Don’t let the wealth effect make you overconfident, complacent, or even arrogant. When you feel you can afford anything without really running the numbers, that’s either a sign that you’re really rich or that you’re a victim of the wealth effect. When that happens tap the brakes and retreat to the basic lifestyle truly congruent with your real income and wealth. Someday you’ll be glad you did.

CHAPTER 3

Money, Prices, and Interest Rates

What would an economy be without money? For that matter, how would life work without money? Sure, you could exchange an hour on your job directly for a package of T-bone steaks, a sack of potatoes, and a bottle of wine, but how complicated would that be? Especially when your cube buddy wants the makings for a Caesar salad instead. And what would happen if you needed to go to the doctor, and all you had to pay with was your steak and potatoes?

Yes, money simplifies the economic picture by giving us a standard of exchange. Money is simply a commodity that can be universally exchanged as “legal tender” for all other commodities and services. It is the lifeblood of an economy. Yes, it does make the world go round.

Like any other commodity, there can be too much of it or too little, and its true worth is judged only by the value of other commodities. So like the economy it supports, the value and worth of money can change over time. Those changes become apparent as changes in prices. Furthermore, unlike most other commodities, money can be used as a lever or tool to moderate, manage, or control the economy. Economists and policymakers concern themselves with the worth of money, the cost of money, and the use of money to influence the economy. This chapter covers money and its interaction with the economy.

16. MONEY

You probably wouldn’t be reading this book if you weren’t interested in money—or at least, the necessities and pleasures that money buys.

What You Should Know

Technically speaking, money is anything that is generally accepted as payment for goods and services and repayment of debts. Usually, it comes in the form of paper or coins, but anything could be used as tender, even bottle caps, if society set an accepted standard for using bottle caps as payment. Money is used primarily as a medium of exchange, but also as a unit of measure of financial activity and as a store of value.

As a medium of exchange, money works because of its universal acceptance. If you try to pay for a cartful of groceries with a goat, it might work, but only if the grocer happens to need or want a goat. Money is designed to work for everybody, no matter what they need or want to purchase. It is much more efficient than direct barter. Although “plastic”—credit and debit cards—has seemingly replaced money, it isn’t really money, only a convenient way to administer the payment; the real money changes hands later on behind the scenes.

As a unit of measure, or “unit of account,” as economists call it, money is a handy means to place a value on things. A tab for $104 worth of groceries is much easier to comprehend than a tab for 2⅔ goats. Likewise, imagine the difficulties measuring GDP, incomes, and so forth without money. Finally, money is divisible into known and like units; if one were trading in diamonds instead, no two diamonds are worth the exact same amount, and would thus complicate the exchange.

The money we see comes in the form of currency—that is, printed paper and minted coinage representing units of generally accepted value. As a store of value, one can convert anything to money, at least for the short term, and store the value there until something else is purchased. Many economists caution against relying on money as a store of value for too long, as the increase in money supply (see #17 Money Supply) over time makes a unit of money worth relatively less. Some question whether current economic policies in the United States, Japan, and other countries will drive the value of money down and threaten its status as a store of value.

The vast majority of money doesn’t exist as $20, $10, $5, and $1 bills, but rather as deposits in banks. Those sums of money—and almost everyone has some—can be created by credit and moved around with a check (the old way) or the click of a mouse or keyboard.

Finally, U.S. money is a type of money known as fiat money, meaning that its value, and that it be accepted as a means of payment, is determined by government order. It is not backed by any hard asset such as gold. Technically, you can only exchange a U.S. dollar with the U.S. government for another dollar. Until the 1960s, that wasn’t true—you could exchange currency for gold or silver, depending on the type of money you held.

Why You Should Care

It’s always useful to step back and think about what money really is. It isn’t an end in and of itself; it is a unit of exchange. It can be exchanged for something else later on. Understanding what money is and what it’s for can give you a more balanced perspective for managing your finances.

17. MONEY SUPPLY

Money is a commodity, just like any other commodity you might purchase with it. The money supply is the amount of money within an economy available for purchasing goods or services. The central banks—in the United States, the Federal Reserve—keep close tabs on the money supply, as the amount of money in circulation can have a big effect on the economy (see #30 Federal Reserve, #29 Central Bank, and #18 Inflation).

What You Should Know

Money is created by either printing paper tender or by making it available as credit through lending. When the central bank lowers interest rates, it stimulates the creation of more money through lending. When there is more money in circulation, people have more money and spend more money, stimulating demand for goods and services. That helps businesses and creates a stronger economy, but also threatens inflation, since more money is chasing the same amount of goods and services, making the money worth relatively less.

The Federal Reserve measures several categories of money supply, four of which are more mainstream and likely to be in the news. The M0 figure is so-called base money—currency (bills and coins) and central bank deposits. The M1 figure includes so-called demand deposits, roughly equivalent to amounts in checking accounts—money on hand as a deposit in an institution designed to be used actively to buy and sell goods and services in the short term. The M1 is the most “spendable” money in circulation at a given point in time. The M2 adds money in time deposits like savings accounts and CDs—money that is there but not as likely to be used actively for transactions. And M3 adds large time deposits like repurchase agreements and institutional money market accounts—also long-term in nature, and largely out of consumer hands. Economists tie their horse to M1 in terms of measuring the amount of money really flowing around and through the economy; it is like “working capital” in a business.

Why You Should Care

Economists watch money supply to forecast inflation and other economic effects. If you see reports of increasing money supply, it can mean good times ahead, but it can also mean inflation. Be suspicious of prolonged money supply increases—the government and particularly the Fed may be sacrificing the future by driving down the value of money in an attempt to realize a short-term gain in business activity and employment.

18. INFLATION

Inflation is an across-the-board rise in prices of goods and services over a period of time. When inflation is present, the purchasing power of a given unit of money buys fewer goods and services; that is, the “real” value of money is less. The idea of inflation is generally scary, as nobody wants to see the decline in the value of money. But if kept in check, some inflation is actually okay, and may even be beneficial.