: a barter economy. In such a world, trade requires the double coincidence of wants—the unlikely happenstance of two people each having a good that the other wants at the right time and place to make an exchange. A barter economy permits only simple transactions.

Money makes more indirect transactions possible. A professor uses his salary to buy books; the book publisher uses its revenue from the sale of books to buy paper; the paper company uses its revenue from the sale of paper to buy wood that it grinds into paper pulp; the lumber company uses revenue from the sale of wood to pay the lumberjack; the lumberjack uses his income to send his child to college; and the college uses its tuition receipts to pay the salary of the professor. In a complex, modern economy, trade is usually indirect and requires the use of money.

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Money takes many forms. In the U.S. economy we make transactions with an item whose sole function is to act as money: dollar bills. These pieces of green paper with small portraits of famous Americans would have little value if they were not widely accepted as money. Money that has no intrinsic value is called fiat money because it is established as money by government decree, or fiat.

Fiat money is the norm in most economies today, but most societies in the past have used a commodity with some intrinsic value for money. This type of money is called commodity money. The most widespread example is gold. When people use gold as money (or use paper money that is redeemable for gold), the economy is said to be on a gold standard. Gold is a form of commodity money because it can be used for various purposes—jewelry, dental fillings, and so on—as well as for transactions. The gold standard was common throughout the world during the late nineteenth century.

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It is not surprising that in any society, no matter how primitive, some form of commodity money arises to facilitate exchange: people are willing to accept a commodity currency such as gold because it has intrinsic value. The development of fiat money, however, is more perplexing. What would make people begin to value something that is intrinsically useless?

To understand how the evolution from commodity money to fiat money takes place, imagine an economy in which people carry around bags of gold. When a purchase is made, the buyer measures out the appropriate amount of gold. If the seller is convinced that the weight and purity of the gold are right, the buyer and seller make the exchange.

The government might first get involved in the monetary system to help people reduce transaction costs. Using raw gold as money is costly because it takes time to verify the purity of the gold and to measure the correct quantity. To reduce these costs, the government can mint gold coins of known purity and weight. The coins are easier to use than gold bullion because their values are widely recognized.

The next step is for the government to accept gold from the public in exchange for gold certificates—pieces of paper that can be redeemed for a certain quantity of gold. If people believe the government’s promise to redeem the paper bills for gold, the bills are just as valuable as the gold itself. In addition, because the bills are lighter than gold (and gold coins), they are easier to use in transactions. Eventually, no one carries gold around at all, and these gold–backed government bills become the monetary standard.

Finally, the gold backing becomes irrelevant. If no one ever bothers to redeem the bills for gold, no one cares if the option is abandoned. As long as everyone continues to accept the paper bills in exchange, they will have value and serve as money. Thus, the system of commodity money evolves into a system of fiat money. Notice that in the end the use of money in exchange is a social convention: everyone values fiat money because they expect everyone else to value it.

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The quantity of money available in an economy is called the money supply. In a system of commodity money, the money supply is simply the quantity of that commodity. In an economy that uses fiat money, such as most economies today, the government controls the supply of money: legal restrictions give the government a monopoly on the printing of money. Just as the level of taxation and the level of government purchases are policy instruments of the government, so is the quantity of money. The government’s control over the money supply is called monetary policy.

In the United States and many other countries, monetary policy is delegated to a partially independent institution called the central bank. The central bank of the United States is the Federal Reserve—often called the Fed. If you look at a U.S. dollar bill, you will see that it is called a Federal Reserve Note. Decisions about monetary policy are made by the Fed’s Federal Open Market Committee. This committee consists of two groups: (1) members of the Federal Reserve Board, who are appointed by the president and confirmed by Congress, and (2) the presidents of the regional Federal Reserve Banks, who are chosen by these banks’ boards of directors. The Federal Open Market Committee meets about every six weeks to discuss and set monetary policy.

The primary way in which the Fed controls the supply of money is through open-market operations—the purchase and sale of government bonds. When the Fed wants to increase the money supply, it uses some of the dollars it has to buy government bonds from the public. Because these dollars leave the Fed and enter into the hands of the public, the purchase increases the quantity of money in circulation. Conversely, when the Fed wants to decrease the money supply, it sells some government bonds from its own portfolio. This open–market sale of bonds takes some dollars out of the hands of the public and, thus, decreases the quantity of money in circulation. (Later in the chapter, we explore in more detail how the Fed controls the supply of money.)

One of our goals is to determine how the money supply affects the economy; we turn to that topic in the next chapter. As a background for that analysis, let’s first discuss how economists measure the quantity of money.

Because money is the stock of assets used for transactions, the quantity of money is the quantity of those assets. In simple economies, this quantity is easy to measure. In the POW camp, the quantity of money was the number of cigarettes in the camp. On the island of Yap, the quantity of money was the number of fei on the island. But how can we measure the quantity of money in more complex economies? The answer is not obvious, because no single asset is used for all transactions. People can use various assets, such as cash in their wallets or deposits in their checking accounts, to make transactions, although some assets are more convenient to use than others.

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The most obvious asset to include in the quantity of money is currency, the sum of outstanding paper money and coins. Most day–to–day transactions use currency as the medium of exchange.

A second type of asset used for transactions is demand deposits, the funds people hold in their checking accounts. If most sellers accept personal checks or debit cards that access checking accounts balances, then assets in a checking account are almost as convenient as currency. That is, the assets are in a form that can easily facilitate a transaction. Demand deposits are therefore added to currency when measuring the quantity of money.

Once we admit the logic of including demand deposits in the measured money stock, many other assets become candidates for inclusion. Funds in savings accounts, for example, can be easily transferred into checking accounts or accessed by debit cards; these assets are almost as convenient for transactions. Money market mutual funds allow investors to write checks against their accounts, although restrictions sometimes apply with regard to the size of the check or the number of checks written. Because these assets can be easily used for transactions, they should arguably be included in the quantity of money.

Because it is hard to judge which assets should be included in the money stock, more than one measure is available. Table 4-1 presents the three measures of the money stock that the Federal Reserve calculates for the U.S. economy, together with a list of which assets are included in each measure. From the smallest to the largest, they are designated C, M1, and M2. The most common measures for studying the effects of money on the economy are M1 and M2.

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