Economics for Life Real World Financial Literacy Chapter 4 What is Money

. What is Money ?

The Definition of Money Money is most often defined as a medium of exchange with no intrinsic value . This essentially means that what people accept as money can be used as money . lfyou go back in history , you will see that people have used a number of different things as money , some that had intrinsic value ( such as gold and silver ) and many that had no intrinsic value oftheir own ( such as seashells and cocoa beans ) Currently , all countries around the world use money that is known as fiat money . From Latin , this term means , Let it be Essentially , this means that each country prints money on paper ( or in some cases , plastic ) and that currency is not backed by anything of intrinsic value except the full faith and credit ofa country Central Bank . In the past , money was backed by silver ( the silver standard ) or gold ( the gold standard ) However , that came with its own set of problems . It meant that you had to have silver or gold equivalent in value to the amount of total money you had in circulation . This made it difficult to increase the supply of money in your economy , since you had to acquire enough silver or gold to back up the additional money you wanted to circulate . So the Central Banks of the world went off the metal standard for their currency . The abandoned the gold standard in 1933 but allowed holders of dollar currency to convert them to gold at the fixed price of 35 per ounce , an arrangement that was eliminated in 1971 . The abandoned the silver standard in 1935 . So , in a way , all paper money is fake ! It is , of course , backed by the full faith and credit ofthe country that issued it , but that the only thing backing it . That means that unstable countries might end up with currency that can not be used as payment for oil or food . Even if it is accepted , it is only at a greatly value . The world currencies fluctuate relative to each other according to the rules of demand and supply . For example , if you are trying to understand the exchange rates between the dollar and the Euro , consider how many dollars it would take to buy one Euro . If a lot of people who own dollars want to buy Euros but not an equal amount of people who own Euros want to buy dollars , the Euro will appreciate relative to the dollar .

The Barter System Some economies in the past did not use money instead , they used the barter system . It is a simple system . Let say that I have two extra bushels of corn , and I need some wheat . I will swap you my two bushels of corn for two bushels of wheat . The problem is that the barter system depends on what is called a coincidence of wants . Now let say that I have three extra pigs , and I ask my neighbor ask to trade them for a cow . However , he does not have any cows he wants to trade , and he does not want any more pigs . That means I have to go searching for someone who wants to trade a cow for my pigs . Money solves this problem , because cows and pigs ( and everything that is for sale ) can be valued in terms of money . Instead of bartering , I can sell my pigs in the local marketplace and then use that money to buy a cow . How Money Is Used Money is used in several ways I . It is a medium medium of exchange is something that can be traded for goods and services . As we showed above , it solves the problem of the coincidence of wants . It is a store of value . Money function as a store of value allows you to hold on to money and buy something in the future , and the money is still accepted . If you are going to hold onto money , you should , of course , not hide it under your pillow , but put it in a savings account and earn some interest on it . When we save money for our future retirement , it is functioning as a store of value , and we must have confidence in the money still being valuable when we retire . It is a unit of account . Money functions as a universal yardstick that expresses the value and services in a single measure . For example , your labor might be valued at 15 per hour and then you can take that money you earn and buy a dozen eggs at per dozen .

The Amount of Money in the ( The Money Supply ( in 2019 is . This is a lot of money . According to the Louis Federal Reserve Bank , the types of money that are counted in the are . Savings deposits ( which include money market deposit accounts ) time deposits ( less than ) Balances in retail money market mutual funds Money plush Mona Su I Savings deposits Coins and currency In . Money market funds Certificates of deposit ' Othertime deposits Figure . Measuring Money and by Steven and David Shapiro has been adopted by Fred and is used under License . Who Owns the Money Technically , the monetary base ( coins and paper currency ) belongs to the

