Measuring Money
Because money reduces the costs of making transactions, all societies that have any amount of exchange have developed money. They have used many things as money, including salt, cattle, pigs, goats, tobacco, gold, iron, and bank debt. An item serves as money when everyone is willing to take it in exchange. For example, in World War II cigarettes served as money in prisoner-of-war (POW) camps. Most transactions involved cigarettes, and even people who did not smoke were willing to sell items for cigarettes. Cigarettes did not become money because someone in authority ordered that they be money. Their use as money arose spontaneously because, of the items available, they best served as money. They were limited in quantity, durable, and a pack could be split up for small purchases. To decide what should be counted as money, one must observe what it is that people spend.
What serves as money in the U.S. economy? Paper money and coin certainly do because we spend them. So do travelers' checks. But these forms of money are far less important than deposits against which we can write checks even though the amount in checking accounts is not much different than the total of currency, coin, and travelers' checks. Only small transactions are made with currency and coin, and the total spending done in this form is less than 1% of total transactions. For larger transactions, people use their checking account balances, either writing checks or spending these deposits with debit cards or automatic payments. Writing checks is becoming less important as people increasingly use electronic transfers to make purchases. According to the Federal Reserve, the number of electronic payments (44.5 billion) exceeded the number of checks processed (36.7 billion) for the first time in 2003.1 In this study, electronic payments included those made with debit cards, credit cards, and the Automated Clearing House (ACH) payments system.
There is dispute among economists if anything else should be counted as part of the U.S. money stock. Some economists believe that since savings accounts are almost like checking accounts, representing funds that can be quickly obtained and spent, they too should be counted as money. As a result, there are several different measures of money that the Federal Reserve publishes.
The narrowest definition of money, called the M-1 definition, includes only the public's holdings of coin, currency, travelers' checks, and deposits against which checks can be written. This definition emphasizes the medium-of-exchange definition of money. Notice that when the government or banks hold these items, they are not counted as money; the government is not part of the public.
Broader definitions of money add some very liquid assets such as savings accounts to the M-1 definition. Although debate about what should count as money are very old (with roots in the 19th century), the drastic changes in the financial sector in the late 1970s and early 1980s have made the debate especially confusing. There has been a large increase in deposits which both earn interest (and thus are very much like savings accounts) and against which checks can be written. This difficulty of deciding what should, and what should not, be counted as money is a major problem for theories that argue that changes in money stock can be an important source of macroeconomic instability.
When we measure money, we are measuring a stock, not a flow. A stock variable is one that has meaning at a point of time, while a flow variable only has meaning over a duration of time. One can talk about the amount of money one had at 12:00 on October 26, 1983, but one cannot talk about the amount of income one earned at that time. Income needs a time duration: there is weekly income, monthly income, and yearly income. Accountants separate stocks and flows with balance sheets and income statements. The first is a statement of stock variables and the second of flow variables.
Next we meet the equation of exchange.
1. 2004 Federal Reserve Payments Study, retrieved in November, 2006 at: http://www.frbservices.org/Retail/pdf/2004PaymentResearchReport.pdf. A summary of the report was found at: http://www.federalreserve.gov/BOARDDOCS/PRESS/Other/2004/20041206/default.htm