Money

The most important function of money is to be a medium of exchange.

Example:
Imagine trying to obtain an iPhone from the Apple store without money.  You would have to find some sort of way to trade (or barter). You could give the Apple guy 50 loaves of bread in exchange (if you can find a way to trade for the flour and yeast). What if the Apple store does not need 50 loves of bread?  You could offer to work for them, but you probably don’t have the skills they are looking for right off.  Wouldn’t it just be nicer if you could give the Apple guy something that he could take and go to, say Chick-Fil-A, and get what he really wants for that iPhone – a few chicken sandwiches. Money fills that role; it becomes the medium through which exchange occurs. The Apple guy knows that if he takes your money he can go next door or anywhere that he wants and they will accept that money for the goods that he wants!

• Money is often paper or coin (currency) with an official seal of approval by the government. That government is responsible for printing and minting the money.
• There are cases where things other than currency have been used as a medium of exchange – cigarettes acted as “money” in prison camps during World War II.
• What determines the value of your money?
• The value of your money is driven by a promise of the government who printed it that the currency must, by law, be accepted anywhere in that country.
• The value of money is also determined by the supply of money.  The supply of money is controlled by the central bank of the country, and is often manipulated in order to conduct monetary union.
  • The relationship between the supply of money, the price level, and inflation is captured in the quantity theory of money.
    M*V = P*Y
    Where (M) is the supply of money, (V) is the velocity of money, (P) is the price level, and (Y) is output.
  • If you look at the percentage change of this relationship and assume that money velocity (V) and output (Y) are fixed then you get that:
    • % change in the money supply (M) = % change in prices (P)
• If the money supply increases 10%, prices will increase 10%. There is too much money chasing too few goods (remember we assumed Y stayed the same).
• An increase in prices is called inflation
•  Inflation causes the value of your money to fall.

Example:
Assume that a biscuit costs one dollar today.  If the central bank increases the money supply there are more dollars available. With more dollars, people want to buy more biscuits. The baker cannot make any more biscuits so in order to not run out he raises the prices, say to two dollars (too much money following too few goods). The money that you hold cannot buy as many biscuits tomorrow as it could have today. The value of your money has gone down.

• Because each country prints its own money, there are problems with using currency as a medium of exchange across countries. The law dictates that if you are going to buy something in the United States then you must use dollars.  If you are going to sell your guitar to a European, but you don’t want to buy anything from Europe, you will not accept a euro in payment. No one in the United States will accept a euro from you as a medium of exchange. So the person must go and exchange their euro for a dollar before he/she buys your guitar. The number or fraction of dollars that he gets for his euro is determined by the exchange rate.