Lecture Notes on Mishkin Chapter 3
("What is Money")
Econ 353: Money, Banking, and Financial Institutions
- Last Updated: 28 March 2015
- Latest Course Offering: Spring 2011
- Course Instructor:
Professor Leigh Tesfatsion
tesfatsi AT iastate.edu
- Econ 353 Homepage:
Economists' Meaning of Money
1. Basic Definition
Money is anything that is generally accepted in payment for
goods and services and for the repayment of debts, as a matter of social
It follows that money is defined more by its function (what purposes
it serves) than by its form (coin, paper, gold bars, etc.).
Moreover, the stress on "generally accepted" in this definition indicates
that money is largely a social convention in the sense that what
actually constitutes money in a society depends on what people in the
society are generally willing to accept as money.
An interesting question is how this "general acceptance" comes
to be established!
Note on Terminology:
- Money must be distinguished from both "wealth" and "income."
- The wealth of an agent at any given point in time is
the current market value of the total collection of assets currently
owned by that agent. Money holdings might constitute part of an
agent's wealth, but the agent would presumably own other types of
assets as well (e.g., land, equipment,...). On the other hand,
income is a flow of value accrued over some specified period of time.
- Example: A student works part time as a teaching
assistant, earning $900 per month, and has a checking account
balance of $400. He also owns a car worth $1100 and books worth
$500. Consequently, ignoring for simplicity the student's "human
capital" (e.g., his embodied labor skills, valued by estimating the
capitalized stream of all of his potential future wage earnings),
- Money holdings = $400
- Wealth = Market value of his asset holdings consisting of
(money holdings, car, books) = ($400 + $1,100 + $500) = $2,000
- Income = $900 per month
As illustrated by this example, income is a flow variable in the sense
that it measures an amount of value accrued over a specified period of
time (e.g., a month). In contrast, money and wealth are both stock
variables in the sense that they measure an amount of value at a given
point in time.
2. Types of Money
- Commodity Money: Commodity money is any commodity
that is used as money, i.e., any commodity that is generally accepted as a means of payment for goods and services and for the repayment of debts.
In the past, a "commodity" was considered to be anything with intrinsic use value. In modern usage, a commodity is interpreted to mean anything of value that is available for purchase and sale in standardized form (e.g., cell phone minutes). This standardized form permits purchases and sales to take place within organized markets.
- Commodity Money Examples from the Past:
- Cattle, skins, furs, corn, gold, silver, copper, and cigarettes.
- Fiat Money: Fiat money is any paper money that is "unbacked" and "legal tender." A money is unbacked if it is not collateralized by any valuable commodity. That is, no one is obliged by law to convert the money into coins, precious metals, or any other type of physical good or service. A money is legal tender for a country if, by law, the citizens of the country must accept the money for repayment of debts.
- Fiat Money Example:
- In the United States, the Federal reserve notes (dollar bills)
issued by the Federal Reserve System (the central bank of the US)
are paper money that is unbacked legal tender, hence fiat money.
The general acceptance of dollar bills in the US as payment for goods and services depends upon the persistence of a widely shared trust among citizens that any person who accepts dollars now in exchange for goods or services will be able to exchange these dollars later for other goods and services.
- Note: Under the Coinage Act of 1965, legal tender in the
United States consists of all currency (coins and paper money) issued by the U.S. government. This includes Federal reserve notes as well as other older paper money issued by the U.S. government, such as United States notes first authorized and issued in 1862 during the Civil War (1861-1866).
- Electronic Means of Payment (EMOP): A means of payment that
permits payments to be transmitted using electronic telecommunications.
- EMOP Examples:
- One example is the Fed's use of Fedwire, a telecommunications system
that permits all financial institutions that maintain accounts with the Fed
to wire (transfer) funds to each other without having to send checks.
- Other examples include private EMOP systems such as CHIPS
and SWIFT (used by banks, money market mutual funds, securities
dealers, and corporations to wire funds) and ACHs (automatic
clearing houses) used for smaller wire transfers, e.g., from
employers to their employees.
