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 pay less in transaction costs, compared to barter trading.
The first types of money were commodities. Their physical properties made them desirable as a medium of exchange. In contemporary markets, money can include government-issuedlegal tenderorfiat money, money substitutes, fiduciary media, or electroniccryptocurrencies.
Key Takeaways
- Money is a system of value that facilitates the exchange of goods.
- The use of money eliminates the problem of bartering where both parties must have something the other wants or needs.
- 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 central banks.
- Digital cryptocurrencies also have some of the specific properties of money.
How Money Works
Money is aliquid assetused to facilitate transactions of value. It is used as a medium of exchange between individuals and entities. It's also a store of value and a unit of account that can measure the value of other goods.
Prior to the invention of money, most economies relied on bartering, where individuals would trade the goods they had directly 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. These goods were in high demand and traders knew that they would be able to use or trade these goods again in the future. Cocoa beans, cowrie shells, and agricultural tools have also served as early forms of money.
As economies became more complex, money was standardized into currencies. This reduced transaction costs by making it easier to measure and compare value. Also, the representations of money became increasingly abstract, from precious metals and stamped coins to 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.
What Are the Properties of Money?
In order to be most useful, money should be fungible, durable, portable, recognizable, and stable. These properties reduce thetransaction costof using money by making it easy to exchange.
Money Should Be Fungible
The word fungible refers to a quality that allows one thing to be exchanged, substituted, or returned for another thing, under the assumption of equivalent value. Thus, units of money should be interchangeable with one another.
For example, metal coins should have a standard weight and purity. Commodity money should be relatively uniform in quality. Trying to use a non-fungible good as money results in transaction costs that involve individually evaluating each unit of the good before an exchange can take place.
Money Should Be Durable
Money should be durable enough to retain its usefulness for many, future exchanges. A perishable good or a good that degrades quickly due to various exchanges will be less useful for future transactions. Trying to use a non-durable good as money conflicts with money's essential future-oriented use and value.
Money Should Be Portable
Money should be easy to carry and divide so that a worthwhile quantity can be carried on one's person or transported. For example, trying to use a good that's difficult or inconvenient to carry as money could require physical transportation that results in transaction costs.
Money Should Be Recognizable
The authenticity and quantity of the good should be readily apparent to users so that they can easily agree to the terms of an exchange. Using a non-recognizable good as money can result in transaction costs relating to authenticating the goods and agreeing on the quantity needed for an exchange.
Money's Supply Should Be Stable
The supply of the item 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, because of scarcity or over-abundance, before the next transaction.
How Is Money Used?
Money primarily functions as the good people use for exchanges of items of value. However, it also has secondary functions that derive from its use as a medium of exchange.
Money As a Unit of Account
Due to money's use as a medium of exchange for buying and selling and as a value indicator for all kinds of goods and services, money can be used as a unit of account.
That means money can keep track of changes in the value of items over time and multiple transactions. People can use it to compare the values of various combinations or quantities of different goods and services.
Money as a unit of account makes it possible to account for profits and losses, balance a budget, and value the total assets of a company.
Money As a Store of Value
Money's usefulness as a medium of exchange in transactions is inherently future-oriented. As such, it provides a means to store a monetary value for use in the future without having that value deteriorate.
So, when people exchange items for money, that money retains a particular value that can be used in other transactions. This ability to function as a store of value facilitates saving for the future and engaging in transactions over long distances.
Money As a Standard of Deferred Payment
To the extent that money is accepted as a 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 someone else for an agreed-upon period of time, and repay a different agreed-upon quantity of money at a future date.
Different 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 of money listed above.
Over time, these goods may become desirable as objects of exchange, rather than for practical use. Eventually, people may come to desire a good solely for future trading.
Historically, precious metals such as gold and silver were often used as market-determined monies. 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.
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 issue standardized coins or notes to further reduce transaction costs.
A 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.
Issuing money allows the government to benefit from seigniorage, the difference between the face value of a currency and the cost to produce 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 seigniorage may inadvertently debase their currency.
