All Terrain Thinking

A Compendium of things I think are Important

Generally Speaking, Think on this...

Evolution of Money

What are the greatest discoveries/inventions of all times? On the short list of responses are the two that I was taught when I was in school - fire and the wheel. What is generally missing from my original list and students' lists, but what ranks up there on my current list, would be money.  In a very real sense we can think of money as the oil that keeps the economic engine producing the goods and services we consume running smoothly.  Just think back over the past 24 hours and list the transactions you have been involved in, the transactions that are the essence of an advanced economic system.  In a class of 100 meeting early in the morning, you are likely to find someone who has already bought the newspaper, paid a tuition bill, paid the rent, made the monthly car payment, bought breakfast, purchased gasoline and bridge tokens.  We could go on but you get the point - these transactions are so numerous and painless they slide by almost unnoticed - and on one side of each transaction was money, either cash, a check,  plastic, or e-money.  Without these monies these transactions would not have been possible, or at least a good deal more painful.

For those of you who have not grasped the full significance of money, consider the problem of a carpenter who needed a plumber. The carpenter could have spent the day producing wood work for sale and used the money to pay for a plumber's services. An alternative would have been to spend the day looking for a plumber who happened to need the services of a carpenter.  Of the two, I suspect you would look at the second of these as clearly inferior because of its inefficiency. Rather than spending time doing what they did best, carpentry and plumbing, the two would spend their time searching. What happens in the first system is that the plumber and carpenter are able to specialize in what they do best and minimize the time and effort spent searching.  As a result, society has access to additional plumbing and carpentry services and people live in better homes with better water systems.  This is the power of the market system envisioned by Adam Smith who first pointed out the benefits to specialization.

If you are going to have specialization and not self sufficiency, then you will need a system to facilitate the massive number of exchanges required to move goods and services around.  The earliest system of exchange was barter - a system where the plumber and carpenter would need to find each other for a direct exchange of services. Slowly over time, however, a new system emerged - a monetary system - and in this section we will briefly review the evolution of money and monetary systems. 

The emphasis here is on the word evolution.  Our monetary system today can be traced back to the early civilizations of China and the Mediterranean, and the history of money is intricately related to the rise and fall of nations and the emergence of the business class.  If we are going to "efficiently" move through 4500 years of evolution, we will need some organizing principles - means of creating order out of the myriad of events filling thousands of pages of history.  Our focus will be on productivity - how society reduces the full cost of money.  The important "leaps forward" in the evolution have been significant reductions in the cost of supplying money. A money system will beat out a barter system since there are likely to be fewer resources devoted to transactions in the money economy and more energies devoted to producing things individuals desire - food, shelter, clothing....  Similarly, when two monetary systems exist, the monetary system requiring fewer resources to produce the money will come to dominate. 

If you agree that money can be thought of as the oil for the economic engine generating jobs, providing income, and creating "stuff" that provides the quality of life, then it is worth spending a little time answering a few important definitional questions. 

• What is money?
• Why so many monies and how did the US end up with the dollar?
• How do we measure the supply of money?

Once we have gotten past the definitional type questions, we will then shift to a more thorough discussion of the questions.

• What is the price of money and how is it determined?
• What / who controls the supply of money?
• Does the supply of money matter?

When we are talking about the price of money - interest rates - we will use the familiar supply & demand model of prices.  This will mean that we must briefly discuss both money demand and money supply.  The discussion of money supply, meanwhile, will center on the basic structure of the monetary system.  The emphasis here will be on the role of the Fed and the banks.  In this section we will examine how the Fed would act if it wanted to change interest rates.  This will set the stage for the discussion of the monetary transmission mechanism - the link between the money supply and macroeconomic performance.  Once we know how the Fed might increase interest rates, we will look at why they might want to do that.  

First, we will turn our attention to the initial questions and quickly outline the evolution of money.  

What is money?

Money is one of those things we know when we see it, but we have difficulty defining.  What has emerged as an acceptable approach to the problem of defining money is to define it by the functions it performs, which is good since the functions have remained constant even though the actual "things" used as money have changed. 