Central Bank of the country that created it ( in our case , The Federal Reserve Bank ) lfyou look at a US . dollar , you should see a few important details . First , at the top of the banknote , it says , Federal Reserve Note . A note is an . or promissory note that you will repay a loan . In essence , this paper currency is a loan from the Federal Reserve Bank to the holder of the note . It also has the signatures ofthe Secretary of the Treasury and the Treasurer ofthe United States . Since a promissory note is a legal document , it must be signed . This . is signed . Finally , the bill also states that This note is legal tender for all debts , public and The currency may be used to pay for goods and services and to satisfy all debt . Of course , when you are paid money for your work , you get to use the money , but the actual currency is on loan from the Federal Reserve Bank . A lot of people do not realize that not only does the Federal Reserve Bank create money , but the actual banking system also creates money . When you deposit your money into a bank , whether it be currency or a paycheck , the bank credits your account electronically . If you deposit 1000 , you can claim it back whenever you want . This is called a demand deposit . The bank then might lend out the to someone else , and now there is in the economy money supply . If the person deposits that loan of in their own bank , that second bank can then lend it out , and now there is in the . sneaky , huh ?

In aggregate terms , of the total 2019 , only about 10 is currency . The rest of has been created electronically by the banking system . The Federal Reserve Bank The Federal Reserve Bank of the United States is the Central Bank of the United States . Virtually all countries have a Central Bank . The main exception to this is the European Union , which created a common currency , the Euro , in 1999 . The EU has 27 members and 23 of them currently use the Euro as their official currency . As a result , the EU created the European Central Bank , which functions as the Central Bank for countries using the Euro . The key function of these Central Banks is threefold . It monitors the banks and institutions in the country to make sure they are following its rules and are acting in a financially responsible manner . The Central Bank has great power in this area and can shut down sei

banks , either on its own or ( in the United States ) through the Federal Deposit Insurance Corporation , which guarantees all the deposits at US . banks . It controls key interest rates , such as rates for bank and , indirectly through the prime rate , commercial lines of credit for companies . It also indirectly influences longer term rates such as car loans and mortgages . It also controls the money supply . These activities all together are called monetary policy . The Federal Reserve Bank ( or the Fed ) is made up ofthree key entities , The Federal Reserve Board of Governors . The seven governors are appointed by the President ofthe United States and serve for fourteen years each . Their terms are staggered so that one governor term expires every two years . This arrangement prevents one President from controlling the Fed through their appointments . The Chair ofthe Federal Reserve Board of Governors is also appointed every four years by the President . The Federal Reserve Banks . There are twelve Federal Reserve Banks in the United States and these are effectively local offices of the Fed . The United States is divided into twelve Federal Reserve Districts , with a Federal Reserve Bank monitoring the commercial banks in each district and each Federal Reserve Bank is headed by a President .

Geographic Boundaries of the Federal Reserve Districts . Figure . Federal Reserve Districts Mop Banks Branches by is used under License . The Open Market Committee . The Open Market Committee dictates monetary policy . It has twelve members and is composed of the seven members of the Board of Governors , the President of the New York District Federal Reserve Bank , and four additional Presidents ofthe District Federal Reserve Banks , each of whom serves on a rotating basis for one year . The Open Market Committee meets every six weeks to decide on monetary policy . In addition to the function and structure of the Fed , we also need to understand the mandate ofthe Fed . According to the various laws creating and underpinning the Federal Reserve Bank , it has a dual mandate To maintain low and predictable rates of inflation To maintain maximum levels of employment that are sustainable . The Fed meets these mandates by controlling the amount of money in the economy . This indirectly influences the amount of goods and services bought in the economy . The total amount and services made and purchased in any economy ssi

in a specific time period ( usually a year ) is called the Gross Domestic Product ( of an economy . If we look back over the last forty years of the . economy , the empirical evidence tells us that the ratio of the purchased each year to the is pretty constant . Specifically , it is a ratio . Nominal ( The technical term for this ratio is the Velocity of Circulation . The relatively constant Velocity of Circulation has three important implications for Monetary Policy . First , this constant to ratio means that every dollar of money in the economy buys two dollars of over the course of a year . Second , it also means that if the Fed wants to influence the growth of , it needs to create of Money for every of it wants to stimulate . Third , the growth rate of needs to be equal to the growth rate of or the lack of money will slow down the growth of . The relatively constant ratio of to is an important assumption of the Quantity Theory of Money , as espoused by the economists . is of monetary emphasizes the role of governments in controlling the amount ofmoney in circulation . theory asserts that variations in the money major influences on national the short run and on price longer periods ( Wikipedia ) The standard bearer of was Nobel Laureate Milton of the University of Chicago . Unfortunately , although the ratio of to was fairly constant in the 19605 and when was doing his Nobel Prize winning research , it is no longer true ( see graph below ) This discrepancy now calls into question the validity of .

