4.1 What Is Money?

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 liquid financial assets that can be readily used to make transactions. Roughly speaking, the dollars in the hands of the public make up the nation’s stock of money.

The Functions 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. Of course, money is an imperfect 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 $15,000, 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 unit in 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” is printed on all Canadian bills. 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 understand better 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 her 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 pay the lumberjack; the lumberjack uses his income to send his child to university; and the university 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.

The Types of Money

Money takes many forms. In the Canadian economy we make transactions with an item whose sole function is to act as money: dollars. These coins and pieces of paper 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.


Although fiat money is the norm in most economies today, historically most societies have used a commodity with some intrinsic value for money. This type of money is called commodity money. The most widespread example of commodity money 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.



Money in a POW Camp

An unusual form of commodity money developed in some Nazi prisoner of war (POW) camps during World War II. The Red Cross supplied the prisoners with various goods—food, clothing, cigarettes, and so on. Yet these rations were allocated without close attention to personal preferences, so naturally the allocations were often inefficient. One prisoner may have preferred chocolate, while another may have preferred cheese, and a third may have wanted a new shirt. The differing tastes and endowments of the prisoners led them to trade with one another.

Barter proved to be an inconvenient way to allocate these resources, however, because it required the double coincidence of wants. In other words, a barter system was not the easiest way to ensure that each prisoner received the goods he valued most. Even the limited economy of the POW camp needed some form of money to facilitate transactions.

Eventually, cigarettes became the established “currency” in which prices were quoted and with which trades were made. A shirt, for example, cost about 80 cigarettes. Services were also quoted in cigarettes: some prisoners offered to do other prisoners’ laundry for 2 cigarettes per garment. Even nonsmokers were happy to accept cigarettes in exchange, knowing they could trade the cigarettes in the future for some good they did enjoy. Within the POW camp the cigarette became the store of value, the unit of account, and the medium of exchange.1 image

The Development of Fiat Money

It is not surprising that in any society, regardless of its stage of development, 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 largely a social convention, in the sense that everyone values fiat money simply because they expect everyone else to value it. (The role of private banks in this historical evolution, the drift from 100 percent reserves to fractional reserves, and now our system of zero required reserves are discussed in Chapter 18.)


Money and Social Conventions on the Island of Yap

The economy of Yap, a small island in the Pacific, once had a type of money that was something between commodity and fiat money. The traditional medium of exchange in Yap was fei, stone wheels up to 12 feet in diameter. These stones had holes in the center so that they could be carried on poles and used for exchange.

Large stone wheels are not a convenient form of money. The stones were heavy, so it took substantial effort for a new owner to take his fei home after completing a transaction. Although the monetary system facilitated exchange, it did so at great cost.

Eventually, it became common practice for the new owner of the fei not to bother to take physical possession of the stone. Instead, the new owner merely accepted a claim to the fei without moving it. In future bargains, he traded this claim for goods that he wanted. Having physical possession of the stone became less important than having legal claim to it.

This practice was put to a test when an extremely valuable stone was lost at sea during a storm. Because the owner lost his money by accident rather than through negligence, it was universally agreed that his claim to the fei remained valid. Even generations later, when no one alive had ever seen this stone, the claim to this fei was still valued in exchange.2 image

How the Quantity of Money Is Controlled


The quantity of money available in an economy is called the money supply. In a system of commodity money, the money supply is 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 Canada and many other countries, monetary policy is delegated to a partially independent institution called the central bank. The central bank of Canada is the Bank of Canada. If you look at Canadian paper currency, you will see that each bill is signed by the Governor of the Bank of Canada, who is appointed by the federal cabinet for a term of seven years. The Governor and the Minister of Finance together decide on monetary policy.

Ultimately, the power to make monetary policy decisions rests with the federal cabinet. The Minister of Finance communicates the overall desires of the government to the Governor of the Bank, and the Governor is left to implement those broad instructions on a day-to-day basis. For 15 years now, the mandate for monetary policy has been that the Governor of the Bank of Canada should issue as much money as is appropriate to ensure that the Canadian annual inflation rate stays within a target range of 1–3 percent. While no dispute has emerged during this period, if the government were to lose confidence in the Governor, it cannot simply fire him or her. First, it must issue detailed written instructions concerning the changes it wants. If the Governor feels that the government’s instructions represent an inappropriate policy, the Governor must resign. But the Governor has significant power, since the resignation must be preceded by a formal directive—a written document in which the government makes quite explicit what it wants done. Thus, both the resignation and the details of the disagreement between the government and a respected banker become very public. Governments do not want to force a Governor’s resignation unless they are sure that they can defend their views on monetary policy under heavy scrutiny. The Governor of the Bank can use this power to influence policy.


