Money

Money is any medium of exchange that is widely accepted in payment for goods and services and in settlement of debts. Money also serves as a standard of value for measuring the relative worth of different goods and services. The number of units of money required to buy a commodity is the price of the commodity. The monetary unit chosen as a measure of value need not, however, be used widely, or even at all, as a medium of exchange. During the colonial period in America, for example, Spanish currency was an important medium of exchange, while the British pound served as the standard of value.

II

MONEY AND THE ECONOMY

The functions of money as a medium of exchange and a measure of value greatly facilitate the exchange of goods and services and the specialization of production. Without the use of money, trade would be reduced to barter, or the direct exchange of one commodity for another; this was the means used in primitive societies, and barter is still practiced in some parts of the world. In a barter economy, a person having something to trade must find another who wants it and has something acceptable to offer in exchange. In a money economy, the owner of a commodity may sell it for money, which is acceptable in payment for goods, thus avoiding the time and effort that would be required to find someone who could make an acceptable trade. Money may thus be regarded as a keystone of modern economic life.

A

Types of Money

The most important types of money are commodity money, credit money, and fiat money. The value of commodity money is about equal to the value of the material contained in it. The principal materials used for this type of money have been gold, silver, and copper. In ancient times, various articles made of these metals, as well as of iron and bronze, were used as money, while among primitive societies commodities such as shells, beads, elephant tusks, furs, skins, and livestock served as mediums of exchange. The gold coins that circulated in the United States before 1933 were examples of commodity money because the value of the gold contained in the coin was about equal to the value of the coin. Credit money is paper backed by promises by the issuer, whether a government or a bank, to pay an equivalent value in the standard monetary metal, such as gold or silver. Paper money that is not redeemable in any other type of money and the value of which is fixed merely by government edict is known as fiat money. This is the type of money found today in the United States in the form of both coins and dollar bills. Credit money becomes fiat money when the issuing government suspends the convertibility of credit money into precious metal. Most fiat money began as credit money, such as the U.S. note known as the greenback, which was issued during the American Civil War. Most minor coins in circulation are also a form of fiat money, because the value of the material of which they are made is usually less than their value as money. For example, the amount of nickel in a nickel coin today is less than its value as money.

Both the fiat and credit forms of money are generally made acceptable through a government decree that all creditors must take the money in settlement of debts; the money is then referred to as legal tender. If the supply of paper money is not excessive in relation to the needs of trade and industry and the people feel confident that this situation will continue, the currency is likely to be generally acceptable and to be relatively stable in value. If, however, such currency is issued in excessively large volume in order to finance government needs, confidence is destroyed and it rapidly loses value. Such depreciation of the currency is often followed by formal devaluation, or reduction of the official value of the currency, by governmental decree.

B

Monetary Standards

The basic money of a country, into which other forms of money may be converted and which determines the value of other kinds of money, is called the money of redemption or standard money. The monetary standard of a nation refers to the type of standard money used in the monetary system. Modern standards have been either commodity standards, in which either gold or silver has been chiefly used as standard money, or fiat standards, consisting of inconvertible currency paper units. The principal types of gold standard are the gold-coin standard, the standard in the United States until 1933; the gold-bullion standard consisting of a specified quantity of gold; and the gold-exchange standard, under which the currency is convertible into the currency of some other country on the gold standard. The gold-bullion standard was used in the United Kingdom from 1925 to 1931, while a number of Latin American countries have used the dollar-exchange standard. Silver standards have been used in modern times chiefly in Asia. Also, a bimetallic standard (see Bimetallism) has been used in some countries, under which either gold or silver coins were the standard currency. Such systems were rarely successful, largely because of Gresham’s law, which describes the tendency for cheaper money to drive more valuable money out of circulation.

Most monetary systems of the world at the present time, including those in Canada and the United States, are fiat systems; they do not allow free convertibility of the currency into a metallic standard, and money is given value by government fiat or edict rather than by its nominal gold or silver content. Modern systems are also described as managed currencies, because the value of the currency units depends to a considerable extent on government management and policies. Internally, the monetary systems of Canada and the United States contain many elements of managed currency; although gold coinage is no longer permitted, gold may be owned, traded, or used for industrial purposes.