FRED , 22 20 IH Ram war 1255 um use 1955 Ban 1595 zoos 2011 am 2020 Shaded areas . Source Federal Bark ! 51 . Louis Figure . Federal Reserve Bank . Louis , Velocity of Money Stock ( retrieved from FRED , Federal Reserve Bank . Louis September 30 , 2027 . Firms need employees to make things and provide services , and we can get pretty specific about how many people will be employed based on additional purchases . In 2018 , if we take the total and divide it by the number of employed people , we get this result 2018 Nominal 2018 2018 Employed Workers pu per or er ( Trillion Workers Output per Wor er Thus we see that for every in purchased throughout the course of the year , the economy needs to hire on average one additional worker . This is how the Federal Reserve Bank influences employment . As for inflation , the Fed influences this by maintaining the growth of . Simply put , inflation is caused by too much money trying to buy fewer goods

and services , thus raising prices . This can be expressed in the Inflation Equation rom the economic Quantity Theory of Money Rate of Rate of Growth of Money Supply Rate of Growth of Real Although this does not hold exactly for every year , it is true over the long run ( ten years or more ) and we see that the actual data support this relationship . An important way to interpret this equation ( for our purposes ) is that if the money supply is growing more quickly than the supply of goods and services available to purchase , then prices will rise . As we said , this general rise in the prices in an economy is called inflation . Therefore , we see that the Fed can influence employment by increasing the money supply or reduce the rate of inflation by decreasing the money supply . Unfortunately , these dual mandates are sometimes in conflict , and when they are , the Fed will always choose controlling inflation overachieving maximum employment . In the past , the Fed has sometimes put the economy into a recession in order to control inflation . The Fed is very interested in controlling expectations in the marketplace , and it has been very clear about its targets for maximum employment and low and stable prices . The Fed is trying to achieve the natural rate of unemployment . The determination of this rate is an empirical question , not a theoretical one . The natural rate of unemployment is the rate which if we go below it wages generally rise ( wage inflation ) and this then causes general inflation in the economy . The Fed used to think the natural rate of inflation was , but at the end 2019 , the unemployment rate is without seeing any significant inflation in the economy . As to the ideal inflation rate , the Fed set a target of a general rise in prices over the course of a year . We might call this target Goldilocks inflation , as the Fed does not want the rate of inflation to be much higher or much lower than this . Higher inflation can feed on itself ( through inflation expectations ) while lower inflation can cause consumers to hold off their spending . I should '

note that the Fed targets core inflation , which is the rise in prices , and it eliminates food and energy prices from the calculation , as they are too volatile . In order to control the money supply and therefore short term interest rates , the Fed conducts Open Market Operations . If unemployment is too high , the Fed buys Treasury Bonds from the banks , thereby increasing their Reserves ( the banks money that has not yet been lent out ) This increases the money supply and lowers interest rates , stimulating the economy through the availability of cheaper borrowing rates for all loans . If inflation is too high the Fed sells Treasury Bonds to the banks , thereby decreasing their Reserves . This decreases the money supply and increases interest rates and slows down the economy due to more expensive borrowing rates . Nominal Money and Real Money This subtitle might confuse you . What is the difference between nominal and real money ?

Further , what is the distinction between nominal and real wages ?

Simply put , nominal value is money face value . If you have a bill , its nominal value is 100 . On the other hand , its real value is what it can purchase . Let say you hold that 100 bill for a year , and in that year , prices ofthe things you normally buy rise ( as measured by the Consumer Price Index , or ) Your 100 bill is now worth 10 less or 90 in real money . This is why high inflation is so pernicious it erodes the value of your money . High inflation hurts poor people the most , because the things that usually and a large portion oftheir budget . High inflation also hurts retired people on a fixed pension for the same reason . As a side note , social security payments are increased every year according to the rise in the , but many corporate pensions are not ) Nominal wages are the face value ofthe wages you receive , and similar to our discussion of real money above , real wages are what your wages can purchase . High inflation erodes the value of your wages , and this has a deep impact on your life . Pew Research shows that real wages have been flat for the last 30 years or so , noting that despite the strong labor market , wage growth expectations . In fact , despite some ups and downs over the past several decades , today real average wage ( that is , the wage after accounting for inflation ) has about the same purchasing power it did 40 years