Above all else, money is a medium of exchange. You have certainly used money to go to pay for your food at the supermarket, to pay for the movies, or to buy gas for your car. We use money when we buy and sell commodities or services.

Money is also useful as a unit of account. All prices are denominated in terms of a monetary unit, dollars, yen, or marks for example, which allows one to minimize the information needed to make price comparisons. Rather than having to keep track of all pair-wise values, 20 packs of cigarettes for one sweater which can be traded for 4 CDs which means that 1 CD equals 5 packs of cigarettes, you need only know the prices of the products denominated in terms of a monetary unit. A pack of cigarettes equals $2.50 while the sweater and CD cost $50 and $12.50.

Finally, money also shares one important property with other financial assets, it is a store of value. If you sell something today, maybe your labor for a salary or wage, you receive money that you can use to purchase something in the future. Money acts as a bridge between the present and the future - it stores value just as a refrigerator stores food to be used at  later date.  To function as a store of value, people must have confidence in the money, which is why you will find the word "trust" on the bills that circulate as money in the US.

Why so many monies and how did the US end up with the dollar?

These are questions none of you are likely to have ever asked yourself, but it should strike you as odd that there are so many versions of money and that the US, originally a British colony does not use the £as its basic monetary unit.  We will look into this question, which comes rather late in our story of the evolution of money, but first we will look at a more fundamental question: Why are there so many different monies? 

Anyone who has studied history or traveled abroad realizes that money varies across time and space. What is money today in the US is very different from what was money a century ago.  It is also very different from what is accepted as money in other countries today. Each society has attempted to develop in isolation its money, and a system for supplying the money.  In France you have French francs, which are not to be confused with the Swiss francs, while in Germany, Vietnam, and Brazil you have the Mark, Dong, and Cruziero. What you are not aware of, unless you happen to be in the finance business, are the substantial differences in the monetary systems.

The same could be said of architecture, food, clothing, or art which all possess distinct national or regional differences, although the differences are declining.  If you travel across the US today you will find a sameness in the nation's largest cities you would not have found 100 years ago.  Where once you had local banks financing local builders and restaurants serving local cuisine reflecting the ethnic backgrounds of the city's peoples, today you find international banks financing international construction firms and food and clothing being sold through international franchises.  You are never very far away from a McDonalds, Gap, or Wal-Mart.  Similarly, where once people were likely to live their entire life within a five mile radius of where they were born and interact with only a small number of people in their lives, today you are likely to travel thousands of miles and interact with thousands of people scattered across the world.  

The same is true with languages.  Both languages and money have evolved in all parts of the world as individual societies have developed systems to facilitate cooperation and the transactions accompanying specialization and division of labor.  As the world gets "smaller," as the division of labor stretches beyond national boundaries, we can expect to see a convergence toward a common currency and a common language.   The existence of separate languages and monies is the result of  historical accident, the product of a distant time where societies developed in virtual isolation, and current developments in the monetary system are simply corrections to the past "accidents."

As the world becomes smaller, a result of advances in transportation and communication technology, we can expect to see an erosion of the existing national differences in monies and languages. This is clearly evident in the movement toward a common European currency and the establishment of a supranational monetary authority.  In 1999 many people were shocked to hear that Argentinean officials were considering replacing the peso with the dollar, but this is precisely what we see in Europe as independent European nations eliminate their currency in favor of the Euro.  As for languages, the explosive growth of the internet is speeding the movement toward English as a common language.

To begin our search for money, it is helpful if we accept the fact that the 'something' society will use as money must posses certain properties.  It must be durable, divisible, transportable, readily accepted, and not easily duplicated.  Ice cream would be out as money because it fails the durability criterion, while automobiles would fail the divisible and transportable criteria. You would certainly not want to deliver 10 cars to someone who was selling you a home. As for the problem of a money that is easily duplicable, at some point  the widespread production of new money would create a transportability problem.  With more money in circulation all prices would rise and transactions would require more money.  Taken to the extreme, you might find yourself taking a trunk full of bills to the store to buy a loaf of bread.  Finally, since money has no intrinsic value, there is one additional property which we would like to see our money possess. We would like to have the cost of 'producing' money as low as possible.  Let resources be used to produce "stuff" that has intrinsic value.

