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 custom.

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), one has:

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

e-Money Examples:

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.

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.

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:

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 payment systems.

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 Coinflation.com.

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.

Measuring Money

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 following reasons:

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.

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.