ago . And what wage gains there have been have mostly flowed to the paid tier of workers ( 2018 ) These relatively flat real wages have exacerbated both the income distribution and wealth distribution in the United States . The top 10 of income earners have gained an increasing share of total income , and this has also contributed to the top 10 owning an increasing share ofthe wealth in the United States . Finally , it is worth noting that employers consider real wages in their hiring decisions . This is true both in economic theory and in their decisions . An increase in wages above the actually causes a drop in labor demand and vice versa . The fact that real wages have been stagnant for many years is good for employers but bad for workers . Foreign Exchange Rates As part of your financial education in a global economy , you should understand global exchange rates . When importers bring foreign goods into the United States , they will put them up for sale at dollar prices . However , the manufacturer in the foreign country wants to be paid in the local currency . As you see below , supply and demand affect the value of one currency in terms of another , and this influences the price of an imported good in the United States . Here is an example Table . Foreign Exchange Rate Example Price of in Japan Exchange Rate Price of in the Yen 100 US . Yen 90 US . US . Yen 110 US . US . Think of the exchange rate as the price of the foreign currency . Thus when the dollar can purchase 100 Yen , the Yen price translates to in dollars . If the US . dollar to 90 US . dollar , the costs more in the . If the US . dollar appreciates to 110 US . dollar , the costs less in the US . The bottom line is that a stronger dollar makes imports into the United

States cheaper and US . consumers to buy more imports . The contrary is also true a weaker US . dollar makes foreign goods more expensive and discourages imports . Similarly , a weaker dollar makes US . exports cheaper and encourages foreign consumers to buy our goods . Presidents and Treasury Secretaries always say that they want a strong US . dollar , but secretly , they really do not . Overall , a weaker dollar is good for the US . economy . The basic law of supply and demand causes fluctuations in the valuations of currencies relative to one another . Even with these fluctuations , there are a number of reasons someone who holds a foreign currency would want to trade them for US . dollars To buy Exports . US . companies who are exporting goods and services to a foreign company want to be paid in dollars , so foreign importers must exchange their currency for US . dollars . To invest in US . Investments , such as the Stock Market , the US . Bond Market , Real Estate , or to buy a company . Investors from every country in the world invest in the US . Stock and Bond Markets . They are considered one of the most reliable investment markets in the world . Since the stocks and bonds in these markets must be paid for in US . dollars , anyone buying US . stocks or bonds ( or US . Real Estate or companies ) must exchange their currency for US . dollars . Speculation on the volatility in the value of currencies or hot money ) Currency values fluctuate every day relative to each other . Usually , these daily fluctuations are small . However , over a year or longer , there can be significant changes in the relative value of currencies , caused by supply and demand for particular currencies . For example , if an investor expects the dollar to appreciate 10 over time against the Japanese Yen , they can buy and hold dollars until the they rise against the Yen . Then , after converting the dollars back to Yen , the investor will earn 10 ( minus any transaction costs ) For a real world example , the US . dollar appreciated in 2018 and continued to appreciate in 2019 ( measured against a basket of foreign currencies ) due to an influx of foreign money into US . investments . Foreign stock and bond markets were not doing as well as their counterparts at the time , so foreign investors had to trade their currency for dollars in order to invest in American markets . The demand for US . dollars caused it to rise and as a

consequence , foreign imports became cheaper , and the brought in more imports . It all pretty complicated , but that the real world . Since 2019 , the US . dollar has stopped its appreciation ( after a brief jump during the Pandemic Recession ) as seen in the graph below FRED mu . mu am . am . no , i I no Ins Jan 2020417 Shaded areas some Board ! I ) ma Reserve ( US ) was Figure . Board of Governors ofthe Federal Reserve System ( US ) Trade Wei US . dollar Index Broad Goods and Services retrieved from FRED , Federal Reserve Bank Louis September 29 , 2027 . The US . dollar is also the preferred currency for several Central Banks , and it is the preferred international currency . As a result , the dollar is involved in over 90 of over trillion dollars worth exchange trades every day . How We Get Addicted to Money In The Protestant Work Ethic and the Spirit of Capitalism , sociologist Max Weber points out that there has been a predisposition to amassing material things since this country founding ( 1930 ) Puritans , the original were Calvinists , and as such , they believed in predestination . In this tradition , God already knows who is going to end up in heaven or hell however , for , this also meant that those destined for heaven would also be blessed with

