Unraveling the Mysteries of Money

This article originally appeared in the August/September 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000. 

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To many people, the way money works and its link to inflation is rather mysterious, despite its obvious importance in the economy. We take it for granted that the dollar bills in our wallets can be exchanged for goods and services, but what determines their value? Why does a Big Mac cost $3.45, and not $345?

Most people think of inflation as the price of goods and services rising, but really inflation is about the value of money going down. So, if we want to think about inflation or deflation, we have to think about what gives money its value. Are dollar bills intrinsically worthless pieces of paper that are nevertheless valued simply because everyone believes them to be valuable? Or is money perhaps a government liability, backed by an implicit guarantee that the government will be there, if necessary, to accept it in exchange for something of real value?

To get the answers to these questions, we invited two distinguished experts to Morningstar’s Chicago offices on June 8: John H. Cochrane and Harald Uhlig. Cochrane is the AQR Capital Management Distinguished Service Professor of Finance at the University of Chicago Booth School of Business. Uhlig is a professor in economics and the chairman of the Department of Economics at the University of Chicago.

Before we get into our discussion about money, we need to define what money is. Money is basically an asset, just like a stock or bond. It is an asset, however, with some particular characteristics. It is both a unit of account and a medium of exchange. There are different types of money. The monetary base is money issued by the Federal Reserve, a bank owned and run by the federal government. Part of the monetary base exists in physical form (dollar bills and coins), or currency. The rest is electronic, or reserves, which are accounts that banks have at the Federal Reserve.

People tend to hold a fraction of their wealth in the form of money, because we need money to purchase goods and services and we obtain money when we sell them. How much money we hold depends on money’s returns. If the returns to holding money are very low (compared with other investments), we try to hold less money. This low return occurs during inflation, when money is losing value quickly. Conversely, people are willing to hold a lot of money during a deflation.

How much money we hold also depends on the overall level of economic activity—how much we’re buying and selling—and the costs of exchanging money for other assets. To hold very little money, you have to make a lot of trips to the ATM. Finally, people choose to hold a lot of money when the risks of holding other assets seem very high. We saw a massive increase in money demand during the financial crisis.