JP Koning has a proposal for simplifying the teaching of basic monetary economics. He starts with this Venn diagram:
Which he explains as follows:
But we are still left with two useful definitions for money, unit of account and medium of exchange. Which gets us to the money circle.
Note that the two circles in the diagram, medium of exchange and unit of account, don’t perfectly overlap. About 99% of the time the things we use as media of exchange are also the things we use as a unit of account. So the contents of our wallets or our bank accounts, dollar banknotes and dollar deposits are functionally equivalent to the $ units displayed in signs in grocery aisles.
But for the remaining 1% of the time, the unit of account and medium of exchange are separated. The idea of a separation is tough to get one’s head around. Luckily we’ve got a nice example. In Chile the prices of many things, particularly real estate, are expressed in terms of the Unidad de Fomento. But no Unidad de Fomento notes or coins circulate in Chile. It is a purely abstract unit of account.
I have a slightly different view. Because I define “money” as the monetary base, and because most base money is held as a store of value, I view that use as more important than the medium of exchange role. Nonetheless, I’d also drop “store of value” from the key characteristics of money, and just go with “medium of account”, where the medium of account is defined as the good in which other goods and labor are priced. In Chile, peso currency notes (and bank reserves) probably best meets that definition. Here’s Koning again:
The differences between Chile’s monetary system and those of other nations only emerges when we begin look at the unit in which goods are priced. Most nations have one unit-of-account, but Chile has two. While many Chilean prices are expressed in terms of the peso, or P, a broad range of prices are expressed in an entirely different unit, the Unidad de Fomento, or UF. Real estate, rent, mortgages, car loans, long term gov securities, taxes, pension payments, and alimony are all priced using UF. As examples, this real estate website sets prices in UF terms, and this car rental business levies insurance in UFs. On the other hand, wages, consumer good prices, and stock prices are expressed in peso terms.
In the end, I see no reason to focus on money’s role as a medium of exchange. Money is important because the nominal prices of goods, services and labor are priced in money terms, and because those prices are sticky. Thus when a shock to the supply and/or demand for money changes its value (i.e. its purchasing power), it will cause disequilibrium in the markets for goods, services and labor.
[It might also cause a financial crisis. But not necessarily in Chile, where financial contracts are not priced in terms of ‘money’ as I define money. Chilean financial contracts are not denominated in peso terms.]
The easiest way to teach money to students is with a supply and demand model for the medium of account (which might be gold or cash), where the value of money is defined as 1/Price level, or better yet 1/NGDP. All that’s left is to explain how and why the supply and demand for money changes over time. That can’t be so hard!! (Just kidding.)
HT: David Beckworth