What's Money Anyways? (Part Two)

There are two forms of currency. The first is fiat money which like the dollar and most currency around the world, is government issued and has no intrinsic value. The key to fiat legal tender is the trust that it will be accepted in exchange (liquidity). This may seem trivial in the US where the dollar has always been a fairly strong currency, fully backed by the government (printed is “This note is legal tender for all debts, public and private”); yet a failure in trust for any reason can cause economic ruin and has in the past. A notable example of such an occurrence dates back to World War II. During this period the German Mark became so inflated by depression and wartime spending, citizens simply could not use it and as was reported, were better off burning Marks than buying firewood. This is illustrated today by the Zimbabwean dollar which though once more valuable than the USD, is now hyper-inflated to the point that currency exchanges often have to update the country’s exchange rate every half hour or more and $100 billion legal tender is printed.

The second form of money, commodity money, is fairly immune to such fluctuation because it possesses intrinsic value and therefore is trusted & accepted around. This form of currency has prevailed for much of history up until just over a century ago, primarily in the form of gold (gold standard economy) and occasionally other precious metals. Though this practice has largely died out and one cannot walk into a store offering a hunk of gold as payment, many invest in gold for fiscal security (especially in times of recession). I found an interesting example of commodity money from Mankiw’s Macroeconomics 5^th ed. which also appears in the commendable Maus series. In the Nazi POW camps during World War II, the Red Cross provided prisoner with food, clothing, cigarettes etc.  These resources were fairly, evenly allocated without attentions to individual preferences. Eventually, the soldiers allocated cigarette values to commodities such as 80 cigarettes for a shirt. Soon these became an accepted medium of exchange at the camps.

Despite its safety, commodity money quickly becomes cumbersome and difficult to manage; as you can imagine carrying around a pouch of gold gets heavy and measuring commodities isn’t very convenient. But how do you get a society to begin using and accept fiat money especially considering it has no intrinsic value. This process can be best explained through an example which has occurred in the past repeatedly. The process begins as the government issues gold or similar commodity money of standard value to replace commonly used raw gold bullion. In time the government can offer gold certificates which can be reclaimed for the original standard issue gold. Nonetheless, this is the intermediate phase to fiat money for it requires that people trust the government will at any time provide gold at any time in exchange for the certificates. In time as this trust becomes universal and more money is printed, the gold collateral becomes meaningless and a fiat system takes root.

And there you have it; the story as money as we know it. So the next time you lay down that dollar bill, think about the history, the evolution and the trust that makes the whole system possible.

What's Money Anyways? (Part One)

Moolah, bling, dough, greenbacks; rappers can’t seem to get enough of it nor can the media stop blabbing about it these days. Whatever you call it, do you really know what money is?

Most of us think of money as a measure of wealth but from an economist’s standpoint, money refers specifically to the stock of assets that can be used at any time for transactions.  Money is used primarily in three ways (and I’m not referring to clothes, eating out and iTunes): as a store value, unit of account and most importantly, as a medium of exchange. The first simply refers to savings which allow us to spend money we earn now at a later time. Though most people save as a means of financial security, money is not accepted as ideal for a store value due to inflation.

We are all accustomed to money as a unit of account or the use of currency to quote prices, balances or debts. For example, when we go to buy a house we may receive a quote of say $300,000 rather than a potentially equal but far more complicated value of 120 leather couches. This notion of money as a denoted and comparable value goes hand-in-hand with the final use as a medium of exchange.  This function applies to our everyday lives because it just denotes the use of money to buy goods and services. Without a “medium of exchange” transaction would require us to find someone in possession of what we want, who wants something we possess (and both parties are willing to give this up). This type of a lucky accident is called a double coincidence of wants and admittedly cannot be expected every time we want something. Unless you’re a prospective home buyer who just happens to have 120 leather couches on hand and stumble upon the realtor in dire need of a 120 leather couches. Thus, money enters the picture.

