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Chapter 12 243
Money and the Banking System

FDIC established

Number of Bank Failures



Number of Bank Failures
SOURCE: Federal Deposit Insurance Corporation.

Great Depression
400 0
1945 1955 1965 1975 1985 1995 '03 '04 '05 '06 '07
1915 1920 1925 1930 1935 1940 1945
(a) Bank Failures in the
United States,
The most obvious way to trade commodities is not by using money, but by barter”a
system in which people exchange one good directly for another. And the best way to Barter is a system of
exchange in which
appreciate what monetary exchange accomplishes is to imagine a world without it.
people directly trade one
good for another, without
Barter versus Monetary Exchange using money as an
intermediate step.
Under a system of direct barter, if Farmer Jones grows corn and has a craving for peanuts, he
has to find a peanut farmer, say, Farmer Smith, with a taste for corn. If he finds such a person
(a situation called the double coincidence of wants), the two farmers make the trade. If that
sounds easy, try to imagine how busy Farmer Jones would be if he had to repeat the sequence
for everything he consumed in a week. For the most part, the desired double coincidences of
wants are more likely to turn out to be double wants of coincidence. (See the accompanying
cartoon.) Jones gets no peanuts and Smith gets no corn. Worse yet, with so much time spent
looking for trading partners, Jones would have far less time to grow corn. In brief:
Money greases the wheels of exchange and thus makes the whole economy more
SOURCE: By permission of Johnny Hart and Creators Syndicate, Inc.

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Part 3
244 Fiscal and Monetary Policy

Dealing by Wheeling on Yap
Primitive forms of money still exist in some Besides stone wheels and beer, the
remote places, as this extract from an old Yapese sometimes spend gaw, consisting of
newspaper article shows. necklaces of stone beads strung together
around a whale™s tooth. They also can buy

SOURCE: University of Pennsylvania
Yap, Micronesia”On this tiny South Pacific
things with yar, a currency made from large
Island . . . the currency is as solid as a rock.
seashells. But these are small change.
In fact, it is rock. Limestone to be precise.
The people of Yap have been using stone

Museum (58“21338)
For nearly 2,000 years the Yapese have
money ever since a Yapese warrior named
used large stone wheels to pay for major
Anagumang first brought the huge stones
purchases, such as land, canoes and per-
over from limestone caverns on neighboring
mission to marry. Yap is a U.S. trust terri-
Palau, some 1,500 to 2,000 years ago.
tory, and the dollar is used in grocery stores
Inspired by the moon, he fashioned the
and gas stations. But reliance on stone
stone into large circles. The rest is history. . . .
money . . . continues.
By custom, the stones are worthless when broken. You never
Buying property with stones is “much easier than buying it
hear people on Yap musing about wanting a piece of the rock.
with U.S. dollars,” says John Chodad, who recently purchased a
building lot with a 30-inch stone wheel. “We don™t know the
value of the U.S. dollar.”
Stone wheels don™t make good pocket money, so for small SOURCE: Excerpted from Art Pine, ”Hard Assets, or Why a Loan in Yap Is Hard to Roll
transactions, Yapese use other forms of currency, such as beer. . . . Over,” The Wall Street Journal, March 29, 1984, p. 1.

Under a monetary system, Farmer Jones gives up his corn for money. He does so not
because he wants the money per se, but because of what that money can buy. Now he need
simply locate a peanut farmer who wants money. And what peanut farmer does not? For
these reasons, monetary exchange replaced barter at a very early stage of human civiliza-
tion, and only extreme circumstances, such as massive wars and runaway inflations, have
been able to bring barter (temporarily) back.

The Conceptual Definition of Money
Under monetary exchange, people trade money for goods when they purchase something,
Money is the standard
object used in exchanging and they trade goods for money when they sell something, but they do not trade goods
goods and services. In directly for other goods. This practice defines money™s principal role as the medium of
short, money is the
exchange. But once it has become accepted as the medium of exchange, whatever serves as
medium of exchange.
money is bound to serve other functions as well. For one, it will inevitably become the unit
of account”that is, the standard unit for quoting prices. Thus, if inhabitants of an idyllic trop-
The medium of exchange
is the object or objects used ical island use coconuts as money, they would be foolish to quote prices in terms of seashells.
to buy and sell other items Money also may come to be used as a store of value. If Farmer Jones™s corn sales bring
such as goods and services.
him more cash than he wants to spend right away, he may find it convenient to store the
difference temporarily in the form of money. He knows that money can be sold easily for
The unit of account is
goods and services at a later date, whereas land, gold, and other stores of value might
the standard unit for quot-
ing prices. not be. Of course, if inflation is substantial, he may decide to forgo the convenience of
money and store his wealth in some other form rather than see its purchasing power
A store of value is an
eroded. So money™s role as a store of value is far from inevitable.
item used to store wealth
Because money may not always serve as a store of value, and because other commodi-
from one point in time to
ties may act as stores of value, we will not include the store-of-value function as part of
our conceptual definition of money. Instead, we simply label as “money” whatever serves
as the medium of exchange.