- Interesting EMOP observation:
- As noted by Mishkin, in the United States, even though an EMOP is
used by fewer than 1 percent of the number of payments made, over 80
percent of the dollar value of payments made is through EMOP
- Electronic Money (e-Money): E-money is money that is stored
electronically rather than in paper or commodity form. Once established,
e-money cuts way down on transactions costs; but it can be expensive to set
up an e-money system, and concerns have been raised about record-keeping,
security, and privacy (as well as the elimination of "float" for consumers!).
- e-Money Examples:
- Debit Cards: Charged expenses are immediately deducted
from some corresponding bank account -- there is no float (time
between purchase and deduction) as with credit cards and paper
- Mobile Money: A mobile-phone based money system that permits people to use their mobile phones to deposit, transfer, and withdraw funds via text messages. For example, participants can receive money remittances from abroad, send money to relatives across town or abroad, buy items at retail outlets, and borrow money from (or lend money to) other participants. In short, mobile phones are used as a flexible form of debit card.
- Stored-Value Cards: Charged expenses are immediately
deducted from a fixed amount of digital cash stored on a card.
- Electronic Cash: A form of e-money that can be used to purchase goods and services on the Internet.
- Electronic Checks: A process by which users
of the Internet can pay their bills directly over the Internet
without having to send a paper check.
Functions of Money
Money performs three basic functions in an economy: (1) It serves
as a unit of account; (2) it serves as a medium of
exchange; and (3) it serves as a store of value.
- Unit of Account: A unit in terms of which a single price
for each good and service can be quoted.
- In the US, the price of an apple is given as dollars
per apple, the price of a gallon of milk is given as
dollars per gallon of milk, etc. That is, each good or service
on sale at an outlet is generally offered at a single quoted
"dollar price" -- that is, a
price quoted in terms of dollars.
- In reality, however, any particular good or
service (e.g., apples) has a huge array of different prices
that could be quoted for it, one for each other good or service
in the economy (e.g., pounds of bread per apple, cans of beer per
apple, hours of doctor visits per apple, etc.)
- Without a money unit to provide a single accepted
unit of account, sellers would have to quote prices of items
in terms of whichever goods or services they were willing to
accept in return at the time the items were purchased. That is,
as clarified further below, the payment system would be a
"barter" payment system.
- Medium of Exchange: An accepted means of payment for
trade of goods and services.
- As noted above, the existence of a money unit permits each
item for sale to have a single price quoted for it in terms of the
money unit. But this is not enough to ensure the item will actually
be sold to buyers for money units.
- Sellers have to be willing to accept the money units from
buyers in return for giving up the item, which requires a trust on
the part of sellers that others will in turn be willing to accept
these money units from them at a later time in return for goods and
services. That is, the money units have to act as a medium of
exchange in the economy before one can conclude that they indeed
constitute money in the economy.
- Store of Value: A repository of purchasing power for
- Money can be held for future use, allowing for the ability to
save (store value) over time. All assets act as stores of value
to some extent, but money by definition is the most liquid, i.e.,
the most easily converted into a medium of exchange, since by
definition it already is a medium of exchange!
- On the other hand, money is by no means a risk-free store of
value. The real purchasing power of money depends on the inflation
rate, that is, on the rate at which the general price level is
changing. If the inflation rate is positive (prices are
increasing), any money held loses purchasing power
over time. If the inflation rate is negative (prices are
decreasing), any money held gains purchasing power over time.
- To the extent that the inflation rate is unpredictable,
inflation reduces the ability of money to act as a reliable store of
value and as a method of deferred payment in borrowing-lending
transactions. A positive inflation rate is bad for lenders
and good for borrowers since the dollars lent out are worth more
than the dollars later paid back. Conversely, a negative
inflation rate is good for lenders and bad for borrowers.
In extreme cases in which the inflation rate exceeds 50 percent per
month -- a situation referred to as hyperinflation -- the
entire monetary system generally breaks down and is replaced by
barter. This has devastating effects on an economy.