So what has been used as money?  As we look back over the history of money, we find societies have experimented with many monies. The common denominator in the early experiments was the monies were real commodities, things possessing value outside of their value as money.  This was called commodity money and the list of commodity monies is long.  Salt  mined in large slabs in the Sahara was a popular form of money in China, North Africa, and the Mediterranean.  It was fairly durable, easily divisible and it certainly had value as a commodity during medieval times where spices to improve the bland food was in high demand.  In the Philippines and Japan it was rice, in Mongolia it was bricks of tea, and among the Aztecs in Mexico it was cacao beans that were used as money.  You could also add to the list of monies stone disks on the island of Yap, colored shells in India, leather in China, whale's teeth in Figi, grain in Egypt, animal skins and furs in Canada and Siberia, Wampum (shells) in Massachusetts, bags of corn in Guatemala, and tobacco in Virginia to mention just a few.  And let's not forget animals which were also a common form of money among pastoral people.  "The Siberian tribes used reindeer, the people of Borneo used buffaloes, the ancient Hittites measured value in sheep, and the Greeks of Homer's time used oxen." _{Weatherford p21}

The heritage of money can be seen in some of the terms that have found their way into the modern English vocabulary.  Salary can be traced back to the Latin word sal meaning salt, while pecuniary (related to money) is derived from the Latin pecuniarius meaning "wealth in cattle."  The "buck," a slang term for the American dollar can be traced back to the deerskins used as money in the British colonies in North America. Finally, the words cattle and capital are derived from the same Latin root. 

For a brief history of money you might want to check out A Comparative Chronology of Money from Ancient Times to the Present Day © Roy Davies & Glyn Davies, 1996. You also may want to check out an abbreviated outline of some of the important dates in the evolution of money and monetary systems.  Another source was The History of Money by Jack Weatherford.   Random House 1997.

Eventually, as other monies fell from favor because they did not satisfy one or more of the above criteria, they were replaced by metals.  "The Sudanese made iron ... Egyptians used copper, while the people of southern Europe preferred Bronze.  The people of Burma used lead, and the people of the Malayan Peninsula used tin that abounds there." _{Weatherford p25}  As early as 2500 B.C. Mesopotamians were using silver as a means of payment.

After many centuries of experimentation, one metal surfaced as the preferred money - gold.  It seems that gold has had a nearly universal appeal to people across the world as gold and silver have historically been associated with magic and divinity.  Part of its appeal was the fact it did not change color as it aged and its color was related to the sun.  There was something close to a common denominator, something generally accepted everywhere.  This was not the case for animal furs possessing little value in southern areas, cowrie shells with limited value outside of the areas bordering the Indian Ocean, or the myriad of other commodities with "local" value. 

But there is a limitation of using silver and gold - the two parties in the transactions needed to be able to weigh the metal and judge its purity.  While the solution may be obvious today, it was not then, and it took approximately 2,000 years for the next "leap forward" in the evolution of money.  The next step was the minting of coins which appeared first in Lydia, an ancient civilization in Asia Minor.  Between 640 and 630 BC Lydia produced the first real coins made from gold and silver. The minting of coins, each with the stamp of a lion, standardized money and eliminated the need for the parties in an exchange to verify the quality of the gold or to measure the quantity of gold.  This allowed even illiterate people to become involved in transactions and greatly speeded up the transaction, something that the Lydians needed if they were to expand their trade throughout the Mediterranean region.  

One of the by-products of the invention of coins was the emergence of retail markets as a center of ancient cities. Once trade reached a critical level, it made sense to centralize the sellers and let the buyers come to the sellers.  Other by-products of the money economy were the first brothels and the invention of dice.

In the Greek civilization that followed the decline of Lydia, money and the market played an even more central role.  Two changes this monetary society underwent were a growing complexity and rationalization. 

