MONEY MECHANICS Copyright © 1996 – 2009 David B.

Ashby All Rights Reserved Chapter 1

1
INTRODUCTION

Sections
The Kinds of Money 4
The U. S. Money Supply 6
Velocity of Money 10
Appendix: Money and Gold 13

In primitive societies ─ in which household members

produce for themselves most of the products and services that
they use ─ purchases from outside suppliers are few and far
between. Consequently, it is not particularly inconvenient for
these transactions to involve barter exchange ─ a direct
swapping of products and services. Barter exchange requires
a would-be buyer to track down someone

(a) who desires to sell what the buyer wants,

(b) who will accept in exchange the products or services
that the buyer offers, and
(c) who can come to an agreement with the buyer upon
the terms of the exchange.

This requires too much time and effort to be tolerable except

when transactions are rare.

One of the keys to increased productivity for a society ─

and to a resulting rise in the standard of living ─ is speciali-
zation. This involves structuring production processes in ways
that enable workers and machines to restrict their efforts to a
small number of tasks for which they are particularly well
suited. But, increased specialization implies reduced
self-sufficiency. Indeed, households in economically advanced
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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

societies nowadays produce only a small fraction of the pro-

ducts and services that they consume (mostly housework and
meals). They must buy most of their desired products and
services from external suppliers. These transactions are so
varied and so frequent that barter would be unworkable.

Specialization requires earnings to be paid in the form of

some generally-accepted medium of exchange ─ some item
that can be used to purchase any desired products or services.

Anything that is commonly used as a medium of

exchange is called money.

In economics, the word “money” is defined and used in

ways that differ considerably from the non-economist’s casual
definition and uses. For example, people do not earn money
when they work. What they earn is “income” which they
generally receive in the form of money. Money is the
messenger that delivers income.{1} Each year in the U.S., the
nation’s approximately $1.6 trillion of money delivers over $14
trillion of income. This means that the same dollar is used to
deliver income in approximately nine different paychecks each
year. Because either the amount of money or the amount of
income may change at any time without there being a
corresponding change in the other, economists must be quite
precise in their use of these two related ─ but distinctly
separate ─ concepts.

You will learn shortly that coins and paper currency ─

which are always money in the minds of non-economists
(including bankers) ─ are not always money in the minds of
1 Not all income is received as money, however. Many employees receive some of
their compensation as “in-kind” fringe benefits ─ life and medical insurance,
retirement contributions, etc.

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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

economists. For example, savings accounts contain no

money, and cash in a bank is not money.

The money supply must be carefully controlled. If it is too

large, people will try to buy too much. With orders outstripping
production, many businesses will raise prices. Inflation ─ a
sustained rise in the average level of prices ─ results. If there
is too little money, sales will lag behind production, and
inventories will grow. Businesses will respond by laying off
workers and cutting output. Some may try to stimulate sales by
cutting prices. Hence, too little money leads to recession (a
sustained drop in total output by the nation’s producers),
unemployment (people out of work), and maybe some
deflation (a fall in the average level of prices). Responsibility
for control of the U. S. money supply resides in the Congress.

Whereas the federal government has the responsibility for

controlling the U. S. money supply,

most of our money is created (under the watchful

eyes of government regulators) by privately-owned
and operated enterprises called banks.

Here, the term bank refers to all financial institutions that offer
transaction accounts ─ accounts from which payments are
made directly using checks or similar instruments. As a result
of the Depository Institutions Deregulation and Monetary
Control Act of 1980, banks now include savings associations
and credit unions as well as traditional commercial banks.

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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

The Kinds of Money

Anything can become money. What is money is an

empirical question. We must look around and observe what is
being commonly accepted in payment for products and
services.

It is clear that government-issued coins and paper

currency are commonly used for purchases and
hence are money.

But, what about checks and such similar instruments as

negotiable orders of withdrawal and share drafts?{2} To
simplify the terminology throughout the remainder of this book,
we shall define checks to include negotiable orders of
withdrawal and share drafts and define checking accounts to
include all transactions accounts.

There can be no dispute about the widespread use of

checks for making payments; however, they are not money.

The checking account balances themselves are

money, not the checks.

Here is why.

If we were to count only checks as money, rather than the

checking account balances themselves, we would be excluding

2 Technically, negotiable orders of withdrawal and share drafts are not checks, but
they accomplish exactly the same thing ─ only they do so for accounts at savings
associations and credit unions, respectively, rather than at traditional banks. They
are written instructions authorizing institutions that offer transaction accounts to
transfer balances between two of those accounts.