material prosperity in this life . The Puritans then worked hard to attain material wealth but also led ascetic drinking , no dancing , and no enjoyment of their wealth . As Weber points out , all of this was so that these forefathers of the American Dream could assure themselves that they were truly one ofthe chosen . American materialism still exists in our society materialistic value orientation ( as defined by and From our perspective , an involves the belief that it is important to pursue the culturally sanctioned goals of attaining financial success , having nice possessions , having the right image ( produced , in large part through consumer goods ) and having a high status ( defined mostly by the size of one pocketbook and the scope of ones possessions ( 2004 ) Further , and focus on two questions . What causes people to care about and to accept materialistic values and to buy into high consumption behavior ?

develops in individuals through two pathways From personal experiences and environments that deny peoples basic psychological needs of safety , relatedness and love , and competence and autonomy From exposure to social models that encourage materialistic values parents who are excessively materialistic or by heavy exposure to the advertisements and influences ofour materialistic culture or by schooling ( 2004 ) What are the personal , social and ecological consequences of an individuals or a society having a strong ?

According to and , personal declines as materialism becomes more centralized in someone value system . Further , they show that an encourages behaviors that damage interpersonal and community relations and destroy the ecological health ofthe planet . Many psychologists , economists , and neuroscientists have presented research that shows how easily money can become addictive ( 2005 , Peterson , eel

2007 ) The human brain constantly engages in what is called hedonic adaptation . When we reach a higher level of income , we initially derive satisfaction from it . However , very soon , we adapt mentally and emotionally to that higher level and need even more money to achieve the same level of happiness . Through the same mechanisms by which we can succumb to drugs , alcohol or gambling , people can become addicted to money . Current psychological theories characterize money as both a tool ( a function of money as what it can be exchanged for ) and as a drug ( a function of money as an interest in the money itself ) Lea and 2006 ) Essentially , this posits that people not only value money for its is , how it enables people to achieve for that is , for the totally false sense of control , security , and power that it gives ( et al . 2006 ) Conversely , Price et al . 2002 ) have shown that physical and mental illness after financial strain due to job loss is triggered by reduced feelings of personal control . Unfortunately , even with enormous amounts of money , the wealthy are no happier than the less wealthy . In fact , they are actually more prone to depression and psychopathology ( 2004 , 129 ) Adults who engage in conspicuous consumption are largely trying to compensate for our unique human awareness of mortality and the pursuit of and meaning that this engenders or , simply put , existential anxiety , or the fear of going out of existence ( 2004 , National and studies attest to the fact that large amounts of wealth have little or no effect on happiness . Real purchasing power has more than doubled in the United States , France , and Japan over the last fifty years , but life satisfaction has not changed at all ( 2002 , 2005 ) I believe that people with a are at risk for anxiety , psychological problems , family , health problems , and personal financial problems . The evidence for this is voluminous ( and 2004 ) These attitudes cause real damage and are then major contributors to social problems that undermine the fabric ofour society . even contributes to world discord , as the exportation of American materialism emphasizes the gulf between the haves and the around the globe .

For economists , Bitcoin and other are an interesting experiment , but they are not yet ready to be adopted by banks and financial institutions as a way of doing business . The extreme volatility of Bitcoin ( see chart below ) and other make them an extremely poor store of value ( one ofthe main functions of money ) though they might be an adequate medium of exchange . Further , if you look at the history of the Bitcoin , you will see that there have been a number of scandals and thefts . Bitcoin defenders say these problems arejust the growing pains of a whole new type of currency and system . To this I say , that is fine , but let me know when it is grown up and adopted by ( and guaranteed by ) major financial institutions in the United States . My advice is to stay away from these for now . The graph below certainly looks enticing . If you had bought one Bitcoin on January , 2015 , at a price of , you would have had your investment grow to dollars by December 16 , 2017 , a return of 67 times your original investment , per year for each of the two years you held it . But how could you have known that ?