- Mishkin notes that Post-WWI Germany suffered a hyperinflation
in which the inflation rate at times exceeded 1000 percent per
month. More recently, various Latin American economies experienced
hyperinflations during the 1980s. For example, as discussed by
Mishkin in Chapter 28, in the first half of 1985 Bolivia's inflation
rate was running at 20,000 percent and rising.
Evolution of Payment Systems
Tracing the historical evolution of payment systems in various
economies is a fascinating and complex task. Although highly
simplified, the following three-stage process captures the general
way in which this evolution has occurred in many parts of the world.
- Autarky: Each family or tribal group produces all
of what they consume, with the outputs of production being
shared in accordance with some kind of group distribution rule
determining who gets what and in what amount. No trade takes place
and there is no use of money.
- Barter Payment System: Within family or tribal groups,
and possibly between such groups, people trade goods and services
for other goods and services. There is no use of money.
- Monetary Payment System: People trade goods and services
in return for money.
A barter payment system has several problems that make it extremely
inefficient relative to a monetary payment system if a large number
of goods and services are produced in an economy:
- Double Coincidence of Wants: Under a barter payment
system, a double coincidence of wants is needed before any trade
can take place. That is, two individuals seeking to trade must have
exactly the goods or services that each other wants.
of having a double coincidence of wants before exchange can take place
discourages both specialization
in labor (generally referred to as "division of labor") and specialization
in production; for the fewer the
types of goods and services one produces for sale, the fewer the types of goods
and services one can expect to be able to trade for.
The need for double coincidence of wants in barter payments systems thus tends to reduce
- Multiple Prices for Each Good or Service: Under a
barter payment system, many different prices must be maintained for
each good and service, making informed decisions about what to buy
(and from whom to buy it) extremely difficult. Specifically, an
exchange ratio ("goods price") is needed for every distinct pair of
items to be traded.
- For example, given two items (say apples and beer), one
needs one goods price (apples per beer or beer per apples, either
one will do). For three items (say apples, beer, and cars), one
needs three goods prices (e.g., apples per beer, apples per car, and
beer per cars). But for four items one needs six prices, for five
items one needs ten prices, and so it goes. As the number of items
keeps increasing, the number of needed goods prices increases
- More precisely, given a barter economy with n goods, the number of
needed goods prices is n[n-1]/2, which is the number of distinct ways that n items can
be selected 2 at a time without consideration of order. An equivalent
formula for calculating the needed number of goods prices in a barter economy
with n goods is the sum of numbers between 1 and n-1, inclusive; i.e.,
(n-1) + (n-2) + ... + 1. Can you explain why?
- High Transactions Costs: Under a barter payment
system, the above two problems result in high transaction costs,
that is, large amounts of resources (time, effort, shoe leather,...)
being spent on trying to exchange goods and services.
As previously discussed, the use of money dramatically cuts down on
the transactions costs arising from barter, so it is not surprising
that barter payment systems have tended to evolve into monetary
The nature of the monies used in monetary payment systems continues
to evolve over time.
The first monies were commodity monies, i.e., goods with direct ("intrinsic") use value that were used as money. Examples include cattle, tobacco, and gold that could directly be used for eating, smoking, and jewelry, respectively. Their direct use value made them useful as money because people were willing to accept them as means of payment even if they, themselves, had no direct use for them.
Different types of commodities have different kinds of drawbacks
for use as commodity money. For example, gold and silver are
durable and can be molded into portable coins of standard size
for ease of use in trade, but they tend to lose commodity value when
subdivided into very small quantities for everyday transactions. On
the other hand, tobacco is not very durable and its quality is
highly variable, but it can be subdivided into small amounts without
loss of commodity value.
To avoid various difficulties associated with the use
of commodity monies in trade, private banks along with governments
began to issue paper notes (claims against themselves) that were
backed (collateralized) by the commodity money they replaced,
usually gold or silver coin. That is, the issuers of these paper
notes normally promised to redeem their notes in gold or silver
coins on demand. This paper form of money was therefore simply a
way to cut down on the transactions costs associated with the use of
commodity monies without actually eliminating these commodity monies.
