The Financial System Promotes Economic Activity

Modern economies rely on money and a variety of financial institutions to support business activity. Some financial institutions such as banks, thrifts, and credit unions accept deposits and pool savings for productive investments and consumer loans. Other financial institutions such as stock and bond markets, mutual funds, and futures markets also help raise money for business start-ups and other productive purposes. Globalization has integrated financial institutions around the world, which has created opportunities for productive investment but has also laid the groundwork for financial contagion.


Money is any item that is commonly accepted in payment for goods or services, or in payment of debts. Money has been used for thousands of years to facilitate business and financial transactions. The use of money is a far more efficient mechanism of exchange than barter, the direct exchange of one good for another. Barter requires a double coincidence of wants, and tedious negotiations to determine the relative value of goods in the marketplace.

Functions and Characteristics of Money

Money has three primary functions in an economy. First, money serves as a medium of exchange. That is, the item that is used as money is commonly accepted in payment for products. Second, money serves as a unit of account. In the United States monetary units are stated in dollars and cents, and prices enable people to easily compare the value of products. Third, money serves as a store of value because it holds its worth over time. The ability of money to retain its purchasing power over time increases people's confidence in the economy and their willingness to save, invest, work, and produce.

Throughout history societies have struggled to create and maintain a monetary system that could satisfy these three interrelated functions. Three characteristics help distinguish “good” money from “bad” money. First, good money is commonly accepted in payment for products. The acceptability of money is derived mainly from its scarcity, durability,

PRIMARY DOCUMENT: Alan Greenspan Calls Money the Lubricant of Economic Progress

[A]t root, money—serving as a store of value and medium of exchange—is the lubricant that enables a society to organize itself to achieve economic progress. The ability to store the fruits of one’s labor for future consumption is necessary for the accumulation of capital, the spread of technological advances and, as a consequence, rising standards of living . . .

So long as individualsmake contractual arrangements for future payments valued in dollars, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output and hence of price that is recognizable to producers and consumers and upon which they will base their decisions.

Speech to the American Enterprise Institute (December 5, 1996), Alan Greenspan

and stability in value. These qualities help explain why gold and silver coins have been accepted as money for millennia.

Second, good money is easily divisible. The divisibility of money into precise monetary units facilitates business and financial transactions. U.S. money is highly divisible, with several denominations of coin and paper currency. Coins are measured in units of cents, with 1, 5, 10, 25, 50, and 100 cent pieces. Paper currency, called Federal Reserve Notes, is subdivided into denominations of $1, $2, $5, $10, $20, $50, and $100. The government discontinued the use of larger denominations of $500; $1,000; $5,000; and $10,000 in 1969.[1]

Third, good money is portable. The portability of money enables it to be transported easily from place to place. Historically the use of paper currency and checks expanded the portability of money in modern economies. Today, electronic funds transfer (EFT) technology has eased many types of transactions through the use of debit cards, automated teller machines, computer banking, and other e-transfers. Alan Greenspan, who served as Chairman of the Federal Reserve System under four presidents, described money as the financial lubricant of economic progress.[2]

Types of Money

Economists generally identify three types of money: commodity money, representative money, and fiat money. Commodity money is an item that is used to buy other products or settle debts, and also has value in itself. Bails of tobacco were often used as a type of commodity money in colonial Virginia and Maryland during the 1600s and early 1700s. Commodity money is not a particularly effective type of money because it lacks divisibility and portability, and its value changes with the supply or demand for the crop, mineral, or other item that serves as money.

Representative money is a type of money that has no inherent value but represents something of value. During the early twentieth century the U.S. government issued Gold Certificates, a type of representative money that could be redeemed for gold. Gold redemption ended in 1934, however, and Gold Certificates were removed from circulation. U.S. Silver Certificates, another type of representative money, were issued until 1957 and were redeemable for silver bullion until 1968.[3] Over time the redemption of these paper notes

The Bureau of Engraving and Printing in Washington, D.C. produces U.S. paper currency

The Bureau of Engraving and Printing in Washington, D.C. produces U.S. paper currency. (Bureau of Engraving and Printing/U.S. Department of the Treasury)

for gold and silver depleted U.S. supplies of these precious metals, and the government discontinued their use. Federal Reserve Notes was another form of representative money in the early twentieth century, and could be redeemed for gold until 1934.