At the same time , ifyou had bought one share stock on January , 2015 at 320 , you would have had your investment grow to on August , 2020 , a return times your original investment , an equivalent to 200 annual return on your investment for each ofthe five years you held it . The fundamental difference here is that Amazon makes something . It provides goods and services to customers , it has a cash flow , and it has revenue and net income on which you can calculate Return on Investment ( the universal way we value companies and the price of their stocks ) Buying Bitcoin is almost like buying collectibles , like an rookie baseball card or a pair of original Air . Will these collectibles increase in value ?

Maybe yes or maybe no . Do you remember the Beanie Baby collecting craze ?

Did those increase in value ?

68 ) Bitcoin Stock Price so , co , 01 25 , ea Figure . Bitcoin Stock Price by Fred Rowland is used under License . Source ( 000 Amazon Stock Price 500 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Figure . Amazon Stock Price by Fred is used under a License . Source Yahoo Finance data ( Risk follows reward is an immutable law of Wall Street if you are seeking higher than average returns , you must go after riskier investments . You might have been lucky enough to invest in Bitcoin in 2015 , but you might have bought it in 2017 , at the height of its speculative run . You also could have bought shares in an 843 mutual fund at the Vanguard Mutual Fund Company , and your return from January , 2015 to August , 2020 , would have been 63 over five and a for an annual return , with much less risk than Bitcoin ( and the , Amazon )

500 4000 3500 3000 2500 2000 1500 1000 2012 2013 2014 2015 2016 2017 2018 2019 2020 Figure . 500 by Fred Rowland is used under a License Source Yahoo Finance data ( A Society Unquestionably , we are moving more and more toward a society . In a society ( in the US . it possible only drug dealers and firms paying their employees under the table will be using cash . Think about all the transactions you use debit or credit cards for each month . Like me , you might also be paying your bills electronically through your financial institution . And , as I mentioned earlier , only about 10 of is actually currency its circulation creates the rest of in the worldwide banking system . Debit cards could easily replace this currency .

Hyperinflation In Zimbabwe As I said before , the Quantity Theory of Money states that the growth rate in he money supply will equal the growth rate in the prices and services in an economy ( inflation rate ) minus the growth rate in real Gross Domestic . Rearranging this equation , we have Rate of Rate of Growth of Money Supply Rate of Growth of Real This is called the inflation equation . As we said above , although this relation does not hold for every year , it is accurate over the long run , a fact supported by the empirical evidence . To paraphrase the Nobel Prize winning economist , Milton , inflation is always and everywhere a money supply problem ( 1970 ) As a thought experiment , imagine an economy with a certain ( fixed ) money supply . You need money to buy goods and services created within that economy ( the ) Now let imagine that over time the money supply grows 10 greater ( rate of growth 10 ) but the goods and services do not change at all ( rate ) Therefore , the prices paid for the fixed amount and services will be bid up by 10 ( rate of ) For example , consider Robert , the strongman dictator who ruled Zimbabwe for over 30 years . From 2007 to 2010 , he created seismic shifts in his country monetary policy . Since he needed more money to run the government , to pay the military , and to buy imports , he simply ordered the Central Bank of Zimbabwe to print more money . Unfortunately , he printed so much money compared to the supply of goods and services that the rate of inflation in 2008 was over one billion percent ( As things became more expensive , the Central Bank had to print currency notes in larger and larger denominations so the residents would not have to carry money around in wheelbarrows to pay for food at the market . 721

In addition , instituted poorly land reforms that did not help , but the root cause ofthe hyperinflation was printing too much money . In 2009 , so many people had lost confidence in the Zimbabwe dollar that the government had to allow the US . dollar and other foreign currencies to be used for payments . They also stopped printing the Zimbabwe dollar , which caused the inflation rate to drop precipitously . Even so , in 2010 , it still cost 100 Billion Zimbabwe dollars to buy lunch . Eventually , the inflation rate in Zimbabwe was tamed ( relatively , at least ) and as of June 2019 , the official inflation rate was annually .