Chapter in a Nutshell

Although we know from experience that, under certain circumstances, barter exchange works, the complications associated with the requirements of a double coincidence of wants make the exchange of one good for another inefficient in the modern world. Money was invented to facilitate exchange. Money serves three functions. It is a medium of exchange, a measure of value, and a store of value. What properties must money have? It must be durable, portable, divisible, homeogeneous, and be relatively scarce. Gold has these characteristics and has long been used as money. Paper money -- called fiat money -- works as well, as long as it is universally accepted as the medium of exchange.

Let's look at our modern world of money. Money is described as a liquid asset because it exchanges easily for other assets. Our money supply is categorized according to its liquidity. M1 is the most liquid. It includes currency and demand deposits (our checking accounts) and traveler's checks. M2 is M1 money plus savings accounts, certificates of deposit, money market mutual funds, money market deposit accounts, repurchase agreements, and small-denomination time deposits. M3 is M2 money plus other less liquid forms of money such as large denomination time deposits and large overnight repurchase agreements.

The relationship between an economy's prices and its money supply is expressed in the quantity theory of money, which derives from the equation of exchange: MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q the quantity of goods. The quantity theory of money restates the equation to read, assuming both V and Q are constant:

We now see the direct relationship between money and prices (increase money, and the price level increases).

Economists hold different views concerning the velocity of money. Classical economists believe velocity is constant; monetarists believe it is not constant but stable and predictable; and Keynesians believe it is neither constant, stable, nor predictable. Economists' views on velocity affect their policy prescriptions. These show up in their theories of demand for money.

Classical economists believed that the demand for money is strictly a transactions demand, that is, a demand arising from the need to carry out transactions. They assume that since output is constant at full employment and velocity is constant, then the transactions demand for money depends on the price level. Monetarists accept the variability of velocity but believe that MV = PQ can still be a good tool for analysis because even though velocity is variable, it is predictable.

Keynesians believe that there are three motives for demanding (holding) money: the transactions motive, the precautionary motive, and the speculative motive. The speculative demand for money is inversely related to the interest rate. A fall in the interest rate increases the quantity demanded of money. Therefore, if the money supply increases, interest rates will fall and investment will increase, causing aggregate demand and real GDP to increase. To Keynesians, money matters. Classical economists and monetarists, on the other hand, believe that increases in the money supply only cause the price level to increase because the economy is continuously at full employment.

After studying this chapter, you should be able to:
· Explain why money has replaced barter.
· List the functions of money.
· Explain the liquidity characteristics of our money supply.
· Describe the classical view of money demand and the quantity theory of money. · Explain monetarism.
· Contrast the Keynesian and the monetarist views of money demand.
· Account for the Keynesian belief that money matters.

On the Net

• The Federal Reserve (http://www.bog.frb.fed.us/) issues the money we use to buy our favorite goods and services.

• The Federal Reserve (http://www.bog.frb.fed.us/) maintains current and historical data on M1, M2, and M3 money.

• Think about the credit card applications you receive in the mail, or visit Visa (http://www.visa.com/) and MasterCard (http://www.mastercard.com/). Is it clear from these advertisements that credit cards aren't money?

Economic Consultants

JoAnn Weber is an economics teacher at Washington High School in Miami, Florida. For her honors economics class, JoAnn has decided to include a section on the history, uses, and quantity of money in the United States.

As part of an arrangement with school districts in the Miami area, Economic Consultants helps economics teachers create their curricula. JoAnn has contacted Economic Consultants to prepare background materials on money. You are assigned to the project and asked to prepare a report for JoAnn that addresses the following issues:

1. Why and in what ways do we use money?
2. What economic institutions have been instrumental in the historical development of money in the United States?
3. What is meant by liquidity and how is it used to distinguish different money forms? Who actually produces the money we commonly use?
4. What resources are available for students interested in learning more about money?

• Fundamental Facts about U.S. Money
(http://www.frbatlanta.org/publica/brochure/fundfac/money.htm)
The Atlanta Federal Reserve publishes an online brochure about U.S. money.

• Monetary Museum
(http://www.frbatlanta.org/about/frbatlana/tours_mon/monet/index.html)
The Atlanta Federal Reserve maintains a physical and virtual museum devoted to money.

• Our Money
(http://woodrow.mpls.frb.fed.us/econed/curric/money.html)
The Minneapolis Federal Reserve provides information on U.S. currency and new designs, counterfeit protections, and the history of money.

• Your Money Matters
(http://www.treas.gov/currency/)
The U.S. Treasury Department publishes information on every denomination of U.S. paper money.

• The U.S. Mint
(http://www.usmint.gov/)
(http://www.treas.gov/mint/)
The U.S. Mint provides extensive information about the composition, production, and history of coins.

• Bureau of Engraving and Printing (BEP)
(http://www.treas.gov/bep/)
The BEP designs and manufactures paper money, among other securities. The BEP has extensive information about paper money, including videos that show how currency is printed and information on what happens to mutilated money.

• Currency Fun Facts
(http://www.bep.treas.gov/nptemp.cfm?id412)
The Bureau of Printing and Engraving has dozens of facts and trivia about currency.

• Know Your Money
(http://www.treas.gov/kids/money/kymintro.html)
The U.S. Secret Service, which, in addition to protecting the president, protects against counterfeiting, provides information for spotting fake money.

Added Perspective: More on the Net

• For more on the history of money, visit History of Money from Ancient Times to the Present Day (http://www.ex.ac.uk/~RDavies/arian/llyfr.html).

Interactive Quiz

Test your understanding of the chapter's concepts with the interactive quiz. The quiz contains twenty multiple-choice questions, like those found on a typical exam. Questions include detailed feedback for each answer, so that you may know instantly why you have answered correctly or incorrectly. In addition, you may email yourself and/or your instructor the results of the quiz, with a listing of correct and incorrect answers. Finally, check your results versus other students around the world -- previous scores to quizzes are displayed online.

How to Take the Quiz
Start the quiz, type in your name (required), your email address (optional), and the email address of your instructor (optional). Answer the questions (as many or as few as you like, but you need to answer at least one question). Then hit the submit button and see your results. At the results page, click on the link in the "description" column to see feedback on your answers. Scroll down the page to see quiz results from students around the world.

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Author Updates

Another Illustration of Velocity

How about this? Suppose you were in a class of 100 students taking Economics 101 this semester and each student, aware that careful reading of the textbook was essential to a good grade, wanted a book of his or her own. That would mean 100 textbooks would be needed to serve 100 students. But suppose the students were spread over 5 semesters so that this semester had only 20 students enrolled. These students would need only 20 textbooks. Suppose, after the final exam, they sold these 20 textbooks back to the campus bookstore who sold them as used books to the 20 new students enrolled in next semester's class, and who at the end of their semester, resold it to the same bookstore who sold it again as used books to the class of the third semester, and so on. Sound familiar? Now what can we say about the relationship between textbooks and students in the 5-semester scenario compared to the 1-semester scenario? In the 5-semester scenario, the 100 students get their own textbooks, but only 20 textbooks were used to satisfy their needs. Each of the 20 textbooks could be said to have "worked" 5 times as hard - or 5 times more, or 5 times as much - as the 100 textbooks used in the class of the 100 students who took the course in one semester. In the one case, the velocity of the textbook was 1 and in the other, the velocity of the textbook was 5. Reread the section in the chapter on money velocity with this textbook analogy in mind. Does it help?

P.S. keep your textbook, don't sell it!

Updated 2/04/99

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