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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

from our measure of money all idle checking account balances

─ the portion against which checks have not yet been written.
This would be inconsistent with the way in which we treat coins
and paper currency. We consider idle cash (in pockets,
purses, piggy banks, jars, etc.) to be money. So too, then,
must we consider idle checking account balances to be money.

Now, what about credit cards? Are they money? In a

word, no; they are not. Neither do they replace money. They
replace checks as a means of transferring checking account
balances. The same is true for debit cards. A credit card gives
the holder the right to order that payment for purchases be
made with funds drawn from a checking account maintained by
the card issuer. The issuer later seeks to replenish that
account balance by billing the card user.

Currently, there are no kinds of money in the United

States other than coins, paper currency, and
checking account balances ─ because nothing else
is commonly used to pay for products and services.

This is true, even with the recent advent of electronic funds

transfers, stored-value gift and smart cards, and web-based
payments systems. All add to the number of ways that we
have available to transfer money. They are – like checks,
credit cards, and debit cards – alternative money transfer
mechanisms but are not themselves money.

If it ever becomes common to pay for products and

services by directly transferring ownership of savings
certificates ─ rather than the current practice of first converting
them into coins, paper currency, or checking account balances
─ savings certificates will have become money. For now,
savings accounts contain no money!

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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

When people use money to buy bonds or shares of stock,

there is no question that they have given up money in order to
acquire alternative financial assets. However, when people
acquire savings account balances, they talk in terms of
"depositing money into" their accounts and refer to the "amount
of money" that they have accumulated in savings. This causes
confusion during discussions of the money supply.

Think of savings account balances the same way

you think of bonds and stocks ─ as non-money
financial assets.

Only coins, paper currency, and checking account

balances are money, but not all coins, paper
currency, and checking account balances are
money.{3} The term money applies only to items
that are included in the measured money supply.

Don’t call anything (even cash or an account balance) money if

it is not included in the measured money supply.

The U. S. Money Supply

By official definition, the U. S. money supply includes: {4}

3 Don't forget that we are using the term "checking account" to include all
transactions accounts, including NOW accounts at savings associations (against
which negotiable orders of withdrawal can be written) and similar accounts at credit
unions (against which share drafts are permitted).

4 This measures what is called M1 (we’ll call it M), the supply of immediately
spendable dollars (coins, currency, and checking account balances). Conceptually,
this is the appropriate measure of the money supply. Unfortunately, its actual
measurement leaves much to be desired. As measured, it includes cash that is not
circulating within the economy (as explained later in this chapter), and it fails to
include such checkable accounts as money market deposit accounts.

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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

all U. S. issued coins and paper currency except

amounts in the vaults of banks, Federal Reserve
Banks, and the U. S. Treasury

plus all U. S. dollar checking account balances in

banks except those owned by other domestic banks
and by the U. S. Treasury.{5}

We can represent this as follows: M = CC + CA , where

CC represents the coins and currency component of the money
supply (M) and CA represents the checking account
component. The current totals are approximately

M = CC + CA
$1700 billion = $870 billion + $830 billion

Any activity that increases CC or CA creates money

and increases M. Any activity that decreases CC or
CA destroys money and decreases M.

Only banks, Federal Reserve Banks, and the U. S.

Treasury have the legal power to create money.

5 One or more days will pass between the time that a check depositor's bank re-
cords an increase in the depositor's account balance and the time that the check
writer's bank learns that the check has been written and reduces the writer's
account balance. During this period, the total of all checking account balances will
rise by the amount of checks that have been deposited but have not yet been
charged against the writers' balances. Hence, to get an accurate measure of the
checking account balances, it is necessary to subtract the dollar amount of checks
that are in the process of collection (and, hence, have not yet "cleared" the writers'
banks) from the total of all checking account balances. Note also that bank reserve
accounts in Federal Reserve Banks and the U. S. Treasury's checking accounts in
the Federal Reserve Banks are excluded from the measure of the money supply.
But, the money supply does include checking account balances held in banks (and
in Federal Reserve Banks) by foreign governments and international organizations.
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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

How much they have created is crucial to all the rest of us,
because we must get our hands upon portions of that money in
order to make purchases. So,

the official measure of the U. S. money supply tells

us the amount of money that is circulating outside of
the money-creating institutions and is available for
use by those of us who need to use money but are
not allowed to create it for ourselves.

It excludes all coins, paper currency, and checking account

balances that belong to banks, Federal Reserve Banks, and
the U. S. Treasury, because those funds are not available to
us.