$18.32 Trillion
The total value of the M1 money supply in the United States as of August 2023. This is more than a 10% reduction in M1 compared to May 2022, where it stood at $20.6 Trillion.This illustrates the variable nature of the money supply.
Fiat Currency
Many countries issue fiat currency, which is currency that does not represent any type of commodity. Instead, fiat money is backed by the economic strength of the issuing government. It derives its value from supply and demand and the stability of the government.
Fiat money allows the issuing government to conduct economic policy by increasing or reducing the money supply. In the U.S., the Federal Reserve and the Treasury Department monitor several types of money supplies for the purpose of regulating and mitigating monetary issues.
Since fiat money does not represent a real commodity, it falls to the issuing government to ensure that it meets the five properties of money outlined above.
The International Monetary Fund (IMF) and World Bank serve as global watchdogs for the exchange of international currencies. Governments may enact capital controls or establish pegs in order to stabilize their currency on the international market.
Money Substitutes and Fiduciary Media
To reduce the burden of carrying large quantities of currency, merchants and traders sometimes exchange money substitutes such as written statements of debt that can be redeemed later. These statements can themselves adopt some of the properties of money, particularly if traders use them in lieu of actual currency.
For example, ancient banks issued bills of exchange to their depositors, stating the amount that had been deposited and the terms for redemption. Rather than withdraw money from the bank to make payments, depositors would simply trade their bills, allowing the recipient to redeem or trade them at will.
This use of money substitutes can increase the portability and durability of money, as well as reduce the cost of storage. However, there are risks involved with money substitutes. Banks may print more bills than they have money to redeem, a practice known asfractional reserve banking. If too many people try to make withdrawals at the same time, the bank may suffer from a bank run.
Fiduciary media are types of money substitutes introduced into circulation that aren't fully backed by the base money held to back money substitutes. For example, paper checks, token coins, and electronic credit represent contemporary examples of fiduciary media.
Cryptocurrencies As Money
In recent years, digital currencies that do not exist in physical form, such as Bitcoin, have been introduced. Unlike electronic bank records or payment systems, these virtual currencies are not issued by a government or other central body. Cryptocurrencies have some of the properties of money and are sometimes used in online transactions.
Although cryptocurrencies are rarely used in everyday transactions, they have achieved some utility as a speculative investment or a store of value. Some jurisdictions have recognized cryptocurrencies as a payment medium, including the government of El Salvador.
What Are the 4 Types of Money?
Money can be something determined by market participants to have value and be exchangeable. Money can be currency (bills and coins) issued by a government. A third type of money is fiat currency, which is fully backed by the economic power and good faith of the issuing government. The fourth type of money is money substitutes, which are anything that can be exchanged for money at any time. For example, a check written on a checking account at a bank is a money substitute.
What Is the Difference Between Hard and Soft Money?
Hard money is money that is based on a valuable commodity, such as gold or silver. Since the supply of these metals is limited, these currencies are less susceptible to inflation than soft money such as printed banknotes. With no guarantee that extra notes will not be printed, soft money may be considered risky by some.
Is Cryptocurrency Money?
Cryptocurrency has many of the properties of money and is sometimes used as a medium of exchange for transactions. Many governments consider cryptocurrency to be a taxable asset, but very few give it the same legal treatment as a foreign currency. Some jurisdictions, notably El Salvador, have embraced cryptocurrency.
The Bottom Line
Money is some item of value that allows people and institutions to engage in transactions that result in an exchange of goods or services.
Money has to be exchangeable, convenient to carry, recognized as legitimate by all, physically long-lasting, and have a value that's stable.
Money comes in various forms, including precious metals, currencies, and money substitutes. At this time, though cryptocurrencies have some of the properties of money, they function without a central authority and aren't backed by governments. While cryptocurrencies (such as Bitcoin) are considered property for tax purposes by the IRS, they aren't considered legal tender by the U.S. government.
