In this video, we're going to focus on the role of money, and first start with the definition of money. People produce different goods and need to exchange them. They also produce things at some point in time and want to consume the product at some other points in time. So we need to have some means of payment, some mechanism for storing value of production for a while and then spending it when the need arises. In other words, we need a universal means of payment that can be exchanged for any good produced in the economy and that's basically money. Money has to have some features, but let me first start by the definition and by the measurement of money. Money is the set of assets that people accept as means of payment in an economy. Any asset that serves that purpose and it's widely accepted can be called money. In modern economies specifically, money is defined as some of all currency in circulation and all demand deposits, which is essentially checking accounts. You might say that actually nowadays people use their credit cards to pay for the goods and services they purchase and that's not part of this currency circulation and demand deposits. But actually it is, credit cards represent the money in the banking account, a checking account of credit card company. When you purchase something the vendor charges the checking account of the credit card company. And then later on the credit card company comes to you and you pay the money in your checking account or whatever form you've kept it, back to the credit card company. So if you add up all the credit available in the checking accounts and also the money circulation, we've taken account of all liquid forms of payment. There are of course other types of means of payment that, essentially, can be used for payment. But, first, have to be made more liquid before we can use them. For example, many of us have money in our savings account that can't be immediately used for purchases, but you can move the money into your checking account or get some cash and go shopping. This kind of money that can be easily turned into forms of payment is called near money. And when you add up near money and the strict definition of money which is M1, we get another measure of money which is known as M2. Which is M1 plus all the savings and time deposits. There are of course additional for means of storing value. People who may have stocks, mutual funds, other forms of savings, even their housing, the houses they own, the buildings they own, the shares they own. Those things could also be eventually turned into money and used as forms of payments. So one can have measures of money that include these additional items. But that is going to be a higher order in terms of liquidity and in terms of not being liquid and therefore, those things are not easy to use for purchases because they have to first turn into cash or turn into time deposits before one can actually use them for payments. To give you an idea how much money is in circulation in some economies, and here's the example I'm giving you for the United States. How much of the money people hold is in the form of savings accounts. I've created a graph here from the St. Louis Fed, which shows you the amount of currency in circulation, this green line. If one looks at currency, it adds up to about 7 to 8% of GDP. If you add checking account type money, the total of checking account and currency together adds up to about 17, 18% of GDP. The big chunk of money that people hold is near money, which is part of M2, as I mentioned before. And if one look at looks at M2, it's close to 65% to 70% of GDP nowadays. It used to be much lower in the 1990s, but especially after the crisis of 2008, 2009 because of money creation by the Fed, money holding as a share of GDP has gone up. In order to understand how a money market works, let's first examine what exactly it does. Management of money and monetary system is very critical to operation of modern economies. To give you a picture of an economy that has had huge trouble managing it's money supply and monetary system and money market. Here's some data for Zimbabwe. In table 1 you can see the rates of inflation and it'd be between 2007 and 2008. Inflation rate was about 50% month over month, this is not yearly. For example, in April 2007, prices doubled over one month. And as you keep going, you can see that in November of 2008, inflation rate had gotten into trillions of percentage points. Year over year, inflation rate was such a huge number that many of us don't know how to read. And the government, in order to deal with this situation, to enable people to buy things given the high inflation rate kept printing more money. Fueling more inflation itself by making it easier to pay by issuing higher notes. For example, here's one of the bank notes that was issued in 2008, $100 trillion. Hardly you could buy a piece of bread with this. That's what high inflation does. That's how mismanagement of the monetary system could ruin the economy and get things out of hand. You know the consequence of this is that a lot of people started switching to US dollars using international means of payments. And Zimbabweans decided that US dollars are very valuable because they are not part of US system. And directly the old bills are not taken out of circulation very easily, so they wash them, clean them and re use them. In order to also better understand what money is and how it works, it might be interesting to think about new forms of money that are appearing. Essentially money is whatever people except as means of payments. It means that trust in that means of payment is the key. A lot of people think that the value of money comes from the value of gold behind it. That's not true. We are working nowadays has been going on for a long time, we're working with Fiat money. This is the money that is created by the government, nothing is backing it. And in order to see how this could happen, it's maybe a good idea to look at digital cryptocurrencies that are popping up nowadays, especially BitCoin. A lot of people use BitCoin as means of payment. Not because it's backed by anything, but it's a system people believe others value as means of exchange, and therefore, they take it. These new types of currency that are popping up are not controlled by any government, have a system of their own. A lot of them are not under the control of anyone, especially BitCoin has that feature. And as the beliefs about what others think about this currency change, the value of this currency relative to goods and prices and relative to other currencies, currencies backed by governments also changes. For example, here's the price of BitCoin in terms of dollars, as you can see has gone from near zero to about close to $1,000 and then down to about $400 in recent months. Let me finish this discussion by emphasizing three key features of what we call money. The asset that we use as money has to be a medium of exchange widely accepted. It has to keep its value for a while, be a store of value. And also, it should have an easy unit of account, so we can measure the value of goods and services that we buy and make payments for them in terms of that asset. The interest rate is directly connected to the amount of money that we have, because it's the price of using money. Interest rate is important, especially because it determines the cost of capital. And therefore, the amount of investment you see in the economy. So in order to understand interest rates, we need to understand the money market. We want to know what factors affect supply? What factors affect demand?