Technically then (by definition), the cash ─ coins

and paper currency ─ held by banks is not
money!{6}

This exclusion also addresses a money supply

measurement problem that arises whenever money users
exchange one kind of money for the other by depositing or
withdrawing cash. If we were to include bank held cash in the
CC component of M (and we don’t!), the deposit (into a
checking account) of $100 of cash would leave CC unchanged
but would increase CA by $100. M ─ our measure of the
amount of money available ─ would rise by $100 even though
no one has any more money to spend. Similarly, a $100
withdrawal from a checking account would leave CC
unchanged while reducing CA by $100. M would decline by
$100 even though no one has any less money to spend. To be
6 This means that bank robberies create money (because M rises as the liberated
cash adds to the CC component). Also, until they are detected and confiscated,
counterfeit currency notes add to the actual circulating amount of cash (but not to
M, the measured money supply) and spend just like the legal ones.
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useful, M must rise only when there is more money available

for the public to spend and fall only when there is less money
available. Excluding bank held cash from CC accomplishes
this. The deposit of $100 reduces CC as CA rises, leaving M
unchanged. A $100 withdrawal reduces CA but increases CC,
again leaving M unchanged.

When we make cash deposits at banks, we talk of making

"deposits into" our accounts ─ as if the accounts consisted of
boxes of cash in the bank's vault. Our accounts, however,
have no such physical existence. Instead, they are merely
maintained as sets of numbers stored electronically in the
bank's computer files. Making a cash deposit is really much
like the purchase of any product. When you buy groceries,
they become yours and the cash you used belongs to the
store. You have exchanged cash for groceries. It is no
different at a bank. You "sell" to the bank $100 of cash and
"buy" from it a $100 addition to your checking account balance.

If you make a $100 deposit of coins and paper currency to

your transaction account, this cash becomes the possession of
the bank and ceases to be money (because it is now excluded
from the measured money supply). The bank pays you for this
cash by increasing your checking account balance by $100 ─
creating $100 of checking-account money. This deposit
transaction (which is simply a swap out of cash and into
checking-account money), by itself, leaves the quantity of
money unchanged. Similarly, if you cash a $100 check at a
bank, $100 of coins-and-paper-currency money is created
(because it is now added into the measured money supply) as
you receive the cash from the bank, and $100 of
checking-account money is destroyed (as the bank charges
your account balance) ─ leaving the quantity of money
unchanged.

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A bank is simply a store that sells cash and checking

account balances.{7} It also sells other financial
assets (certificates of deposit, savings accounts,
etc.) and loans checking account balances.

Velocity of Money

When someone spends a dollar, whoever receives it will

be able to use it to fund another dollar's worth of purchases.
Subsequent recipients will use the same dollar to make still
more purchases. In this fashion, a single dollar will fund many
dollars' worth of purchases over a year's time.

The velocity of money (V) is the average number of

times that a dollar is spent each year for purchases
of current domestic output (only).

You and I ─ together with the nation's other money users

─ determine the velocity of money. We do it by the ways in
which we manage our money. How often we are paid, how
often we shop, when we are billed, and how quickly we pay our
bills all influence the average length of time that dollars are in
our possession. Those who spend money quickly help to raise
the velocity of money. Those who try to hang onto dollars as
long as possible help to slow it down.

The U.S. economy produces and sells more than $14

trillion worth of goods and services each year, and this is
accomplished with only about $1.7 trillion of money. This

7 The bank also commits to buying them back upon demand ─ paying cash for
checking account balances and paying account balances for cash.
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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

implies that the velocity of money is approximately 8.25. {8}

This says that each dollar of our money is spent on average
only once every 1.45 months for purchases from our current
domestic output. Casual observation suggests that dollars are
being spent considerably faster than that, and indeed they are.
This apparent inconsistency has two fairly straightforward
explanations.

First, notice that the definition of the velocity of money

recognizes only purchases from the current domestic product.
Many expenditures of dollars are for other purchases – for
example to acquire savings media (such as stocks, bonds, and
savings certificates), goods produced in previous years,
imports, and land. Exclusion of these purchases from the
measurement of V is wholly appropriate, because our analysis
is focused upon the determinants of current domestic
employment, and these purchases do not support current
domestic employment.

Second, recall that the coins and currency component of

the U.S. money supply is approximately $870 billion. However,
possibly as much as two-thirds of that cash is circulating
outside of the United States.{9} This means that, whereas the
measured U.S. money supply is approximately $1.7 trillion, the
actual amount of money circulating within our economy may be

8 $14 trillion divided by $1.7 trillion equals 8.25.