What Serves as Money?
Anthropologists and historians can testify that a bewildering variety of objects have served
as money in different times and places. Cattle, stones, candy bars, cigarettes, woodpecker

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Chapter 12 245
Money and the Banking System

Remaking America™s Paper Money
Over the last few years, the U.S. Treasury has replaced much of
America™s paper money with new notes designed to be much more
difficult to counterfeit. Several of the new anticounterfeiting fea-
tures are visible to the naked eye. By inspecting one of the new $20
bills”the ones with the big picture of Andrew Jackson that looks
like it™s been through a washing machine”you can easily see sev-
eral of them. (Others are harder to detect.)
Most obvious are the various shades of coloration, including the
silver blue eagle to Jackson™s left. Next, hold the bill up to a light,
with Jackson facing you. Near the left edge, you will find some small
type set vertically, rather than horizontally. If your eyesight is good,
you will be able to read what it says. But, if you were a counter-
feiter, you would find this line devilishly difficult to duplicate. Third,
twist the bill and see how the gold numeral “20” in the lower-right
corner glistens and changes color. An optical illusion? No, a clever
way to make life hard on counterfeiters. © AP Images

scalps, porpoise teeth, and giraffe tails provide a few of the more colorful examples. (For
another example, see the box “Dealing by Wheeling on Yap” on the previous page.)
In primitive or less organized societies, the commodities that served as money gener-
ally held value in themselves. If not used as money, cattle could be slaughtered for food,
cigarettes could be smoked, and so on. But such commodity money generally runs into Commodity money is an
object in use as a medium
several severe difficulties. To be useful as a medium of exchange, a commodity must be
of exchange, but that also
easily divisible”which makes cattle a poor choice. It must also be of uniform, or at least
has a substantial value in
readily identifiable, quality so that inferior substitutes are easy to recognize. This short-
alternative (nonmonetary)
coming may be why woodpecker scalps never achieved great popularity. The medium of uses.
exchange must also be storable and durable, which presents a serious problem for candy-
bar money. Finally, because people will carry and store commodity money, it is helpful if
the item is compact”that is, if it has high value per unit of volume and weight.
All of these traits make it natural that gold and silver have circulated as money since
the first coins were struck about 2,500 years ago. Because they have high value in nonmon-
etary uses, a lot of purchasing power can be carried without too much weight. Pieces of
gold are also storable, divisible (with a little trouble), and of identifiable quality (with a lit-
tle more trouble).
The same characteristics suggest that paper would make an even better money. The
Chinese invented paper money in the eleventh century, and Marco Polo brought the idea
to Europe. Because we can print any number on it that we please, we can make paper
money as divisible as we like. People can also carry a large value of paper money in a light-
weight and compact form. Paper is easy to store and, with a little cleverness, we can make
counterfeiting challenging, though never impossible. (See the box “Remaking America™s
Paper Money” above.)
Paper cannot, however, serve as commodity money because its value per square inch in
alternative uses is so low. A paper currency that is repudiated by its issuer can, perhaps,
be used as wallpaper or to wrap fish, but these uses will surely represent only a small frac-
tion of the paper™s value as money.2 Contrary to the popular expression, such a currency

The first paper money issued by the U.S. federal government, the Continental dollar, was essentially repudi-

ated. (Actually, the new government of the United States redeemed the Continentals for 1 cent on the dollar in
the 1790s.) This event gave rise to the derisive expression, “It™s not worth a Continental.”

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Licensed to:
Part 3
246 Fiscal and Monetary Policy

literally is worth the paper it is printed on”which is to say that it is not worth much. Thus,
paper money is always fiat money.
Fiat money is money that
is decreed as such by the Money in the contemporary United States is almost entirely fiat money. Look at a dol-
government. It is of little lar bill. Next to George Washington™s picture it states: “This note is legal tender for all
value as a commodity, but
debts, public and private.” Nowhere on the certificate is there a promise, stated or implied,
it maintains its value as a
that the U.S. government will exchange it for anything else. A dollar bill is convertible into,
medium of exchange
say, 4 quarters or 10 dimes”but not into gold, chocolate, or any other commodity.
because people have faith
Why do people hold these pieces of paper? Because they know that others are willing
that the issuer will stand
to accept them for things of intrinsic value”food, rent, shoes, and so on. If this confidence
behind the pieces of


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