"Money connected human in a more extensive and efficient way than any other known medium.  It created more social ties, but in making them faster and more transitory, it weakened the traditional ties based on kinship and political power." _{Weatherford p35}

The use of counting and numbers, of calculating and figuring, propelled a tendency toward rationalization in human thought that shows in no human culture without the use of money. Money did not make people smarter; it made them think in new ways, in numbers and their equivalencies. It made thinking far less personalized and much more abstract." _{Weatherford p36}

The stage was now set for the next step - the Roman Empire.  "The coining of the first money in Lydia unleashed a revolution that began in commerce but spread almost simultaneously to urban design, politics, religion, and intellectual pursuits. It created a whole new way of organizing human life.  After nearly five hundred years of rapid social change, all of these forces came to focus in the rise of a new type of empire centered in Rome." _{Weatherford p45}   Rome would be the first empire organized around money. Rome provided security and the conquered territories provided the gold and silver to mint into coins, a process that worked well and led to the territorial expansion of Rome.

GOLD Þ Coins Þ Soldiers Þ Security Þ GOLD...

The geographical extent of the empire can be seen in the map below that you can access at the original web site.

This was a system that worked well for hundreds of years - as long as the gold from the conquered territories exceeded the increased cost of providing the security.  Eventually, however, the territorial expansion led to areas such as England where the balance shifted against Rome.  So how would you, as Rome's Caesar, deal with the problem of paying the mounting expenses of maintaining order and purchasing luxuries from India and other distant lands?  

Rome's rulers latched onto a novel idea - but one with undesirable side effects.  In Rome there was a certain amount of gold to back a money supply supporting a certain size army. The problem is the cost of the soldiers expanded as the empire expanded, but the supply of gold did not expand.  In fact the supply of gold decreased as Rome's wealthy spent lavishly on luxury imports - simply following the pattern we saw in ancient Lydia.

GOLD Þ Coins Þ Soldiers

The solution was to debase the coins, to mix the gold with other metals so there would be a bigger supply of metal to mint into coins. This was first done in 218 - 201 BC during the 2nd Punic War between Rome and Carthage, and then by Nero in 54- 68 AD.  In each instance this practice of reducing the metallic content in the coins allowed the number of coins in circulation to increase without any increase in gold.  It seemed like the perfect solution. 

GOLD Þ Coins Þ Soldiers

The problem was the debasement "fooled" no one and what Rome experienced was inflation.  Increasing the supply of money did not expand the production of "stuff," but it did lead to higher prices which led to further debasement.  The result was a sustained period of inflation and laws passed to reign in inflation.  It was here we saw our first price controls.  The sequence of events as summarized in Davies appears below.  

• 250 AD Silver content of Roman coins is down to 40%. After this level is reached inflation accelerates.
• 270 - 275 AD Reign of Aurelian. Aurelian issues new, nearly pure coins, using gold from his eastern conquests, but raises their nominal value by 2* times hoping in this way to stay ahead of inflation. However this "reform" sends inflation soaring. A rebellion by mint workers led by Felicissimus costs Aurelian's army some 7,000 casualties.
• 295 Diocletian reforms the coinage. This fails to halt inflation, probably because the older coins remain in use and, in accordance with Gresham's law, drive the good coins out of circulation.
• 301 Diocletian issues the Edict of Prices The Edict introduces direct controls of prices and also wage rates. This, too, is defeated by market forces.
• 307 One pound of gold is worth 100,000 denarii. The value of the denarius is only half that stipulated in Diocletian's edict of prices 6 years earlier.
• 324 One pound of gold is worth 300,000 denarii. Later, in Egypt by the middle of the 4th century the denarius' value collapses completely so that a pound of gold is worth 2,120,000,000 denarii: another early example of runaway inflation.
• 410 Rome falls to the Visigoths. Banking is abandoned in western Europe and does not develop again until the time of the Crusades.

With the fall of the Roman Empire, Europe fell into what has been referred to as the Dark Ages - a time where the extensive commercial networks were replaced by self-sufficient feudal manors.  Accompanying the decline of commerce was the decline of money.  Eventually, however, Europe emerged from feudalism and new elements of a financial system began to emerge.  Money began to return as a means of facilitating the increased number of transactions accompanying the growing volume of trade evolving around the Mediterranean.  It was still much faster to ship over water than land.