Fiat money is a type of money that derives its value by government decree, or fiat. That is, the government declares its currency to be valuable without backing it with gold, silver, or other precious item. Federal Reserve Notes, today's paper currency, represent “legal tender for all debts” and thus must be accepted in all types of transactions in the United States. The stability of the U.S. government and its money supply are vital to maintaining the purchasing power of fiat money.

Measurements of the Money Supply

The money supply, or money stock, consists of the total amount of money in circulation in an economy. To be counted in the nation's money supply, money must be available for use in a variety of transactions and investments. Thus, the U.S. money supply does not

Table 9.1 U.S. Money Supply (M1), May 2013

Components of M1

Dollar Value ($ billions)

Percentage of M1

Coin and paper currency



Demand deposits



Other checkable deposits



Traveler's checks



Total M1



Source: Federal Reserve System, Federal Reserve Statistical Release, June 27, 2013.

include money stored away by the Federal Reserve System (Fed), the Treasury Department, or other federal agencies. Today economists use two main measures to determine the size of the money supply, the M1 and M2. In 2006 the Fed discontinued use of a third measure of the money supply, the M3.

M1 is often called transactions money because it can readily be spent. M1 is the narrowest measurement of the nation's money supply. The four main components of M1 are coin and paper currency, demand deposits, other checkable deposits, and traveler's checks. In May 2013 the M1 topped $2.5 trillion, as shown in Table 9.1. Coin and paper currency was the single largest category of M1. The second largest component was demand deposits, which represents the money held in individual checking accounts in banks. Another significant component of M1 was other checkable deposits (OCDs) such as negotiable order of withdrawal (NOW) accounts, credit union share draft accounts, and automated transfer service (ATS) balances at banks, thrifts, and credit unions. Traveler's checks accounted for less than 1 percent of M1.[4]

M2 is a broader, more inclusive measure of the nation's money supply than M1. M2 consists of M1 plus near monies such as savings deposits (including money market deposit accounts, or MMDAs); small-denomination time deposits of less than $100,000; and retail money market mutual funds (MMMFs). Near monies are highly liquid assets that are easily converted into money. In May 2013 the nation's M2 topped $10.5 trillion, as shown in Table 9.2. The largest category of near monies in M2 was savings deposits, which were held in depository institutions. These near monies of M2 totaled $8 trillion and represent the non-M1 portion of the M2. Thus, the M2 totaled $10.5 trillion in 2013 ($2.5 trillion + $8 trillion = 10.5 trillion).[5]

Table 9.2 U.S. Money Supply (M2), May 2013

Source: Federal Serve System, “Tables 1, 3, 4,” Federal Reserve Statistical Release, June 27, 2013.

  • [1] U.S. Department of the Treasury, Bureau of Engraving and Printing, “Currency Facts,”
  • [2] Alan Greenspan, “The Challenge of Central Banking in a Democratic Society,” speech delivered to the American Enterprise Institute for Public Policy, Washington, DC, December 5, 1996
  • [3] Federal Reserve Bank of Boston, Currency Points: Understanding Our Money (Boston: Federal Reserve Bank of Boston), 6.
  • [4] Federal Reserve System (Fed), “Table 1: Money Stock Measures,” “Table 3: Seasonally Adjusted Components of M1,” Federal Reserve Statistical Release, June 27, 2013, 1, 3
  • [5] Fed, “Table 1: Money Stock Measures,” “Table 3: Seasonally Adjusted Components of M1,” and “Table 4: Seasonally Adjusted Components of Non-M1 M2,” Federal Reserve Statistical Release, June 27, 2013, 1, 3, 4
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