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Economics: The Money Supply


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About this Lesson

  • Type: Video Tutorial
  • Length: 8:11
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 88 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Banking, Spending, Saving and Investing (19 lessons, $30.69)
Economics: Money in the Economy (4 lessons, $6.93)

This economics video lesson will teach you about the Money Supply. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Imagine a world without money; how would you get the things that you want and need? Suppose you are a canoe maker, and you want a chicken. Well, what you are going to have to do is make a canoe. Then you are going to have to carry it around, looking for someone who has a chicken. And when you find him, you have to hope that he wants a canoe. Then you have got to decide how many chickens is a canoe worth... will you exchange for it? Then, do the transaction, carry your chickens home. Its very, very inconvenient and with all of these search costs in effort to find trading partners, you probably aren't going to spend nearly as much time actually making canoes and creating things of value.
Eventually what happens in an economy like this, an economy that depends on barter is that some good begins to circulate as a medium of exchange. Suppose that everyone wants salt, so you have made a canoe, you can trade it for salt. Then eventually you find somebody who has got chickens, he may not want a canoe, but he wants salt, so the trade is pretty easy to do. A medium of exchange lowers the search costs. Plus what happens, is all prices begin to be quoted in terms of salt, rather than having to figure out how many chickens a canoe is worth, the salt acts as a kind of common denominator, it's called a `unit of account.' A third thing that happens is, if salt can be stored, you can sell your stuff for salt, put salt in your warehouse, and spend the salt when you want stuff in the future. That is it can be a `store of value.' Now you have got something that is functioning as money. Money is anything that is commonly accepted in exchange for goods and services. That is anything that is actually used and accepted for shopping.
Now, lets be very clear about the way the term money is used. When we talk about money, we are usually talking about "exchange" that is, things that can be traded. Whenever you say "money," you might talk about the money that you have in the bank, that is the value that you have stored up. But typically when economists are talking about money, were concerned about those tools that are used in society to make shopping easier to do. The functions of money are: unit of account, medium of exchange, and store of value.
Now the earliest forms of money, like salt are all commodities, things that are valuable for their own sake: cattle, wine, tobacco. In fact, some places in the world today, occasionally when the paper money is worthless, people will still use cigarettes in the transaction. Maybe to pay for a cab ride, or in prison, often cigarettes circulate as money, are commonly accepted in trades.
What is it though, that is going to be the best kind of money? The best kind of money is going to be durable, that it isn't going to melt or rot. It is going to be portable, easy to carry around. It is going to be standardizable, that is, everyone can look at it and clearly see that it is valuable. And it is going to divisible. That is it is pretty easy to make change from. So, what is going to be ideal, what commodity best serves? Well one commodity that is pretty good is gold, or any of the other precious medals. Actually antiquity people probably thought that this gold and silver, and other precious medals were valuable because it reminded them of the celestial bodies which many of them saw the signs of the divine. Once these things are commonly accepted and agreed upon as valuable, then you can cut them up into standard sizes and make coins that can circulate as money. Pretty easy to carry around and everybody knows that they are good.
Now, one problem with this is that a sack full of gold is pretty heavy. So what is about to happen in history is were going to witness the evolution in the ancient world, from people actually carrying commodities around, to carrying around pieces of paper that represent claims on the commodities. So, you put all of your gold with the goldsmith somewhere, he gives you a certificate that stands for gold, and now you can pay in shopping, with this certificate, representative money. Once people are accepting a piece of paper, the next step is that you don't need any gold to back it, that is the government simply says, this money is valuable. This is a movement from commodity money and representative money to what we call `fiat money,' money that gets its value from the word of law.
Now, the way that the government gives money value is first, it requires that you hold this money to pay your taxes. And the army stands behind that, so unless you want to run a foul of the structures of authority, you have got to agree that this is valuable, and you have to come up with some at tax time. The second thing the government can do is it can declare that this is legal tender. Legal tender means that it is good for settling debts. If I owe you money and I give you legal tender, then you can't sue me because the government will throw your claim in court, because I settled it with an instrument that everyone says, by law, has to be accepted. That is what fiat money is all about.
Now why should we care about money? Money makes transactions easier to do, and if there is enough money, then business proceeds normally. If there is too little money, then people revert toward something kind of like barter. They don't specialize, they don't trade, and in the modern world, we call that a recession. The economy slows down when money and credit are difficult to get and business activity slacks off, employment is down and we get a recession. On the other hand, if the government is printing and circulating too much money, then we have got too much money chasing too few goods and that creates inflation, an excess supply of money that drives up prices. So there is a fine line to walk between too little money and a recession in credit crunch, and too much money in inflationary pressure rising prices.
So the Federal Reserve is the monetary authority of the United States. It's charged to making sure that there is not too much money and not too little money. That is, it's charged to making sure that money retains its value by prices remaining stable. That means the Fed has got to make sure that there is just enough money.
So that raises the question, if the Fed is trying to measure money, what in practice, is it actually measuring? What is money? And this question has several answers; depending on who is willing to accept something in exchange for goods and services.
Let's think about a very, very narrow measure of money. What is the stuff that everyone is willing to take in transactions? What can you use to pay for your groceries? What will the pizza boy accept whenever he delivers your pizza? The answer is cash. Everybody will take currency; everyone will take coins; and most people will take personal checks; and traveler's checks. If you add up currency and coin in circulation, the total sum of personal checking accounts, and business checking accounts, and you throw in travelers checks; you have got a measure of money that the Federal Reserve calls M1. This is the narrowest measure of the money supply. And in the U.S. economy, it adds up to about one trillion dollars.
Now, lets make the measure of money a little bit broader. Let's include other things that we might call near money. The Fed's concern here is, how much stuff is actually out there, circulating through the economy to make shopping possible. That is how much shopping are people capable of doing with the existing money supply. So the Fed is now going to say, well this is how much stuff that is actually being used to pay for shopping (and remember even if you are using a credit card, you are eventually settling it with a cash or check). So the next question is; how much stuff is out there poised, about ready to be converted into a spendable form, this is near money. And it includes, well, first of all, your savings account. It includes certificates of deposit, especially the small ones that consumers use when they are saving for things. It also includes the money market/mutual fund shares that you hold. Maybe you have a money market account that you use every so often writing a check to transfer into your account, your checking account whenever you need to pay tuition, or something like that. All of these measures, these broader measures of money are called M2. M2 includes everything that is in M1 plus these additional instruments. See these measures of money are inclusive. M1 is the narrowest measure and M2 includes everything that is in M1 as well as some other stuff; in this case: savings accounts, certificates of deposit, and money market shares that are held by households.
Money: Banking, Spending, Saving, and Investing
Money in the Economy
The Money Supply Page [2 of 3]

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