GOLD Þ Coins Þ Transactions

The next "leap forward" in the supply of money would also be centered in Italy, but this time in the northern cities led by Florence. In the era of the Roman Empire, gold coins had been widely used and abused.  The world had seen the advantages of a metallic money, but gold was not a "perfect" money since gold production consumed too many resources with all those individuals working in the mines, refineries, and mints needed to be paid for their labor producing 'money'.   It could also be in short supply, and it could be stolen.  What began to emerge was a banking system led by the Italian banking families - the most notable being the Medici's of Florence - that financed the growing trade of medieval Europe.

One of the difficulties that faced the bankers was the prohibition of usury - the charging of interest - but Italian bankers managed to find a loophole.  Rather than make loans, they traded bills of exchange.  A merchant "borrowed" money and agreed to repay in another currency at another time at a price that had a built in charge for the service. These bills of exchange began to circulate as money, which reduced the risk of theft and the need to carry bulky coins for large transactions.

GOLD Þ Coins Þ Bills of exchange Þ Transactions

The circulation of bills of exchange as money also allowed an expansion of the money supply.  While the link between the value of gold and coins would be maintained, the value of bills of exchange would only be indirectly related to the supply of coins.  The new stage in the money creation process provided a means for expansion in the world's money supply without an increase in the world's supply of gold, a necessary step if we were to experience substantial growth in trade and production.  The world had "stumbled' onto the fractional reserve system.

GOLD Þ Coins Þ Bills of exchange Þ Transactions

What were some of the innovations that speeded the spread of money?  Two that were critical to the expansion of the money economy were the double entry bookkeeping and the conversion from Roman numerals to Arabic numerals allowing for easier calculations.  According to mathematics historian J.D. Bernal, the introduction of Arabic numerals to Europe in 1202  "had almost the same effect on arithmetic as the discovery of the alphabet on writing. ... they democratized mathematics."  By the turn of the 15th century, the comma had been introduced to break long strings of numbers into groups of 3, and algebra and decimals had arrived.  

The link between money and gold may have been weakened, but it was not broken, and it led many of Europe's nation's to set off in pursuit of more gold. Once ocean travel had been accomplished, the search for specie began in earnest.  The result of these searches was nothing short of remarkable, with the supply of gold and silver minted into coins expanding rapidly through 1800.  The consequence should not be entirely a surprise to those who remember the Roman experience with increases in the money supply.  Inflation swept across Europe as the supplies of gold and silver expanded.  This even caught the attention of Adam Smith who wrote in 1776 "the discovery of the abundant mines of America reduced, in the sixteenth century, the value of gold and silver in Europe to about a third of what it had been before."   It was an era in which western Europe experienced a "price revolution."

GOLD Þ Coins Þ Transactions Þ Prices

One of the consequences of the price revolution and the rapid expansion of the money supply was money's use spread further down the economic ladder.  The use of money, once restricted to the wealthiest, reached the merchant class with the introduction of bills of exchange, and then the lower class with the expansion of the money supply during this price revolution.

The next leap forward was made in America and England.  With the exception of the bills of exchange, money supply was still tied to gold, but this would change with the introduction of paper money.  First, however, let's examine why the dollar became the US currency rather than the pound.  The short answer is that the British ran trade surpluses with the American colonies so the British pounds never left England. The shortage of currency in the US was offset by Spanish dollars that circulated as currency and prompted Thomas Jefferson to note in 1782, "The unit or dollar is a known coin and the most familiar of all to the mind of the people.  It is already adopted from south to north."  In 1785 Congress chose the dollar as the official currency, in 1792 the first mint was established, and in 1794 the first silver dollars were minted.  These dollars could be converted to silver at a rate of one dollar to 371.25 grains of silver, a rate equal to the exchange rate for the Spanish dollar. 

To deal with the shortage of currency, early colonial governments had experimented with paper currency. Paper money first appeared in the period  806 to 821 in China where a severe copper shortage caused the emperor to issue paper money.  China was a nation where the central government was strong, and paper was simply used to pay the government's bills as metal coins were taken out of circulation. Marco Polo commented on encountering the paper money during his travels in the 13th century.  In Europe there had been some limited attempts at issuing paper money - Sweden in the 17th century and France in the 18th century - but it was very limited and it often worked poorly. 

