[E11.2] Money: Medium of Exchange
Currencies differentiate modern economies from bartering to exchange goods and services
For this Post in Product | Strategy | Innovation I will expand on the prior post that introduced in Part 1: “ What is money?” And what jobs do we hire money to do for us?
Job #1 for money is to provide a reliable Medium of Exchange to buy and sell goods and services.
A key requirement for a modern economy is elimination of the need to barter for goods and services we need using the direct exchange of other goods and services. Bartering has significant limitations imposed by time, space, distance and scalability. Job #1 for money is to provide a reliable Medium of Exchange to buy and sell goods and services.
And even in its simplest form when one person buys a good or service from another person with the exchange of money, the value provided can be significant. Because the person who sold the good or service in exchange for money can now take that money to buy another good or service from another person. The efficiency and economic impact of this innovation enables communities to thrive beyond their basic needs to develop more specialized goods and services.
Monetary Base or Narrow Money, M0
A currency like the US Dollar (US$) enables money to act as a Medium of Exchange, unit of account and standard of deferred payment. The Federal Reserve System is the central bank in the United States that sets monetary policy. Legal tender, reported as M0, is the cash created through minting coins and printing banknotes. This “monetary base” includes cash in circulation and commercial banking deposits. Legal tender also determines the currency used within a jurisdiction to settle debts in a court of law.
Bank or Broad Money, M1/M2
Bank money, reported as M1/M2, is the money created by commercial banks through the recording of loans as deposits of borrowing clients. Bank money is created as “electronic money” vs. the minting of coins and printing banknotes. The modern banking system requires adequate currency reserves to offset the risk of money deployed by commercial banks through loans and other instruments.
Central Banks have 3 primary levers to influence the money supply through monetary policy
As a national economy improves, commercial banks tend to deploy more money. This requires currency reserves to increase. Banks can increase their reserves by borrowing more currency through the central bank. Monetary policy refers to the control and supply of money in the economy by a central bank. The 3 primary levers used by central banks to set monetary policy are:
Open Market Operations
The first lever uses buying and selling of financial instruments known as securities by the central bank. Securities like bonds or mortgage-backed securities are bought or sold by the central bank with commercial banks. The central bank increases M0 to buy securities from commercial banks to increase the commercial banks cash reserves. This helps stimulate an economy with more cash reserves for commercial banks to put to use like offsetting loans to borrowing individuals and corporations. This is called expansionary monetary policy.
The central bank can also sell securities it holds to commercial banks. This shrinks the cash reserves to reduce activities by commercial banks. This can be used to reduce the money supply including M0 to help control inflation.
Reserve Requirement
The cash reserve ratio is set by a central bank and determines the currency reserves required for the aggregate amount of money loaned out. If the cash reserve ratio is 10%, then for every $100 in reserve, $900 can be used other activities like loans to individuals and corporations. Central banks use this second lever to expand or contract M1/M2 without directly changing M0. The reserve requirement can be increased during inflation to contract the money supply.
Discount Rate
The third lever to set monetary policy is the rate of interest the central bank charges commercial banks. If a commercial bank is unable to find adequate liquidity from other commercial banks, the lender of last resort is the central bank with a short-term loan. This also impacts the money supply by influencing the risk tolerance of the commercial banks.
Governments also influence the money supply through fiscal policy
Fiscal policy refers to the actions governments take through taxation and government spending. A neutral fiscal policy balances government spending with the money raised through taxation. This is also called a balance budget. However, governments tend to run budget deficits to help boost their economies.
Expansionary Fiscal Policy
Governments use this lever to spend more money than what is taken in with taxes. This may include an increase in government spending, a reduction in taxes, or a combination of both. The result is a budget deficit. And years of budget deficits can lead to expanding government debt and higher spending just to service that debt. This is when monetary and fiscal policies can collide. As government debt increases, it becomes more difficult to service its debt if the central bank uses its lever to raise the discount rate to combat inflation.
Contractionary Fiscal Policy
Governments use this lever to take in more money with taxes than it spends. This policy can also be used to curb inflation by reducing the money supply in the economy. This policy may also be used to control government debt by running a budget surplus.
Fiat currency is the result of wanting more flexibility
Currencies were historically backed by a commodity like gold. U.S. Dollars could be converted to gold based on an exchange rate per troy ounce. However, in 1971, the United States terminated the convertibility of the U.S. Dollar to gold making it a fiat currency. Other currencies followed resulting in floating exchange rates between currency pairs for fiat currencies around the world.