The primary way in which the Bank of Canada attempts to control the supply of money is through open-market operations—the purchase and sale of government bonds (mostly short-term bonds called treasury bills). To increase the supply of money, the Bank of Canada uses dollars to buy government bonds from the public. This purchase increases the quantity of dollars in circulation. To decrease the supply of money, the Bank of Canada sells some of its government bonds. This open-market sale of bonds takes some dollars out of the hands of the public, decreasing the quantity of money in circulation.

In Chapter 19 we discuss in detail how the Bank of Canada attempts to control the supply of money by influencing the chartered banking system. In addition to buying and selling bonds, the Bank of Canada adjusts the size of the government’s deposits at chartered banks. Also in Chapter 19, we explain how the money supply is the product of the monetary base (what the Bank of Canada controls) and the money multiplier (which depends on the behaviour of chartered banks and their customers). Because the central bank cannot directly control the size of the money multiplier, monetary policy is imprecise. In Chapter 19, we discuss the money multiplier and we study the indicator used by the Bank of Canada to summarize the stance of monetary policy—the overnight lending rate—as officials attempt to keep the inflation rate on target. But, for our current discussion, these details are not crucial. It is sufficient simply to assume that the Bank of Canada directly controls the supply of money.

How the Quantity of Money Is Measured

One of the goals of this chapter is to determine how the money supply affects the economy; we turn to that topic in the next section. 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 easily measured. In the POW camp, the quantity of money was the number of cigarettes in the camp. But how can we measure the quantity of money in more complex economies such as ours? The answer is not obvious, because no single asset is used for all transactions. People can use various assets to make transactions, such as cash or cheques, although some assets are more convenient than others. This ambiguity leads to numerous measures of the quantity of money.

The most obvious asset to include in the quantity of money is currency, the sum of outstanding paper money and coins. Many 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 chequing accounts. If most sellers accept personal cheques, assets in a chequing account are almost as convenient as currency. In both cases, the assets are in a form ready to facilitate a transaction. Demand deposits are therefore added to currency when measuring the quantity of money.



How Do Credit Cards and Debit Cards Fit into the Monetary System?

Many people use credit or debit cards to make purchases. Because money is the medium of exchange, one might naturally wonder how these cards fit into the measurement and analysis of money.

Let’s start with credit cards. Although one might guess that credit cards are part of the economy’s stock of money, in fact measures of the quantity of money do not take credit cards into account. Credit cards are not really a method of payment but a method of deferring payment. When you buy an item with a credit card, the bank that issued the card pays the store what it is due. Later, you have to repay the bank. When the time comes to pay your credit card bill, you will likely do so by writing a cheque against your chequing account. The balance in this chequing account is part of the economy’s stock of money.

The story is different with debit cards, which automatically withdraw funds from a bank account to pay for items bought. Rather than allowing users to postpone payment for their purchases, a debit card allows users immediate access to deposits in their bank accounts. Using a debit card is similar to writing a cheque. The account balances that lie behind debit cards are included in the measures of the quantity of money.

Even though credit cards are not a form of money, they are still important for analyzing the monetary system. Because people with credit cards can pay many of their bills all at once at the end of the month, rather than sporadically as they make purchases, they may hold less money on average than people without credit cards. Thus, the increased popularity of credit cards may reduce the amount of money that people choose to hold. In other words, credit cards are not part of the supply of money, but they have likely reduced the demand for 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 chequing accounts; these assets are almost as convenient for transactions. Further, funds in similar accounts in trust companies and the Caisses Populaires in Quebec can be easily used for transactions. Thus, they could be included in the quantity of money.

Because it is hard to judge exactly which assets should be included in the money stock, various measures are available. Table 4-1 presents five measures of the money stock that the Bank of Canada calculates for the Canadian economy, together with a list of which assets are included in each measure. From the smallest to the largest, they are designated B, M1, M2, M2+, and M3. The most commonly used measures for studying the effects of money on the economy are M1 and M2+. There is no consensus, however, about which measure of the money stock is best, and other aggregates (than the several catalogued in Table 4-1) are in use. Disagreements about monetary policy sometimes arise because different measures of money are moving in different directions.

TABLE 4-1 The Measures of Money
Symbol Assets Included Amount in December 2012 (billions of dollars)
B Currency plus chartered bank deposits at the Bank of Canada $75.6
M1 Sum of currency in circulation, demand deposits, and other chequing deposits at chartered banks 299.5
M2 Sum of M1 plus personal savings deposits and nonpersonal notice deposits at chartered banks 1,151.3
M2+ Sum of M2 plus all deposits and shares at trust companies, mortgage loan companies, credit unions, and Caisses Populaires 1,508.8
M3 Sum of M2 plus fixed-term deposits of firms at chartered banks 1,610.8

Source: Weekly Financial Statistics (Ottawa: Bank of Canada), Tables B2 and E1, and CANSIM Table 176–0025.

Luckily, the different measures normally move together and so tell the same story about whether the quantity of money is growing quickly or slowly.