In North America paper money was first issued by the Massachusetts Bay Colony in 1690, but by the middle of the next century England had outlawed the practice despite the pleadings of Ben Franklin.  Just as Rome utilized coins to finance its empire, the United States would use paper money to finance its expansion.  Unfortunately, the start was rather rough with the US experiencing the same over extension of money supply that had brought down the French experiment.  

One of the real advances of the American monetary system was the adoption of the decimal system which greatly increased the ease of financial transactions.  Imagine the situation in England where a pound contained 20 shillings and a shilling contained 12 pence which contained 4 farthing.  At the same time a guinea was worth one pound plus one shilling.  The decimalization of the US currency was adopted by the revolutionaries in France who actually specified the decimalization of space and time, although only the metric system of weights and measures survived. The world did not adopt the clock that had 100 seconds in a minute and 100 minutes in an hour and 10 hours in a day and 10 days in a week and three weeks, called decades, would constitute a month. 

In Europe the growth of money and markets is evident in the folklore and children's stories where we saw the Jack trading a cow for beans, the goose that lays golden eggs, and the search for gold at the end of the rainbow.  It was also accompanied by a substantial growth in intellectual development that was freed from the past and rooted in observations, abstractions, and quantification.   "The decimal system, and its twin, metric measurement, not only changed the way people handled money and numbers but also transformed the way people thought.  A new empiricism in thought, coupled with money's strict discipline in the use of numbers and categories [emerged]. ... the new class of intellectuals no longer sought to discover knowledge only through studying the works of ancient scholars and religious writers.  They themselves could create knowledge through observation and the recording of events around them."   A similar sentiment was expressed by the mathematics historian J. D. Bernal who wrote:

"It is no accident that the intellectual formulations of science, the technical changes of industry, and the economic and political domination of capitalism would grow and flourish together at the same times and the same places. "

The lead in these simultaneous revolutions was taken by England and the stability of the monetary system built on paper contributed mightily to the success.  The key to the paper system was the Bank of England, was founded in 1688 for the purpose of raising money to help finance the operations of William and Mary.   Individuals would deposit their coins in the bank and it would issue receipts, and later bank notes, that would circulate as currency.  This issuance of bank notes was imitated by other lesser banks,  but after passage of the Bank Charter Act in 1844, the Bank of England was given a monopoly on the printing of money.  The stipulation was the notes would be convertible into gold.  This money was not issued by the government, but it became an important piece in the monetary system circling the globe - the gold standard. 

Gold was the world's currency and in the 18th century and it provided a benefit to the people - it restricted the abuses of a government's power to print money.  David Ricardo, in the 19th century recognized the power inherent in running the printing presses:

"neither a state nor a bank ever has had unrestricted power of issuing paper money, without abusing that power; in all States, therefore, the issue of paper money ought to be under some check and control; and none seems so proper as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or bullion."

The growing demand for gold to finance the rapid economic expansion of this era also led to a new round of European colonization that set the stage for WW I which would eventually bring this monetary system down.   "[T]he war arrested and ultimately broke up this unprecedented monetary cosmopolitanism... At the close of the war the practical monetary solidarity of the world had disappeared, and the overprinting of money continued."   The stage was set for the hyperinflation of Germany and England's final abandonment of the gold standard in 1931. 

The passing of the authority for the money supply from the bankers to the politicians after WW I was not mourned by all.  In fact there was a rising anti-banker sentiment that was especially strong in the US.  In 1863 the National Bank Act was passed which effectively ended state chartered banks' ability to print notes and established notes issued by nationally chartered banks as the nation's currency.  To finance the Civil War, both the North and the South ran the printing presses overtime which broke the link between gold and currency.  In the North the link was reestablished, but only through a decrease in the money supply that led to a general deflation and set the western farmers against the eastern bankers.  This conflict helped drive the Populist movement in America and it prompted William Jennings Bryan to deliver his famous cross of gold speech during his run for president in 1896.  Bryan concluded his speech with: "You shall not press down upon the brow of labor this crown of thorns.  You shall not crucify mankind upon a cross of gold."  Bryan wanted the US to adopt a bi-metallic system and mint silver to increase the money supply which would reverse the deflation that was increasing the financial burden of the indebted farmers.  You can check out a little history of money in the US at the San Francisco's Fed's web site.  There you will find a copy of a five cent note issued during the Civil War when all metal was being used for the war effort or hoarded by people.  On that note you will see the picture of Spencer Clark, a Treasury Department official who wanted some publicity.  After this US currency could not have the picture of someone still alive.  