Government takes on the role of backing fiat currency as legal tender. This provides another lever to influence an economy with the strength of one currency relative to other currencies. If a currency weakens relative to another currency, it becomes easier to sell products at lower prices using the strength of the trade partner’s local currency.
Recent actions by the Federal Reserve System to tighten monetary policy and shrink the money supply to combat inflation has strengthened the U.S. Dollar. Over time this makes it more difficult to sell and easier to buy goods and services with foreign trade partners who have a weaker currency. The net result is a boost to inventories which helps control prices in the U.S.
Central Bank Digital Currency (CBDC) aims to innovate money
Many governments around the world are exploring digital versions of their currencies to reduce cost and improve access as an alternative to minted coins and printed banknotes. Although there are clear benefits, there are also disadvantages for CBDC users like traceability and programmability with a centralized digital currency. Coins and banknotes offer some traceability with unique serial numbers and tracking throughout the banking system to determine the circulating money supply, but digital currencies offer even more granular traceability.
Programmability offers centralized, serial control over digital currency with the ability, for instance, to permanently “turn off” specific serial numbers if those CBDCs were stolen. An alternative would be a decentralized form of currency that is backed by specific legal tender.
Stablecoins like the U.S. Dollar Coin (USDC) also aim to innovate money
USDC is one of the leading stablecoins in use today with about $54.2 billion in circulation on the day this Post was published on August 5, 2022. Each USDC is backed by a US Dollar on a 1:1 basis, but the true peg has varied between about 1.0015 to 0.998 USDC per USD over the last year. But for the most part, the true peg varies within an even tighter range between 1.0005 to 0.9996 USDC per USD.
Every unit of USDC in circulation is backed by $1 that is held in reserve, in a mix of cash and short-term U.S. treasury bonds. The Centre consortium which is behind the USDC cryptocurrency asset, has two founding members. One is peer-to-peer payment services company Circle while the other is the Coinbase cryptocurrency exchange. USDC originally launched on a limited basis in September 2018, but Circle and Coinbase collectively announced a major upgrade to USDC’s protocol and smart contract to enable everyday payments, commerce and peer-to-peer transactions.
Coinbase briefly contemplated diversifying the funds backing USDC, but retracted the proposal after heavy opposition from the markets they serve. Both Circle and Coinbase USDC projects are well funded and have achieved regulatory compliance to help pave the way for international expansion. Stablecoins are thought to be one of the first cryptocurrencies to go through more comprehensive regulations to enable more institutional use. But the strength of USDC relative to other stablecoin projects is the US Dollar reserve that backs each USDC on a 1:1 basis.
These regulations may limit some of the features of USDC since it all of the USDCs in circulation are actually ERC-20 tokens on the Etherium blockchain to integrate USDCs into Ethereum-based applications. But one of the strongest use cases for USDC is in foreign countries where other currencies suffer from inflation and hyperinflation. Some countries like El Salvador abandoned their own currency and adopted the US Dollar as legal tender a number of years ago. But USDC can serve a role in countries where the US Dollar is not legal tender, but is commonly accepted as a Medium of Exchange. USDC can be exchanged through digital wallets to make it more widely adopted.
Conclusion
Money as a Medium of Exchange provides significant innovations to improve quality of life and economic viability through more specialized goods and services. Currency created by minting coins and printing banknotes offers a fundamental principle that enables governments and courts of law to formalize accounting and legal tender for settling debts. Modern banking with both a central and commercial banks influences the money supply through monetary policy along with government fiscal policy.
Fiat currency not backed by a commodity like gold has enabled more flexibility around expanding the money supply with the backing of a government. But too much expansion can also lead to inflation, and in extreme cases hyperinflation or even economic collapse. Growing awareness of these conditions have led to interest in more decentralized forms of money like USDC which offers the backing of US Dollar reserves, but the potential innovation of a cryptocurrency with features like digital wallets and smart contracts.
But with all of the innovations around money as a Medium of Exchange, moving towards fiat currency has decoupled the job-to-be-done of money as a store of value from its other jobs. I will discuss that topic in more detail in Part 3 of this Series on What is Money?
Best,
Stephen
Nothing in this post is intended to serve as financial advice. Do your own research. The opinions and views expressed in this newsletter are those of the author. They do not purport to reflect the opinions, views or policies of any other organization, company or employer.