What Is Money?
Money is a system of value that facilitates the exchange of goods in an economy. Using money allows buyers and sellers to reduce their transaction costs, compared to barter trading.
The first types of money were commodities, whose physical properties made them desirable as a medium of exchange. In contemporary markets, money can include government-issued legal tender or fiat money, money substitutes, fiduciary media, or electronic cryptocurrencies.
KEY TAKEAWAYS
- Money is a system of value that facilitates exchange between different actors of an economy.
- The use of money eliminates issues from the double coincidence of wants that can occur in bartering.
- Historically, the first forms of money were agricultural commodities, such as grain or livestock.
- Today, most money systems are based on standardized currencies that are controlled by a central bank.
- Digital cryptocurrencies have also been introduced that have several properties of money.
Understanding Money
Money is a liquid asset used to facilitate transactions of value. It is used as a medium of exchange between different economic actors, as well as a store of value and a unit of account to measure the value of other goods.
Prior to the invention of money, most economies relied on bartering, where individuals would directly trade the goods they had for those that they needed. This raised the problem of the double coincidence of wants: a transaction could only take place if both participants had something that the other needed. Money eliminates this problem by acting as an intermediary good.
The first known forms of money were agricultural commodities, such as grain or cattle. Since these goods were in wide demand, traders knew that they would be able to use or trade these goods again in the future. Coca beans, cowrie shells, and agricultural tools have also served as early forms of money.1
As economies became more complex, money was standardized into currencies, further reducing transaction costs by making it easier to measure and compare values. Also, the representations of money also became increasingly abstract, from precious metals to stamped coins, paper notes, and—in the modern era—electronic records.
During World War II, cigarettes became a de facto currency for soldiers in prisoner-of-war camps. The use of cigarettes as money made tobacco highly desirable, even among soldiers who did not smoke.2
Requirements of Money
In order to be most useful as money, a currency should be fungible, durable, portable, recognizable, and stable. These properties reduce the transaction cost of using money by making it easier to use as an intermediary good.
Fungible
Units of money should be interchangeable with one another. For example, metal coins should have a standard weight and purity, and commodity money should be relatively uniform in quality. Trying to use a non-fungible good as money results in transaction costs of individually evaluating each unit of the good before an exchange can take place.
Durable
Money should be durable enough to retain its usefulness in future exchanges and be reused multiple times. A perishable good or a good that degrades quickly with use in exchanges will be less useful for future transactions. Trying to use a non-durable good as money conflicts with money’s essentially future-oriented use-value.
Portable
Money should be easy to carry and divide so that a worthwhile quantity can be conveniently carried or transported. Trying to use a non-portable good as money could produce transaction costs of either physically transporting large quantities of the low-value good or defining practical, transferable ownership of an immobile object.
Recognizable
The authenticity and quantity of the good should be readily apparent to the users so that they can easily agree to the terms of an exchange. Trying to use a non-recognizable good as money produces transaction costs of agreement on the authenticity and quantity of the goods by all parties to an exchange.
Stable
The supply of a good used as money should be relatively constant over time to prevent fluctuations in value. Using a non-stable good as money produces transaction costs due to the risk that its value might rise or fall before the next transaction.
Functions of Money
Money primarily functions as an intermediary good for exchanges of value. However, it also has secondary functions that derive from its use as a medium of exchange.
Unit of Account
Due to its use as a medium of exchange for both buying and selling and its use to assign prices to all kinds of other goods and services, money can be used to keep track of the money gained or lost across multiple transactions, and to compare money values of various combinations of different quantities of different goods and services. This makes it possible to account for profits and losses, balance a budget, or value the total assets of a company.
Store of Value
Because money’s usefulness as a medium of exchange in transactions is inherently future-oriented, it provides a means to store value obtained through current production or trade for use in the future in the form of other goods and services. In particular trading their non-fungible, non-durable, non-portable, non-recognizable, or non-stable goods or services for money here and now, people can store the value of those goods to trade for goods at other times and places. This facilitates saving for the future and engaging in transactions over long distances possible.
Standard of Deferred Payment
To the extent that money is accepted as a general medium of exchange and serves as a useful store of value, it can be used to transfer value over different time periods in the form of credits and debts. One person can borrow a quantity of money from another for a period of time to use, and repay another agreed-upon quantity of money at a future date.
Types of Money
There are several types of money.
Market-Determined Money
Money can originate out of the spontaneous order of markets. As traders barter for various goods, some goods will prove more convenient than others because they have the best combination of the five properties listed above.
Over time, these goods may become desirable as an object of exchange, rather than for practical use. Eventually, people may come to desire a good solely for future trading.
Historically, precious metals like gold and silver were often used as market-determined monies, because they were highly prized across many different cultures and societies. Today, people in cashless economies frequently turn to cigarettes, instant noodles, or other nonperishable goods as a market-determined money substitute.2
Government-Issued Currency
When a certain type of money is widely accepted throughout an economy, government bodies may begin regulating it as a currency. They may begin issuing standardized coins or notes to further reduce transaction costs. The government may also recognize some money as a legal tender, meaning that courts and government bodies must accept that form of money as a final means of payment.
$20.6 trillion
The total value of the M1 money supply in the United States.3
Issuing money allows the government to benefit from seignorage, the difference between the face value of a currency and the cost of producing it. For example, if the cost of printing a $100 bill is only $10, the government will earn a $90 profit for each bill it prints. However, governments that rely too heavily on seignorage may inadvertently debase their currency.
Fiat Currency
Many countries have moved a step further by issuing fiat currency that does not represent any type of commodity. Instead, fiat money is backed by the economic strength of the issuing government and derives its value from the need to use it in tax payments.
Fiat money allows the issuing government to conduct economic policy by increasing or reducing the money supply. However, since it does not represent a real commodity, it falls to the issuing government to ensure that fiat currency meets the five properties of money outlined above.
The International Monetary Fund and World Bank serve as global watchdogs for the exchange of international currencies.45 Governments may enact capital controls or establish pegs in order to stabilize their currency on the international market.
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