9 Similarly, there are checking account balances in banks all over the world that are
denominated in U.S. dollars because of the popular worldwide use of the U.S. dollar
in international trade transactions. Many of those dollars are spent within the United
States, but they are excluded from our measure of the money supply. Hence, as a
measure of our domestically available money supply, the official measure is at best
quite crude (overestimating the cash portion and underestimating the checking
account portion).

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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

as little as $1.12 trillion – implying a velocity that could be as

high as 12.5.

There are several reasons why all of that cash is

circulating outside of the United States. Some countries use
the U.S. dollar as their national currencies. This is called
dollarization. For example, Ecuador dollarized in 2000, and El
Salvador did it in 2001.{10} In addition, Bermuda, Cayman
Islands, Djibouti, and Hong Kong all back their currencies with
government-held reserves of U.S. dollars. Lots of U.S. cash is
changing hands among international drug traffickers. Finally,
citizens of many countries simply prefer to use U.S. dollars
rather than their own countries’ currencies. This is especially
true in countries where inflation is severe (and dollar prices are
more stable than are those quoted in the domestic currency).

Including externally circulating dollars in the measure of

money overstates M and understates V by offsetting amounts
so that the product of M times V (that is, MxV) is unaffected. It
is MxV that is important for the economy, not M and V
individually. The economy cannot tell the difference between
more money and faster money! The Federal Reserve System
must allow for the velocity of money in order to determine how
much money the economy needs, because

total expenditures on current domestic output during

the year cannot exceed MxV (the quantity of money
multiplied by the velocity of money)!

Suppose that next year the U. S. economy produces $15 trillion

worth of output. If each dollar continues to be spent on
10 Other dollarized economies are American Samoa, the British Virgin Islands, East
Timor, Guam, the Marshall Islands, Micronesia, the Northern Mariana Islands,
Palau, Panama, Pitcairn Island, Puerto Rico, the Turks and Caicos Islands, and the
U.S. Virgin Islands.
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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

average 8.25 times per year, we would need to have at least

$1.82 trillion of money in order to sell all of the year’s output
within a year’s time. If we still have only $1.7 trillion of money,
then the most output that could be sold with the year would be
$14 trillion, leaving at least $1 trillion of output carried unsold
into the next year. The magnitude of V and the value of
domestic output together dictate how much money the nation
needs in order to be able to support the timely sale of its output
and thereby support the jobs of the workforce producing that
output.

APPENDIX: MONEY AND GOLD

Many countries "back" their money with gold. That is, for
each Swiss franc (or yen or peso or whatever) issued, the
government holds in its treasury a certain specified amount of
gold. Many people mistakenly believe that it is this backing by
a precious metal that gives money its value. The fact is that
the value of money derives from its scarcity, not from its
backing. If dollars were to become abundant, there would be
inflation. As prices rise, each dollar would buy less. If
abundant, then, dollars would be worth little, whether they are
backed or are not backed by gold. By keeping dollars scarce
enough to avoid inflation, prices will stay relatively low, and
dollars will remain relatively valuable, whether they are backed
or are not backed by gold.

Because gold is extremely scarce, a gold-backing

requirement supposedly prevents governments from issuing
too much money. The idea is that without more gold in its
coffers, a government that has spent all of its tax revenues will
be unable to make additional purchases by simply issuing more
money. The problem with this argument is that, historically,

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MONEY MECHANICS Copyright © 1996 – 2009 David B. Ashby All Rights Reserved Chapter 1

governments in such situations have simply exercised their

sovereign powers and reduced the amount of gold required to
back each unit of money ─ permitting them to issue more
money and make more purchases even though they had no
more gold! Consequently, gold backing is of little true value in
regulating the amount of money that a government issues. It is
a self-imposed restriction that can be easily circumvented.

The U.S. dollar no longer has gold backing. Congress

substantially reduced the U. S. gold backing requirements in
1945. Then, it eliminated the backing requirement on bank
account balances in 1965 and on paper currency in 1968. This
was not done, however, to enable the government to print more
money to finance federal budget deficits. Instead, it was done
because (1) the gold backing served no useful purpose and (2)
the gold could then be transferred into our "international
reserves" (which had become depleted by years of efforts to
maintain an artificially high value for the U. S. dollar in
international markets) for use in foreign exchange transactions
with foreign governments and international institutions.

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