Money and the Economy - Essay Example

Money and the Economy Traditionally, money has three main uses in the economy. As a medium of exchange, money is used as payment for goods and services. It facilitates trade by lowering transaction costs which could hinder the smooth exchange of goods and services. As a unit of account, money provides a common and acceptable measure in valuing goods and services. Money is also used as a store of value, a repository of purchasing power over time. This means money can be used by the person anytime in availing of goods and services.

However, money becomes an effective store of value only if there is price stability with high inflation not present to erode its value (Mishkin 49- 51). Accordingly, three types of money are recognized in the economy. These classifications are M1, M2, and M3. M1 is the narrowest measure of money which includes currency, checking account deposits and travelers checks. The M2 includes the M1 plus other assets that have check-writing features such as small-denomination time deposits, savings deposits and money market accounts, and money market mutual fund shares (noninstitutional).

The M3 monetary aggregate is composed of M2 plus large denomination time deposits, term repurchase agreements, term Eurodollars and institutional money market mutual fund shares (Mishkin 57- 59). The amount of money in the economy is very important to policy makers. The Federal Reserve is the primary institution which is tasked to control the level of money in the economy. Each of the 12 Federal Reserve banks perform the following: clear checks; issue new currency; withdraw damaged currency from circulation; administer and make discount loans to banks in their districts; evaluate proposed mergers and applications for banks to expand their activities; act as intermediaries between the business community and the Fed; examine bank holding companies and state-chartered banks; collect data on local business conditions; use their staff of professional economist to research topics related to monetary policy (Mishkin 369- 370).

With the aforementioned functions, it is therefore important that the Fed has a concrete definition of the money supply and its composition. The level of money supply is often modified in order to pursue expansionary and contractionary economic policies. Three important moves in changing the money supply and interest rates are open market operations, changing discount rates, and changes in reserve requirements. Nowadays, we can see the proliferation of other types of money which were not currently in the Fed's classification of M1, M2, and M3.

This is largely due to the technological innovations which led to the creation of digital cash. According to BusinessWeek, digital money is the "ultimate-and invetable medium of exchange in an increasingly wired world." Digital cash is widely used due to its numerous advantages primarily in increasing the efficiency of transactions. Amidst all the advantages offered by digital money, experts are seeing macroeconomic consequences which are generated by the continued use of this medium. Tanaka cited that problems in taxation and money laundering can be a direct result of monetary digitization.

Amongst the macroeconomic effects are exchange rate instabilities and financial crises due to expected bankruptcies.Exchange rates instabilities can happen because in the real world, only selected people such as professional dealers, bankers, and trading firms participate in foreign exchange markets. However, in cyberspace, the general public will be encourgaed to join the exchange market because of lower fees and people are not confined to national borders. This massive participation may cause instability of exchange rates (Tanaka 1).

These problems have direct impact on the functioning of the Fed. Monetary policies would be much difficult to implement because the composition of the new money supply has changed. In fact, this new composition is more difficult to control than the previous structure as digital money is characterized by transnationality. As digital cash is not constrained by geographical and other traditional borders, it becomes harder for the Fed to control its total amount in the economy. Also, there is a threat that the entire financial market will be replaced by a "virtual" financial market.

One of the most serious threats for the Fed is cited by Tanaka:When banks in cyberspace begin loans in digital cash, digital cash will exceed reserved real cash (money creation). Reflecting the fluctuation of money demand in cyberspace, cyberspace will absorb or give out real cash. This will affect the money supply in the real world.The problem then for the Fed, is how to control the money creation which will have a substantial effect in the economy.Works CitedMishkin, Frederic. The Economics of Money, Banking, and Financial Markets.

Addison-Wesley, 2004 (7th ed.)Tanaka, Tatsuo. Possible Economic Consequences of Digital Money. 1996. First Monday. April 4, 2006 The Future of E-Money. BusinenessWeek Online. 1997. Business Week. April 4, 2006