Economics for Ashby Chapter 1, 2, and 3

Chapter 1

In primitive societies where members of a household would produce for themselves most of the products and services they needed to survive transactions with outside suppliers were rare. Because these transactions were rare it was common to use barter exchange rather than having a common form of payment like we use today. Barter exchange would involve a direct swapping of products and service and requires a buyer to track down a seller. The buyer would have to find someone who wants to sell what the buyer wants, who will accept the buyers offer of exchange of products and services, and who can reach an agreement with the buyer upon the terms of their exchange. This process requires a lot of time and effort so it is inconvenient unless transactions are rare.

For most societies, including our own, barter exchange was too large of a process to adhere to once purchase and transactions became so common. We switched to specialization. Specialization creates a system that uses a medium of exchange. Anything that is commonly used as a medium of exchange is considered money.

The supply of money must be carefully controlled. The money control for the US is the responsibility of the Congress. Money is actually created by privately-owned and operated enterprise we call banks, financial institutions that offer transaction accounts, but is carefully watched over by government regulators. If the money supply was not carefully controlled the economy could easily fall to pieces. Inflation, a sustained rise in the average level of prices, could quickly occur because of too large a money supply. A recession could occur because of too little a money supply. A recession, a sustained drop in total output but the nation’s producers, could lead to unemployment and deflation.

Money is anything that is commonly accepted in payment for products and services. The only kinds of money in the US are coins, paper currency, and checking account balances. Nothing else is commonly used to pay for products and services. Credit and debit cards and checks are alternative money transfer mechanisms but are not themselves money. Also, savings account balances are not money, they should be considered like stocks and bonds, non-money financial assets.

The US money supply includes all US issued coins and paper currency except amount in the vaults of banks, Federal Reserve Banks, and the US Treasury plus all the US dollar checking account balances in banks except those owned by other domestic banks and the US Treasury. The equation is then, M = CC + CA. M is the money supply, CC is the coins and currency, and CA is the checking account balances. Any activity that increases M is said to create money. M must rise only when more money is available and must fall only when there is less money available. This means that when exchanging one type of money for another it must have no bearing on M because no money is becoming available or unavailable. A deposit into a checking account of $100 in coins and paper currency reduces CC and increase CA, leaving M unchanged. When a withdrawal is made from a checking account it reduces CA but increase CC, again leaving M unchanged. To show this in a checking account it would look like you sold the back $100 in coins and paper currency and they paid you by increasing your checking account balance and vice-versa for a withdrawal.

The velocity of money is the average number of times that a dollar is spent each year for purchases of current domestic output. The velocity of money in the US is currently around nine. This says that each dollar is spent on average once every 1.3 months. Observation shows that money is spent considerably faster than that. The reasons are because velocity measures only purchases from the current domestic products and that possibly two-thirds of our cash is circulating outside the US. This is mostly due to dollarization, where some countries use US dollars as their national currency. Some countries also “back” their money with gold due to its scarcity. This keeps governments from issuing too much money.

Chapter 2

The US Treasury Department, the Federal Reserve System, and the banking system make up a three-tier system for money creation in the US. The US Treasury Department is within the executive branch of the federal government that manages its financial affairs. The Treasury uses accumulated revenues from taxes and bond sales to pay the federal government’s bills. The Treasury operates the agencies that produce the nation’s coins and paper currency. However, the Treasury does not spend the coins and paper currency it makes. The newly manufactures coins and notes are sold to the twelve Federal Reserve banks. They are then stored until the nation’s banks