What is Money?
Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt.
Money has three functions:
- Medium of exchange : A medium of exchange is any object that is generally accepted in exchange for goods and services. Money acts as a medium of exchange. As a result, money eliminates the need for barter , which is the exchange of goods and services directly for other goods and services, which requires a double coincidence of wants (a situation in which two people each want some good or service that the other person can provide).
- Unit of account : Money serves as a unit of account , which is an agreed-upon measure for stating the prices of goods and services
- Store of value : Money serves as a store of value , which is any commodity or token that can be held and exchanged later for goods and services. (18)
Money Today
Fiat money refers to objects that are money because the law decrees or orders them to be money. Today’s fiat money consists of currency (the bills and coins that we use in the United States today) and deposits at banks and other depository institutions. Deposits are money because they can be converted into currency and because they are used to settle debts.
- Currency in a bank is not counted as money; only currency held by individuals and businesses in any form is counted money.
- Credit cards are not money — they are IDs that allow an instant loan.
- Checks, e-checks, and debit cards are not money — they are instructions to a bank to transfer money from one person to another.
- E-cash operates similarly to paper notes and coins, but doesn’t yet meet the definition of money. However, as it becomes more widely accepted it will likely gradually replace physical forms of currency.
The Banking System
The banking system consists of the Federal Reserve (Fed) and the banks and other institutions that accept deposits. There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds.
Commercial Banks
- A commercial bank is a firm that is chartered by the Comptroller of the Currency or by a state agency to receive deposits and make loans. The number of commercial banks in the U.S. has shrunk dramatically in the past decade due to mergers and failures.
- A commercial bank accepts checkable deposits, savings deposits, and time deposits.
- A commercial bank tries to maximize their stockholders’ wealth by lending for long terms at high interest rates and borrowing from depositors and others. Banks must be careful to balance security for depositors and stockholders against high but risky returns from loans. To tradeoff between risk and profit, a bank divides its assets into:
- Reserves . A bank’s reserves are its currency in its vault plus the balance on its reserve account at a Federal Reserve Bank. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold.
- Liquid Assets . Liquid assets are short-term Treasury Bills and overnight loans to other banks — these assets have low interest rates and low risk .
- The federal funds rate is the interest rate on inter bank loans and is the central target for monetary policy .
- Securities and loans . Banks buy securities issued by the U.S. government and large businesses. Some securities have low interest rates and low risk, while others have high interest rates and high risk. Banks also make loans to businesses and individuals. Loans tend to have higher interest rates and high risk and cannot be recalled until the agreed date.
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