The controversy over the gold standard also may have been behind the publication in 1900 of The Wonderful Wizard of Oz, a story with a strong money subplot.  Dorothy is uprooted from Kansas and lands in the East where she sets out on the gold road to the land of Oz, home to the witches and wizards of banking.  She is accompanied by the scarecrow, tin man, and the lion who represent the American farmer, the American factory worker, and Bryan.  The march to Oz is a recreation of the 1894 march led by Jacob Comet to demand issuance of $500 million greenbacks.  Marcus Hanna, the power behind the Republican party was the wizard, and the people of the East were the munchkins.  All that was needed was for the American people to realize that the financial system was run by frauds.  Dorothy, with her silver slippers, that were turned into ruby slippers for the visual effect, would help bring the people to that realization. 

The American people never did, however, follow the lead of Dorothy and throw off the gold standard. Gold remained the basis for the US dollar until 1933 when the first step to end the reign of gold was taken.  In that year at the depth of the Great Depression, Roosevelt outlawed the hoarding of gold which in effect meant that US citizens could no longer hold gold worth more than $100.  To store the gold the US began construction of Fort Knox and it was not until 1975 that Americans were again allowed to hold gold coins. When he assumed office Roosevelt converted the gold at rate of $20.67 per ounce, but in January of the following year the US went off the gold standard as it devalued its currency to $35 an ounce. 

The second step off the gold standard occurred in 1971 when President Nixon announced the "gold window" was closed, foreigners would no longer find gold to exchange for the dollars.  Freed from the constraints of a limited gold supply, the printing presses began to run overtime and the world became engulfed in yet another round of inflation. This set the stage for Paul Volcker's momentous announcement of a change in US monetary policy in 1979 and the gradual reduction of inflation that followed.     

How do we measure money?

Now that we have defined money and looked at the evolution of what societies have used as money, we can look briefly at one final issue, the measurement of money.  If you happen to follow the business news or watch the nightly TV news, you are likely to have seen mention of the nation's money supply. In reality there are two measures of money published by the FED -  M1 and   M2. The narrowest measure is M1 which consists of coins and currency in circulation outside of the banking system, checking account balances, and traveler's checks.

M2 is a broader measure of money and includes a number of very liquid assets, assets that are easily converted into cash. Included here would be M1 plus small denomination time deposits, savings deposits, money market mutual funds. The composition of these components can be seen in the table below.

Composition of Money (M2)
	1970	1980	1992
Currency	8%	7%	8%
Demand deposits	26%	16%	10%
Checkable deposits	0%	2%	11%
Money market funds	0%	4%	10%
Savings deposits	42%	25%	34%
Small time deposits	24%	45%	25%
Other	0%	2%	2%

Over these two decades coins and currency have accounted for 8 percent of M2.  The biggest loses during this time were in the commercial banks which issued demand deposits. Their share of the money supply declined from 25 to 10 percent, in large part because of new financial instruments allowing individuals to have the advantages of checking accounts while still earning interest. The first of these were the NOW accounts that appeared in the Northeast in the early 1970s which were in effect savings accounts that you could write checks on. More recently you had money-market funds that allowed limited check writing ability on portfolios of stocks and bonds.  Having not even existed in 1970, they have grown to account for a full 10 percent of the money supply, the same as traditional demand deposits. 

Now it  is time to turn our attention to that second set of questions, the first of which is a more thorough discussion of interest rates, the price of money.   Because we are talking about a price, this will involve a brief discussion of both the money demand and money supply.   The discussion of money supply, meanwhile, will center on the basic structure of the monetary system and the role of the Fed and the banks.  Our discussion of money will conclude with the section on the monetary transmission mechanism - the link between the money supply and macroeconomic performance. 

Add to Your Social Bookmarks: Del.icio.us Digg Furl Reddit Simpy Spurl Y! MyWeb - StumbleUpon