Money Supply and Fiat Money - Essay Example

The measure of value is one of the functions of money.
The second function arises from the previous one. Once two persons have their subjective values compared in the same equivalent they can settle the price of the initial ‘something’ they were talking about, or simply exchange it for the settled amount of the equivalent — therefore money can be a measure of exchange.

Finally, the third function, the storage of value can be explained as a way to keep value over time. For instance, one person has ‘something’ that costs A. However in the future, its value may change (e.g. furniture becomes antiques growing in value, or milk may turn sour losing value), and the person wants to fix it. He sells it to another person for A, and now despite all the changes that will occur with ‘something’, his acquired value is fixed.

Of course, money was not always green papers with presidents or coins from metal. There were so many forms of money that it is useless to talk about each one separately. It may be time-saving, however, to classify all the forms: barter, commodity money, fiat money, and credit money. Barter is considered to be the earliest form of exchange without any intermediary goods. For example, people simply settled the number of cows they would like to exchange for a certain amount of pots and exchanged the goods. It was inconvenient as someone who wanted your cows did not always have the pots you needed, and also it was difficult to determine the value of one cow: ten pots are too cheap and eleven is too expensive, but then with a half is as much as ten.

The next form was commodity money, which was tradable goods by themselves, but also an equivalent for everything else, like gold or silver coins. This form also had its drawbacks, such as unexpected inflation. For instance, in the 16-17th centuries, a lot of new deposits of gold and silver were discovered in New World, which led to terrible inflation in Europe: the purchasing power of gold and silver coins fell by 60-80% (Galbraith 1975). Such fluctuations were the main reason why most governments adopted a new form of money.

Fiat money is well known to us as paper and coins, and also checks, e-money, and other symbolic forms. Under this system symbols which are used as money, are not valuable by themselves. Therefore they can be easily restored if damaged without the owner losing value. Another form, which is the youngest of all, is credit money. These are not payable on demand, but rather present a claim that can be used for purchasing. The trick with credit money is that it is not a current payment, but a promise of payment in the future, which upholds additional risks for both sides of a deal.

Thus, during the evolution of money forms following characteristics were developed for an ideal money form: durability, divisibility, homogeneity, and convenience for transportation and storage.

Since money can be presented in various forms, the question of calculating all the money available in one country, for instance, has become increasingly difficult. The notion of the money supply is used to reflect different forms of money available within an economy. The narrowest measure of the money supply is M0, which is the total of all physical currency (paper, coins), plus central bank accounts that can be exchanged for physical currency. In other words, M0 shows how much cash the public is in the country. M1 includes M0 and the total deposit balances without any withdrawal limitations. Interestingly M0:M1 ratio is often used to determine the ratio of cash with the public to total financial accounts. M2 consists of M1 and most saving accounts, money market accounts, and certificates of deposit of under $100,000. Finally, M3, the largest money supply aggregate includes M2 and other time deposits and repurchase agreements.

As can be seen, all the money aggregates are focused on forms of money with different liquidity ratios. The most liquid form is present in all of them. It is basic currency, paper, and coins. Since most countries have their currencies, exchange rates should be regulated somehow. The modern system of foreign exchange, known as the Jamaica system because of the Jamaica agreement where it was adopted allows foreign exchange rates to float freely: “The negotiations to give official consent to the de facto generalized float led to the Jamaica Agreement (January 1976) on the second amendment to the Fund’s statutes, which, after ratification by IMF members, took effect on 1 April 1978.” (Ghymers, 2005)

Although money supply measures are published every Thursday they do not tend to adequately reflect the changes in the national economy and serve only for informative purposes to foreign exchange traders. One of the main problems that still diminish the measures of the money supply is, as we can see, the great variety of forms of money and some blur on borders of money aggregates. Setting clear ranges for money supply measures if possible will them more useful for financial a Read More