C

Economic Importance

Credit, or the use of a promise to pay in the future, is an invaluable supplement to money today. Most of the business transactions in the United States use credit instruments rather than currency. Bank deposits are commonly included in the monetary structure of a country; the term money supply, in its most narrow definition, denotes currency in circulation plus bank deposits.

The real value of money is determined by its purchasing power, which in turn depends on the level of commodity prices. According to the quantity theory of money, prices are determined largely or entirely by the volume of money outstanding. Experience has shown, however, that equally important in determining the price level are the speed of turnover of money and the volume of production of goods and services. The volume and speed of turnover of bank deposits are also significant. See National Income.

III

THE MONETARY SYSTEM OF THE UNITED STATES

Like all modern industrialized societies, the monetary affairs of the United States are managed by a central bank. Central banks act as banker’s banks, have a monopoly on the issuance of paper money, and often act as the government’s bank. As late as 1890, there were only about 20 central banks in the world, but by 2000 there were more than 160. In the United States the dollar is the unit of currency, and the Federal Reserve System is the central banking system that manages the currency. As the currency for the largest economy in the world, the U.S. dollar is the dominant world currency and the currency most often used to conduct international transactions. In 1998 the U.S. dollar accounted for over 50 percent of all foreign currency deposits. Dollar deposits are a foreign currency when held by a bank outside the United States. In 1997, the ten largest banks in the world were headquartered outside the United States, but the U.S. dollar was the most important world currency.

A

Early Monetary Regulations

In the American colonies, coins of almost every European country circulated, with the Spanish dollar predominating. Because of the scarcity of coins, the colonists also used various primitive mediums of exchange, such as bullets, tobacco, and animal skins. Many of the colonies issued paper money that circulated at varying rates of discount. The first unified currency consisted of the notes issued by the Continental Congress to finance the American Revolution. These notes were originally declared redeemable in gold or silver coins, but redemption was found impossible after the revolution because of the excess of printed notes over metal reserves. Thus, the notes depreciated and became nearly worthless.

In 1792 Congress passed the first coinage act, adopting a bimetallic standard under which both gold and silver coins were to be minted. The gold dollar contained 24.75 grains of pure gold and the silver dollar 15 times as much silver, making the legal mint ratio 15 to 1 (see Dollar). At this ratio gold was undervalued at the mint, as compared with its value as bullion, and very little gold was presented for coinage. Silver dollars also were largely withdrawn from circulation, because they could be exported to the West Indies and exchanged at face value for slightly heavier Spanish dollars, which were then melted down and taken to the mint for coinage into American dollars at a profit. Until 1834, when Congress adopted a mint ratio of 16 to 1 by reducing the weight of the gold dollar, the metallic currency was limited mainly to a meager supply of small silver and copper coins. The first Bank of the United States, which was chartered by Congress in 1791 for 20 years, and the second Bank of the United States, which existed from 1816 to 1836, issued bank notes that maintained a fairly stable value. Many state-chartered banks also issued notes that, because of the lax state banking laws, often greatly depreciated in value. After the closing of the second Bank of the United States, most of the paper currency consisted of notes of state-chartered banks and circulated only in a limited area.

After 1834, silver was undervalued at the mint; its market value was constantly higher than its coin value. As a result, gold gradually replaced silver in the monetary stock, especially after the discovery of gold in California in 1849. To relieve the famine in small coins, in 1853 Congress reduced the weight of the half-dollars, quarters, and dimes by 7 percent. Because the new subsidiary coins were worth more as money than as bullion, it was possible to keep them in circulation. As a result of a revision of the coinage laws in 1873 the silver dollar was omitted from the list of coins authorized for minting. Although the coinage of silver dollars was resumed in 1878, the metallic gold dollar remained the monetary standard of value in the United States; thus, bimetallism was legally discontinued and the gold standard adopted. Actually, silver dollars had been an insignificant part of the currency since early in the century.

During the Civil War (1861-1865) the governments in both the North and the South financed their needs through the issue of fiat money. The notes issued by the Confederate treasury and the Southern states became entirely worthless after the war. The U.S. notes (greenbacks) and other paper money issued by the federal government also depreciated rapidly, especially after the suspension of payment in specie (redemption of paper money with coins, usually of gold or silver) in 1861, and gold and silver coins were driven out of circulation. In 1863, the National Banking Act authorized the establishment of national banks that could issue bank notes backed by government bonds. A 10-percent tax levied on state bank notes in 1865 forced state banks to discontinue issuing them, thus giving the national banks a monopoly of bank-note issue. The state banks, however, remained an important element in the banking system.

