Thursday, September 3, 2009

Money, it's what you want?

Why? The money we use today, the pieces of green paper with some old dudes on it, funny symbols and words, and pictures of architecture is essentially worthless, fiat. Why do we exchange them for goods and services, that is, why can you give them to a cashier at Starbucks and receive a latte?

There are three basic functions of money: medium of exchange, unit of account and store of value. Medium of exchange is the most obvious. Imagine that instead of money we had a barter system. You would create a pair of socks and you would then try and find me a person who needed socks. Then of course I would need to be able to give something back to you that we felt equaled the value of the socks. Basically you needed to have a "double coincidence of wants." Money obviates the above situation by its ability to be freely substituted for goods and services. Thus, you can sell your socks for money and then use your money to buy a bushel of grapes without having to find someone who had a need for socks and owned a bushel of grapes.

It also works as a yardstick, like an inch of a foot. It makes it easy to compare two relatively different goods or services into like terms. So having a maid clean your house is equal to 10 car washes. Instead we would just say that the maid's services cost 100 dollars and a car wash is 10 dollars.

Finally, it holds value. When the Starbucks or the sock maker takes the cash, they can delay their consumption to a later period. Thus, money can be a holder of wealth.

Here is where money becomes tricky though. It is enough to look in your piggy bank and see a collection of metallic coins and the occasional two-dollar bill which is money, but what else is money? How about the money in your checking account known as a demand deposit? What about CDs. or savings or money market accounts? There are several definitions of money as categorized by the Federal Reserve. M2 is probably the most appropriate measure. It includes:
  • demand deposits - checking accounts
  • traveler's checks
  • other checkable deposits -
  • currency
  • savings deposits
  • short time deposits
  • money market funds
  • various accounts

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