Why It's Important to Define Money Correctly
Most economists hold that, since the early 1980s, correlations between various definitions of money and national income have broken down. The reason for this breakdown, it is held, is that financial deregulation has made the demand for money unstable. As a result it is held the usefulness of money as a predictor of economic events has significantly diminished.
To fix the instability of the demand for money, economists have introduced a gauge of the money supply known as the Divisia monetary indicator. (The indicator is named after its originator, François Divisia).
By assigning variables rather than equal weights to the money-supply components, it is held, one could remedy the issue of an unstable money demand. (By assigning suitable weights one is likely to improve the correlation between the weighted monetary gauge and various economic indicators.) Consequently, one could employ this indicator to ascertain the likely future economic events.1
Note that according to most economists, the validity of various definitions of money can be established by means of a statistical test. What determines whether money — M1, M2, and the other Ms — has been validly defined depends on how well they correlate with various key economic data such as the gross domestic product.
The Problem of Defining Money
No definition, however, can be established by means of a correlation. The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are.
In this sense money is that for which all other goods and services are traded. The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity.
This fundamental characteristic of money must be contrasted with those of other goods. For instance, food supplies the necessary energy to human beings, while capital goods permit the expansion of infrastructure that in turn permits the production of a larger quantity of goods and services.
Through an ongoing selection process people have historically settled on gold as money. In other words, gold served as the standard money.
In today’s monetary system, money supply is no longer gold but coins and notes issued by the government and the central bank.
Consequently, coins and notes constitute the standard money, known as cash that is employed in transactions. In other words, goods and services are sold for cash.
A correct definition of money is a must if one wants to get the right information from monetary indicators. Unfortunately most popular ways of defining money are flawed.
Flawed Definitions of Money
Consider for instance the money M2 definition. This definition includes money market deposit accounts. However, investing in a money market fund is in fact investment in various money market instruments.
The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed.
Thus if Joe invests $1,000 with a money market fund, the overall amount of money in the economy will not change as a result of this transaction. Money will move from Joe’s demand deposit account to a money market demand deposit account with a bank. To incorporate the $1,000 invested with the money market fund into the definition of money plus the original $1,000 would therefore amount to double counting.
The problem of double counting is also not resolved by the "money of zero maturity" definition of money (MZM) — a relatively recent money supply definition.
The essence of MZM is that it encompasses financial assets with zero maturity. Assets included in MZM are redeemable at par on demand. This definition excludes all securities, which are subject to risk of capital loss, and time deposits, which carry penalties for early withdrawal. The MZM includes all types of financial instruments that can be easily converted into money without penalty or risk of capital loss.2
Observe that MZM includes assets that can be converted into money. This is precisely what is wrong with this definition, since it doesn’t identify money but rather various assets that can be easily converted into money. It doesn’t tell us what money actually is and this is what a definition of money is supposed to do.
Likewise the issue of a valid definition is not resolved by the Divisia monetary gauge. As we have seen this gauge is not trying to establish what money is but rather to improve the correlation between the money such as M2 with an economic activity indicator. In this sense the construction of the Divisia gauge is an exercise in curve fitting.
Once it is established that the definition is sound, one must stick to it regardless of whether it is well correlated with some other economic data or not.
The final judge regarding the validity of a money supply definition should not be statistical correlations as such but the soundness of the definition.
The soundness of a definition cannot be established by means of a statistical analysis but only by means of understanding what money is all about.
Is Electronic Money Real Money?
The introduction of electronic money seems to cast doubt on the view that money is coins and notes.
Notwithstanding, various forms of electronic money don’t have a “life of their own.” Electronic money can function as long as individuals know that they can obtain cash on demand.
Various financial innovations do not create new forms of money, but rather new ways of employing existing money in transactions.
Regardless of these financial innovations, the nature of money does not change. It is the thing that all other goods and services are traded for.