[MUSIC] What is money? That's easy to answer, you may say. It's the cash in our pockets. But money actually has a much broader definition. It is anything that can be widely used, and accepted, in exchange for other goods and services. In practice, there are three kinds of money. Commodity money, like gold nuggets, represents the preferred money of centuries past. Today, however, in virtually all countries, commodity money has been replaced by the two other kinds of money, bank money and paper (or fiat) money. An example of bank money is the checkbook you use to pay your bills. So-called Fiat money, or paper money, is simply the dollar bills in America, and the yen in Japan. Money is the most liquid of assets, meaning that it is the most readily spendable, and it has three major functions. First it is a medium of exchange. Without money we would have to conduct our transactions by barter. Which involves the direct exchange of one good or service for another. Second, money serves as a unit of account or standard of value, it tells us the rate at which goods can be exchanged. For example if a loaf of bread costs $1 and a pound of butter costs $2, the butter will exchange for two loaves of bread. Third, money serves as a store of value. This is because people can hold onto money this year and then spend it next year However it is this function that money performs least. Well this is because most methods of holding money do not yield the same kind of monetary returns that you get by storing wealth in the form of. Whether the less liquid assets such as stocks and bonds, thus in the presence of inflation money can rapidly lose its value In talking about monetary policy. Macro economists distinguish between four kinds of money. M one, M two, M three, and L. These different kinds of money reflect variations in the liquidity and the accessibility of assets. They are defined in this table. As a practical matter, macroeconomists concern themselves the most with M1 and M2. M1 is known as transactions money because it consists of items that are actually used for transactions. These items include, most imporantly, paper currency and coins. Plus, checking account demand deposits. M2 is known as broad money. It includes M1, plus so called near moneys, such as savings accounts, small time deposits, and money market mutual fund shares. Finally, M three and L, are the broadest definitions of money, and include almost all short-term assets. Now, you may find these definitions either boring or confusing, or both. But remember that monetary policy uses changes in the supply of money to contract or expand the economy. So in order to conduct monetary policy effectively we must have a very good idea of what we are changing when we change the money supply.