There are two forms of currency. The first is fiat money which like the dollar and most currency around the world, is government issued and has no intrinsic value. The key to fiat legal tender is the trust that it will be accepted in exchange (liquidity). This may seem trivial in the US where the dollar has always been a fairly strong currency, fully backed by the government (printed is “This note is legal tender for all debts, public and private”); yet a failure in trust for any reason can cause economic ruin and has in the past. A notable example of such an occurrence dates back to World War II. During this period the German Mark became so inflated by depression and wartime spending, citizens simply could not use it and as was reported, were better off burning Marks than buying firewood. This is illustrated today by the Zimbabwean dollar which though once more valuable than the USD, is now hyper-inflated to the point that currency exchanges often have to update the country’s exchange rate every half hour or more and $100 billion legal tender is printed.

Measuring and Manipulating the Money Supply

A key aspect of the economy and fiscal policy involves knowing how much money is in circulation. Money can be loosely defined as the stock of assets used for transactions and consequently, the total stock of assets is the quantity of money. Therefore, if for example, you and you friends decide to trade baseball cards based on a certain number of points assigned to each card, the total number of points available would be the monetary supply.

But measuring the stock of assets in a society like ours if extremely difficult as our investments lie in everything from cash to checks to gold to mutual funds and so on. Consequently, four fairly comprehensive, successive measures (each denoted by a particular symbol) are used to illustrate the monetary supply of a given society. The first is C which is the total legal tender currency in circulation. The second, M1, includes C and all demand deposits, traveler’s checks and other checkable deposits. The third measure is M2, which comprises retail money market mutual fund balances, saving deposits (including money market deposit accounts) and small time deposits all in addition to M1. The final measure, M3, includes M2 and large time deposits, repurchase agreements, Eurodollars, and institution-only money market mutual. As of March 2001 these values were $539 billion, $1.111 trillion, $5.1 trillion and $7.326 trillion respectively.

Most of these measures probable don’t make a lot of sense but these values are vital to the way agencies such as the Federal Reserve, specifically the Federal Open Market Committee, determine monetary policy in the United States. Manipulation of the money supply is primarily achieved through open-market operations which involve the purchase and sale of government bonds. When the Fed wants to decrease the public money supply, it issues government bonds and treasury bills which are often bought as secure investments. This removes money of equivalent value of the bonds from circulation. Likewise, when the public money supply needs to be expanded, the Federal Reserve buys bonds back.

This is a basic overview of the measure and manipulations of the quantity of money in circulation.

Macro vs. Micro

In order to analyze the various intricacies of economics, the field is broadly divided into macro and microeconomics. As the prefix suggests, macroeconomics models the economy on a large scale and deals with measures such as gross domestic product (GDP), price levels, unemployment, interest rates and international trade. Thus macro-economics can explain why some countries are rich while others remain poor, why currencies fluctuate the way they do, how countries stay afloat with massive deficits, how interest rates change and what brings on recessions such as the one we face today. Microeconomics on the other hand, details firm/industry level economies such as supply and demand with a market, economies of scale within a company, impact of regulatory policy within a sector. Despite these distinctions, macro and microeconomics are fundamentally interconnected as collective micro- changes affect macro-economic measures. Though each of these topics presents an opportunity for extensive study, the majority of my introductory research will focus around macroeconomics and its implications in our day-to-day life.

An Introduction: The Ten Principles (Part Two)

Now let’s move onto the second category; how the economy works. Though I’m sure you are fascinated by the story of my iTouch and are dying to hear more, I will appeal to broader models to discuss and clarify the following principles that concern the expansive economy as a whole. The fifth rule states that trade can make everyone better off. When I read this and came across the word trade, my mind immediately went to the traditional concept of bartering and the simple exchange of goods of similar value. Yet to understand the generality of this statement, we must think of trade as any form of payment for a good or service including trade in the form of an employee’s salary. In this sense, we understand that Mankiw’s fifth principle is one of the founding and persisting standards of today’s economy, as people specialize in individual professions to maximize efficiency. Next, the sixth principle affirms that markets are usually a good way to organize economic activity. All this means is that consumers and producers interact to increase trade efficiency and better allocate goods. This ideal forms the core of capitalism and has been central to the United States economy (with the exception of dire times such as the ongoing recession). Mankiw’s claim is further validated by the repeated failures of communist regimes in the past which represent the opposite of this system by allowing government interference in fiscal activity. The seventh stipulation offers that governments can sometimes improve market outcomes. This offers an exception to rule six in times of dire circumstance, as we have seen in the ongoing recession as numerous government “bailouts” have interrupted market flow by fueling money into failing corporations and suffering consumers.