After the elimination of the silver dollar in 1873, the greatly expanded production of silver in the West caused the value of silver to fall sharply and led to agitation by the silver interests for restoration of the free coinage of the silver dollar. In this effort they were joined by political groups who favored the free coinage of silver as a means of improving general economic conditions. This agitation led to the passage of the Bland-Allison Act in 1878 and the Sherman Silver Purchase Act of 1890, under which the Treasury was directed to purchase larger amounts of silver for coinage. The former law also created the silver certificate, which remained an important part of U.S. currency until it was retired in 1968. The Sherman Silver Act, which introduced into the stream of currency an enormous quantity of overvalued silver and caused a drastic decline in the gold reserve of the Treasury, helped bring on the panic of 1893 and was repealed by Congress in that year. Even so, silver was the main issue in the 1896 presidential campaign, when William Jennings Bryan called for free coinage of silver at a ratio of 16 to 1. The silver forces were defeated, and in 1900 the Gold Standard Act affirmed the gold dollar as the standard unit of value.

B

Federal Reserve System

The next important change in the currency system was introduced by the Federal Reserve Act of 1913, which authorized the establishment of 12 regional Federal Reserve banks, with power to issue two types of currency (see Federal Reserve System). The first, and most important, was the Federal Reserve note, which is issued under conditions consistent with economic stability and the needs of trade and industry. As member banks require more currency, they can obtain it from the Federal Reserve banks by drawing on their deposits or borrowing or rediscounting commercial paper if their deposit balances with the Federal Reserve banks are insufficient. The second type of Federal Reserve currency, the Federal Reserve Bank note, was originally intended to replace the national bank notes, but never became a permanent part of the currency because the Federal Reserve notes proved adequate. The national bank notes were retired in 1935, but greenbacks are still part of U.S. paper currency.

C

The Great Depression

The economic depression and the epidemic of bank failures in the early 1930s led to sweeping reforms in the nation’s monetary structure. Executive proclamations issued by President Franklin D. Roosevelt in March and April 1933 prohibited gold exports except under government license, and called in all gold and gold certificates from general circulation, thus ending the gold standard. Under the Gold Reserve Act of January 30, 1934, the country returned to a modified gold standard with a devalued dollar. The act gave the president authority to lower the weight of the gold dollar to between 50 and 60 percent of its former gold content. The following day the president issued a proclamation reducing the gold content of the dollar to 59 percent of that established by the Gold Standard Act of 1900, or from 23.22 to 13.71 grains of fine gold.

The years 1933 and 1934 were also marked by important legislation regarding silver. Under the Thomas Amendment to the Emergency Farm Relief Act of May 12, 1933 (commonly known as the Inflation Act), the president was given the power to restore unlimited coinage of silver under a bimetallic system. The Silver Purchase Act, which was signed by the president on June 19, 1934, authorized the nationalization of silver and declared it to be the policy of the United States to have the silver holdings of the U.S. Treasury ultimately make up a maximum of one quarter of the value of the nation’s combined monetary gold and silver stocks. On August 9, 1934, the president issued an executive order requiring that all silver in the United States, with the exception of certain categories such as silver coins, fabricated silver, and silver owned by foreign governments, be delivered to the mints to be coined or held as bullion for later coinage. Under the Silver Purchase Act and subsequent legislation the Treasury purchased large quantities of silver abroad and from domestic producers, which tended to raise the price of the metal and curtail the monetary use of silver abroad, especially in China and India.

D

Post World War II

Near the end of World War II (1939-1945) most of the Allied nations joined together in a conference held at Bretton Woods, New Hampshire, to set up a new international monetary system, replacing the international gold standard that had collapsed during the Great Depression. The conference also provided for the establishment of the International Monetary Fund (IMF). The U.S. dollar played a key role in the new system, becoming, in effect, the world’s currency. This was true, first, because all IMF members defined the value of their own currencies in terms of the dollar and, second, because the United States agreed to convert all dollars held by foreign governments into gold on demand and at the exchange rate agreed on when the IMF was established. Officially, this meant that the world was on a “gold exchange standard” since governments could change their currencies into gold via the U.S. dollar.