As trade continued to expand, however, the power to issue notes
was increasingly transferred to governments and the link with
commodity monies became increasingly tenuous. Eventually paper
notes evolved into fiat monies, i.e., unbacked paper monies officially designated as legal tender. Moreover,
the link between the precious metal content of coins and the
face value of coins also became tenuous. Indeed, many coins in
use today in the world are referred to as token coins because the amounts of silver and other precious metals they contain (i.e., their intrinsic values) are far below their face values.
For a report on the precious metal content of U.S. coins, see
As Mishkin details, the use of fiat money in trade is itself subject
to several difficulties: in particular, expense of transport, and
risk of theft. Attempts to combat these difficulties led to
the invention of checkable demand deposits. More recent innovations
include electronic means of payments (EMOPs), which permit value to be transmitted electronically, and electronic monies (e-monies), which permit value to be stored electronically.
In summary, the nature of monies used in monetary payment systems
has tended to evolve over time from commodity money, to fiat money,
to checkable demand deposits, to EMOPs, and most recently to
e-monies. At this point in time, all of these forms of money are
used to varying extents in different parts of the world. Whether
the earlier forms of money will ever be entirely eliminated by the
later forms remains to be seen.
In the U.S. today, dollar bills and coins are together referred
to as currency. As will be clarified later in the course, dollar bills (Federal Reserve notes) are issued by each of the
twelve banks constituting the Federal Reserve System (Fed), the central bank of the US. Coins are also put into circulation by the Fed, but they are minted by the U.S. Treasury (part of the Executive Branch of the U.S. Federal government).
In value terms, however, currency represents only a small part
of what is used in the U.S. today as money. For this reason, the Fed
makes use of various broader measures of the money supply.
Accurate measurement of the money supply is important for the
- Changes in the money supply are thought to have rather immediate effects on short-term interest rates (e.g., the Federal funds rate), intermediate-run effects on key macro variables such as real GDP, and longer-run effects on other key macro variables such as the aggregate price level and the inflation rate.
- The Fed has some ability to manipulate and control the money
supply (hence short-term interest rates) through open-market operations, i.e., sales and purchases of government bonds to and from the private sector. Thus, by appropriately managing
the money supply (and short-term interest rates), the Fed can exert some longer-run control over key macro variables.
- NOTE: Monetary policy refers to the efforts of central banks such as the Fed to control key macro variables through the management of the money supply and (short-term) interest rates.
- Without an accurate measurement of the money supply, however, it
is difficult for the Fed to judge the effectiveness of its monetary
policy. To judge this effectiveness, the Fed must first be able to
measure the extent to which it has succeeded in changing the money
supply in accordance with its plans. Second, the Fed must be able
to measure the extent to which these changes in the money supply
have had intended effects on key macro variables.
There are two basic ways of measuring money: the
"theoretical approach" and the "empirical approach."
- The Theoretical Approach to Money Measurement:
- The theoretical approach to money measurement tries to use economic
theory to decide which assets should be included in the measure of money. In particular, the theoretical approach focuses on the relative "moneyness" of assets -- in particular, the degree to which assets function as mediums of exchange.
- Traditionally, advocates of this theoretical approach have argued
that only those assets that clearly function as a medium of exchange
should be counted in the measure of money. Unfortunately, however,
many assets function as a medium of exchange to some degree and the
appropriate cut-off point is not clear.
- More recently, however, economists have argued for a "weighted
aggregate" approach to the measure of money.
- In the latter approach, all assets functioning to some degree as a medium of exchange are included in the measure of money. However, each of these assets is weighted, with assets that function more as a medium of exchange receiving a relatively larger weight. This eliminates the need to specify a sharp threshhold determining which assets are included or excluded from consideration. However, one is still left with the problem of how to select specific weight magnitudes for the included assets.
- The verdict on the reliability and usefulness of these newer
weighted-aggregate measures is still out.