Finally, let’s look at the way we interact. Eighth, a country’s standard of living depends on its ability to produce goods and services. As the rule suggests, countries with high productivity where people can produce more goods or services per person, have a higher standard of living. Several of these principles indicate cause and effect and likewise eight goes hand in hand with rule five for trade increases productivity which in turn increases standard of living. The ninth law dictates that prices rise when the government prints too much money. I’m sure many of you have heard this concept before as inflation primarily as the values of currencies fluctuate. The United States for example is currently experiencing minor inflation as a growing debt slowly increases the amount necessary to get one euro or pound… The final principle states that society faces a short-run tradeoff between inflation and unemployment. In other words reducing inflation causes a temporary hike in unemployment. Though I understand what is being stated, I find myself at a loss for explaining it. To get a better grasp, I referred to my dad’s MBA textbook Macroeconomics 5^th ed. and found the subject at hand on page 358 but was once again was lost in the advanced concepts.

I guess the lesson is that I’ve got a lot, as in a lot, to learn but I’m definitely off to a great start.

An Introduction: The Ten Principles (Part One)

I’d like to say that I have a basic understanding of economics but in all honesty, I’m clueless. To get a foothold, I talked to my dad and a close family friend who shared their beginnings in economics during their MBAs. During our discussions, we repeatedly stumbled upon Gregory Mankiw, the former Chairman of the Council of Economic Advisors and a current economics professor at Harvard University (if you would like to find out a little bit more about Mankiw, refer to the link to his blog I hve on the right or I’m sure Wikipedia would oblige). After a little more research, I thought I’d start by looking into Mankiw’s 10 principles of economics appearing in the first chapter of his book, Principles of Economics 3rd ed. Time to delve into the world of scarcity, investment, consumption…

Mankiw’s ten principles can roughly be divided into three categories: how we make decisions (one through four), how the economy works (five through seven) and the way we interact (eight through ten). The first principle states that people face trade-offs or simply put, to get something we want we have to give something else up. I’m sure we’ve all faced this kind of dilemma in our lives. To illustrate, I will share an example that I will refer back to for several of the principles. Last year, for my birthday, I got an 8gb iPod touch. Despite my enthusiasm, I couldn’t help but feel disappointed at how few upgrades were made from the previous generation. After thinking about it for a while, I decided to stick it out till the next generation was released. Now almost a year later, I got the iTouch 4g with a camera, facetime and an upgrade to 32gb. Some would that isn’t worth almost a year of wait but it was a trade-off I was willing to make.

The second principle is that the cost of something is what you give up to get it. This simply encompasses the monetary as well as the implicit moral/personal aspects of pricing. Here we can once again refer to my above example; the cost of the my new iTouch included not only the extra $100 for the memory and generation upgrade but also the year I spent waiting for its arrival. Our next principle stipulates that rational people think at the margin. This means that when we consider an extra unit, we rationally weigh its cost and benefits. I have had the iPod nano (3g) 8gb for about three years now. Thus, deciding to get my new iTouch (an extra unit) required that I rationally judge if the extra storage, applications and other additional benefits excuse the costs incurred. In another, more common example, if you decided to work a few extra hours a week you are employing Mankiw’s third principle to deem if the extra pay is worth the time away from home or leisure. The fourth rule asserts that people respond to incentives. I’m sure this doesn’t require any further clarification but for the sake of tradition, my incentive not to keep my original gift was the promise of a much better, far more worthy iTouch within an acceptable period of time.

Me and Economics

I grew up like every other kid wanting to be a police officer. In time my ambitions molded to my various activities; in the 5th grade after Lego League I was set on being an engineer and sure enough, after Mock Trial in 8th grade I was positive that my future lay in the field of law. Despite my indecision, I have always loved math and have taken advanced courses in the subject whenever possible. Now I know that though I've yet to decide a career, math will undoubtedly be a part of whatever I pursue in life. Over the past year, literature such as Freakonomics and other experiences have interested me in the field of economics. Therefore, I started this blog to begin researching and sharing my introduction to economics in the hope that I will finally find my calling.