So long as the United States had most of the world’s gold supply, as was true after World War II, this system worked fairly well. When the quantity of dollars held by foreign governments began to exceed U.S. gold holdings by large amounts, however, the system started to falter. By the early 1970s foreign government holdings of U.S. dollars were over five times greater than the U.S. gold stock. In August 1971 President Richard M. Nixon suspended gold payments of U.S. dollars. This closing of the “gold window” effectively ended all ties between the U.S. dollar and either gold or silver. Since then the United States has had a fully managed currency system, one with no metallic base whatsoever. United States citizens are free to own, buy, and sell gold, but its price is determined in the same way as any other freely traded commodity—on the basis of supply and demand. Gold no longer serves as a medium of exchange. Federal Reserve notes are overwhelmingly the dominant form of currency in circulation today.

IV

RECENT DEVELOPMENTS

Several important developments took place in the U.S. monetary system in the early 1970s. Until 1971 the Federal Reserve System, also known as the Fed, defined the money supply as equal to the sum of currency in circulation (excluding bank vault cash) and demand deposits (checking accounts). This definition of the money supply ignored saving accounts and time deposits (accounts that earned interest but could not be withdrawn without penalty until they matured). Monetary authorities and economists became concerned that estimates of monetary growth could be misleading if those estimates ignored savings accounts and time deposits. In 1971 the Federal Reserve began publishing measures of broader monetary supplies. The monetary aggregates were given the names M1, M2, and M3. M1 was comparable to the original money supply measure—that is, currency in circulation and demand deposits. M2 equaled M1 plus accounts such as savings accounts and small time deposits. M3 was an even broader measure, adding in larger time deposits.

The 1970s saw the introduction of many types of monetary assets. The Federal Reserve continued to fine-tune its measures of these monetary aggregates. Money market mutual fund shares were added to M2. In 1980 the Federal Reserve began publishing estimates of a broader monetary aggregate, which was designated L and included M3 plus assets such as short-term Treasury bills and commercial paper. Over time, economists and monetary authorities have become less confident of M1 as a single measure of the money supply and have gravitated to broader monetary aggregates. Financial deregulation and other innovations have aided the trend toward identifying broader monetary aggregates as money supply measures. Nevertheless, M1 is still the best-known measure of money. As of June 2001 it totaled $1.1 trillion.

Also in 1980 the Depository Institutions Deregulation and Monetary Control Act was passed. It expanded the range of monetary instruments used by the financial community, gradually eliminated the ceiling on interest rates that savings and loan institutions are allowed to pay depositors, and made all banks subject to the reserve requirements of the Fed by 1989. Previously, only federally chartered banks were subject to the Fed.

A third important development occurred in 1982 when the Federal Reserve changed its monetary policy. Monetary policy involves action to influence the economy’s performance—its output and employment level as well as the inflation rate—by controlling the money supply and the rate of interest. The Federal Reserve specifically initiates and carries out monetary policy. The Fed can increase the reserves of commercial banks, thus making possible an expansion of the money supply, or it can target interest rates to accomplish the same purpose. In the late 1970s the Federal Reserve began to “target” the money supply—that is, the Fed tried to establish a stable rate of growth for the money supply. But in 1982 the Fed went back to the practice of targeting interest rates as the primary way of stimulating or tightening the economy, rather than using its ability to increase the reserves of commercial banks.

Recent experience with policy and legislation shows that the U.S. monetary system is still evolving. Historically, the nation has gone from a wholly metallic system, when coins were the primary money in circulation, to a managed system, in which, aside from the currency in people’s pockets, most of the money consists of entries in the books of banks. The 1990s saw a resurgence of the currency component of M1 because of the export of U.S. currency to areas such as Russia and Latin America where domestic currencies lost credibility. The global underground economy, also known as the black market, also draws in significant sums of U.S. currency. By June 2001 currency accounted for 48 percent of M1; the remaining 52 percent of total M1 consisted of checking account and other deposits, much of which came into existence through borrowing. According to some estimates over half of U.S. currency has quietly found its way to foreign currencies. The Federal Reserve System has no way of measuring exactly how much currency is going to foreign currency. The most popular U.S. currency in foreign countries is the one-hundred dollar bill. This outflow of currency raises concern about the amount of black market activity and illegal transactions involving the U.S. dollar. However, some economists note that the willingness of residents of foreign countries to hold $100 bills as a financial asset is a positive development for the U.S. Treasury Department.