If you're an economist who believes in an active role for the government in managing
the economy, then you know that fiscal policy -- changes in government spending and/or taxation
to achieve particular macroeconomic goals -- is one type of tool that you can use.
But did you know that you can stimulate or slow spending by increasing or decreasing
the amount of money that's available?
By definition, monetary policy is changes to the money supply in order to achieve particular
macroeconomic goals.
Unlike fiscal policy, which in the case of the US, is jointly driven by Congress and
the president, monetary policy in the US is controlled by our central bank, the Federal
Reserve.
But more about the Fed in Episode 31.
For right now, if we’re talking about the changing money supply, the first questions
I have are: 1) what exactly is money, and 2) what exactly is the money supply?
By definition, money is any good that is widely accepted for the purposes of exchange, and
in the repayment of debts.
Over the years, many items have been used as money -- coins and paper, yes, but also
shells, furs, cigarettes…
as long as the item is widely accepted for the purposes of exchange, and in the repayment
of debts, that item serves as money.
To serve well as money, though, there are three basic functions of money that must be
fulfilled: 1) money serves as a medium of exchange.
Without money we would have to barter or trade, and transactions become much more difficult.
Oh, barter works fine when there's a double coincidence of wants -- you have something
I want, and I have something you want -- but if we don't, transactions become much more
complex.
OK, here's an example: You want to learn economics, and I can provide that service for you.
I want someone to babysit, and that’s a service you can provide for me.
But what if a student wants to learn economics from me, and offers me golf lessons in return?
I have no interest in golf, so that student will have to find someone else to trade with,
then come back and trade with me.
If only we had money, something we would all accept for exchanges -- how much easier this
transaction would be!
2) The second function money needs to serve is as a unit of account, i.e. money gives
us a common measurement in which values are expressed.
For example, what there is no money and you want to learn economics at this college.
There are multiple instructors; what if one wants to be paid in babysitting, another in
computer help, and another pet sitting, and so on?
It becomes very difficult to tell who has the best price.
But if every instructor charges in the same item, the accepted money, it becomes very
clear who has the lowest price.
3) The third function that money needs to serve is as a store of value, that is, money
maintains its value over time.
This enables saving, lending, and borrowing.
Do we need to have money?
No; an economy could function without money, but transactions would be much more cumbersome.
Money helps the economy move along more smoothly, reducing transactions costs.
Now that we know something about money, what is the definition the money supply, i.e.,
what's included in the money supply?
Well, there are actually multiple official versions of the money supply; let’s start
the narrowest definition, M1.
M1 includes the components of money that are most easily and immediately converted to goods
and services, or the most liquid assets -- currency held outside banks, checkable deposits, and
travelers checks.
The M2 money supply is actually the most common definition; it includes everything in M1,
plus assets that are slightly more difficult to convert to goods and services, like small
denomination time deposits (that is, CDs), where you'll pay a penalty for cashing in
early, or savings deposits, money market accounts, etcetera.
M3, then, includes everything M2, plus longer-term CDs and financial agreements; that is, M3
contains elements that are more difficult yet to convert to goods and services.
Understanding what's included in the money supply is important in understanding how the
money supply can actually be controlled, and changed, in order to manipulate the economy.
NEXT TIME: Creating money TRANSCRIPT00(MACRO) EPISODE 29: WHAT IS MONEY?