What is money in economics

Money plays a central role in modern economies by facilitating transactions and enabling economic activities. It simplifies the process of buying, selling, and valuing goods and services, which would be much more complicated in a barter system.

Money is defined as any asset that is widely accepted as a means of payment for goods and services. This includes physical items like coins and bills, as well as digital forms like bank deposits. What makes something money is not its physical form, but its acceptance by people and businesses in exchange for value.

The functions of money

Money serves several essential purposes that help economies function smoothly. These functions address practical problems in trade and value assessment, making economic interactions more efficient.

Key functions of money:

• Medium of exchange - Money acts as an intermediary in transactions, allowing people to trade goods and services without needing to barter directly. This function reduces the time and effort required to find someone who wants exactly what you have to offer.
• Unit of account - Money provides a standard way to measure and compare the value of different goods and services. For example, prices expressed in dollars allow easy comparison between items, which helps in budgeting and economic planning.
• Store of value - Money can be saved and used later, maintaining its purchasing power over time. This function enables individuals and businesses to hold wealth without it spoiling or losing utility, though inflation can erode this value.

These functions work together to support economic stability. For instance, as a store of value, money encourages saving, which connects to interest rates—the price of borrowing or saving money. Interest rates reflect the cost of using money over time, influencing decisions about spending and investment.

Measuring the money supply

Economists measure the money supply to understand how much money is available in an economy, which affects inflation, interest rates, and overall economic activity. The money supply is quantified using specific categories called monetary aggregates, which group different types of money based on their liquidity—how easily they can be used for transactions.

Monetary aggregates: M1 and M2

M1:

• This is the narrowest measure of money supply, focusing on the most liquid forms of money that can be used immediately for payments.
• Components include currency in circulation (physical cash held by the public) and demand deposits (checking account balances that can be accessed on demand).

M2:

• This is a broader measure that includes everything in M1 plus additional assets that are slightly less liquid but still easily convertible to cash.
• Components include M1 plus savings deposits, small time deposits (under $100,000), and money market mutual funds held by individuals.

M1 is used to track money actively circulating in daily transactions, while M2 provides a wider view that includes money that can quickly become available for spending.

Formula for M1

$\text{M1}=\text{currency in circulation}+\text{demand deposits}$

Where:

• Currency in circulation = Physical cash (coins and bills) held by the public, excluding amounts in bank vaults
• Demand deposits = Funds in checking accounts that can be withdrawn without notice

Formula for M2

$\text{M2}=\text{M1}+\text{savings deposits}+\text{small time deposits}+\text{retail money market mutual funds}$

Where:

• Savings deposits = Funds in savings accounts that earn interest but may have withdrawal limits
• Small time deposits = Certificates of deposit under $100,000 with a fixed term
• Retail money market mutual funds = Investment funds that offer check-writing privileges and aim to maintain a stable value

Worked example - Calculating M1 and M2

Suppose an economy has the following data: currency in circulation is $1,200 billion, demand deposits are $800 billion, savings deposits are $1,500 billion, small time deposits are $400 billion, and retail money market mutual funds are $600 billion. Calculate M1 and M2.

Step 1: Identify the values

• Currency in circulation = $1,200 billion
• Demand deposits = $800 billion
• Savings deposits = $1,500 billion
• Small time deposits = $400 billion
• Retail money market mutual funds = $600 billion

Step 2: Calculate M1

$\text{M1}=\$\mathrm{1,200}\text{ billion}+\$800\text{ billion}$

$\text{M1}=\$\mathrm{2,000}\text{ billion}$

Step 3: Calculate M2

$\text{M2}=\$\mathrm{2,000}\text{ billion}+\$\mathrm{1,500}\text{ billion}+\$400\text{ billion}+\$600\text{ billion}$

$\text{M2}=\$\mathrm{4,500}\text{ billion}$

Step 4: Interpretation

M1 at $2,000 billion represents the most liquid money available for immediate use, while M2 at $4,500 billion includes additional near-money assets, showing a broader money supply.

The monetary base

Beyond M1 and M2, economists also track the monetary base, which forms the foundation for the broader money supply. The monetary base (often labeled as M0 or MB) includes the most basic forms of money controlled by the central bank.

Components of the monetary base:

• Currency in circulation - All physical cash, including that held by the public and in bank vaults.
• Bank reserves - Funds that banks hold at the central bank or in their vaults to meet regulatory requirements and facilitate daily operations.

The monetary base is crucial because it represents the starting point for money creation through banking activities, such as lending. Changes in the monetary base, often influenced by central bank policies, can affect the overall money supply and economic conditions.

Formula for the monetary base

$\text{Monetary base}=\text{currency in circulation}+\text{bank reserves}$

Where:

• Currency in circulation = All issued cash, whether held by the public or banks
• Bank reserves = Deposits banks hold with the central bank plus vault cash

Worked example - Calculating the monetary base

An economy reports currency in circulation (including bank-held cash) at $1,500 billion and bank reserves at $500 billion. Calculate the monetary base.

Step 1: Identify the values

• Currency in circulation = $1,500 billion
• Bank reserves = $500 billion

Step 2: Apply the formula

$\text{Monetary base}=\$\mathrm{1,500}\text{ billion}+\$500\text{ billion}$

Step 3: Calculate the result

$\text{Monetary base}=\$\mathrm{2,000}\text{ billion}$

Step 4: Interpretation

This $2,000 billion forms the core of the money supply, which banks can expand through lending activities.