- The Empirical Approach to Money Measurement:
- The empirical approach to the measurement of money takes a more
pragmatic view and argues that the decision about what to call money should be based on which measure of money works best in helping to predict the movements of key macro variables.
- Unfortunately for the empirical approach, experience has shown that
different measures may work better for predicting different variables at any given point in time. For example, the measure that works best for predicting recessions may not be the measure that works best for predicting exchange rates. Morever, the usefulness of any one measure for predicting any one variable tends to vary over time. What works in one period may not work well in the next.
- Actual Practice in the United States:
- Over the years the Fed has devised a range of different measures of
money that combine aspects of the theoretical and empirical points
of view. The two measures of money most commonly used by the Fed
-- M1 and M2 -- are explained by Mishkin in Table 1.
- These measures, generally referred to as monetary aggregates, are "nested" in the sense that each aggregate is broader than its predecessor. For example, M2 includes all assets in M1 together with several additional assets not included in M1.
- The narrowest monetary aggregate, M1, conforms to the theoretical
point of view in that it only contains highly liquid assets that are directly usable as mediums of exchange (currency, traveler's checks, demand deposits, and other checkable deposits). However, the continual
introduction of new forms of money-like instruments has driven the
Fed to make additional use of broader monetary aggregates such as
M2 in order to improve its prediction of and control over key macro variables.
- Question: Why might you guess that, the narrower the measure of money, the more "unstable" will be its relationship to key macro variables such as GDP and inflation?
- As seen in Mishkin's Figure 1, the monetary aggregates M1 and M2
have tended to move together over time, but there have been occasions in which they have moved in substantially different directions. These
differences in movement underscore the difficulty of obtaining useful
empirical measures of money.
Reliability of Monetary Data
Estimates of the various monetary aggregates are frequently revised
by large amounts for two reasons.
- First, small depository institutions are only required to report
the amount of their deposits infrequently, forcing the Fed to
estimate these amounts between the reporting dates.
- Second, the monetary aggregates are based on "seasonally
adjusted" data, meaning that corrections are made for systematic
peaks and dips in money use due to such time-dependent events as
regular holidays and seasonal changes in weather. The appropriate
extent of these seasonal adjustments often only becomes clear after
the fact, requiring revisions to the adjustments made at the time of
The revisions made in monetary aggregate estimates can be considerable from one month to the next. However, when averaged over time, these revisions tend to average out to zero.
For example, for the initial and revised monthy estimates of the
growth rate of M2 depicted in Mishkin's Table 2, in some months the initial rate estimates are too high and need to be revised downward, and in other months the initial rate estimates are too low and need to be revised upwards. However, the average of the initial rate estimates across all 12 months is approximately the same as the average of the revised rate estimates across all 12 months, implying that the revisions (error corrections) made in the initial rate estimates tend to average out to zero.
A useful conclusion to draw from these observations is that one
should probably not pay too much attention to reported monthy
movements in monetary aggregates. It is far more meaningful and
useful to consider the trends in these monetary aggregates, i.e.,
to consider the average movements in these monetary aggregates over
longer periods of time.
Basic Concepts and Key Issues From Mishkin Chapter 3
- Basic Concepts:
- Stock Variable
- Flow Variable
- Commodity Money
- Paper Money (Backed or Unbacked)
- Legal Tender
- Fiat Money
- U.S. Federal Reserve System
- Electronic Means of Payment
- Electronic Money
- Unit of Account
- Medium of Exchange
- Store of Value
- Payment System
- Barter Payment System
- Monetary Payment System
- Double Coincidence of Wants
- Monetary Policy
- Monetary Aggregates (M1, M2)
- Key Issues:
- The Definition (Abstract Meaning) of Money
- Types of Money
- Functions of Money
- Evolution of Payment Systems
- Efficiency of Barter vs. Monetary Payment Systems
- Difficulties Encountered in Attempts to Measure the Money Supply
- Measuring the Money Supply: Actual Practice in the U.S.
- Reliability of U.S. Monetary Data
Copyright © 2011 Leigh Tesfatsion. All Rights Reserved.