Money is something that we think about every day and it is a huge part of our existence, yet somehow most of us don't know the full definition of it, what all of its functions are, and why it even has so much power over us all. The full extent of what money is, all its different forms and purposes might surprise you! If you are interested in learning more about money, you've come knocking at the right door! Now, let's take a look.
What is Money?
Money, in its simplest form, is a tool that facilitates the exchange of goods and services. It acts as a universally accepted medium of exchange that allows us to buy a loaf of bread, book a holiday, or even purchase a house, without needing to barter. So, instead of trading your home-grown tomatoes for a haircut, you simply hand over some money!
Bartering is when parties exchange goods without using money but choose which goods to exchange based on their intrinsic values.
Definition of Money
Let's take a look at economic definition of money:
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context.
Imagine you're an artist who paints beautiful canvases. Your neighbor loves your work and wants a painting, but all she has to trade are guitar lessons, and you don't have an interest in learning guitar. So, instead of you two being at a standstill, she gives you money for your painting. You can then use this money to buy something you do want, like piano lessons from someone else.
Currency vs Money
Money and currency often seem interchangeable, but they hold unique roles in the economic system. Think of money as a concept: it's a medium of exchange that allows us to purchase goods and services without needing to swap items directly. On the other hand, currency is a physical representation of money, like coins and bills, that a government has declared legal tender.
Currency refers to the physical notes and coins that are in circulation and recognized by a society as a medium of exchange.
There are also two groups that money is split into. We call these groups M1 and M2. M1 is composed of actual currency, which is paper money and coins, and checkable deposits which are deposits made into commercial banks into either checking or savings accounts that can be withdrawn. M2 includes M1 and near-monies which are assets that are highly liquid that cannot be used as money directly but can be converted into usable money rather quickly.
Fig 1. Components of M1 and M2
Economics of Money
The economics of money, also known as monetary economics, is a branch of economics that examines the various theories behind money, and how money functions. The economics of money looks into the different types of money and how it works as a form of compensation. It also examines how monetary policy affects the economy and can be used to improve efficiency. A goal of monetary policy is to help an economy maintain stability, grow, and develop. Money is an important factor in the economy not just from an economic standpoint but also from a personal one. It is economically important because it pushes economic growth and stimulates the economy to be more productive. On a personal level, it allows society to purchase what it needs such as food, shelter, and healthcare.
To learn more about monetary policy, check out our explanation - Monetary Policy
Characteristics of Money
The characteristics of money are what give money its value. In this case, money is currency. The three main characteristics are its acceptability, its status as legal tender, and its relative scarcity. The benefit of money is that it is portable and replaces the need to carry around tradable goods such as gold, furs, or spices which are heavy and can go bad over time. Having a paper note or lighter coin that has a standardized value and is widely accepted makes trading infinitely easier. This standardized value also means that it can be easily divided into smaller units of account such as halves, quarters, fifths, and tenths.
Acceptability
The acceptance of cash or checkable deposits as compensation or money is partially what gives it its value. Acceptance is the first step to legitimizing anything as money because if a government or a society does not want to accept the money as payment, this suggests that it does not hold value or at least is not in a form that is acceptable to them.
An example of acceptability would be when you are paying at the grocery store, they accept cash, credit or debit card, or food stamps. However, if you went in with the title to your car or a gold ring they would have a hard time accepting it because it is not liquid currency. No doubt both of these items hold value, but they are not accepted as currency.
Legal Tender
The second characteristic of money is its use as legal tender. This is when money has been backed by a government as a legal form of payment for any personal or private debts. This adds to the credibility and acceptability of money. U.S. Dollars all have the phrase, "this note is legal tender for all debts, public and private," written on them.
Another characteristic of money is its relative scarcity. Money also follows the rules of supply and demand. The amount of money demanded is determined by the volume of transactions conducted in the economy and by the amount of money people want to hold as savings. With a consistent level of demand, the amount of money supplied will determine the value of money. There is no unlimited supply of money, it is supplied based on the level of purchasing power that the authorities want it to have.
To learn more about how money is supplied, check out our explanation - Money Supply
Uses of Money
The uses of money are determined by the various tasks required to complete. There are six main uses or functions of money:
Medium of Exchange
A medium of exchange is an instrument used to facilitate the exchange of goods and services. Money is a medium of exchange because it allows one party to compensate another without the complication of bartering.
Store of Value
Money is a store of value because people can hold on to it for the future and expect it to maintain its value. Providing that inflation is low or nonexistent, storing wealth in the form of money is considered risk-free.
Unit of Account
Money allows us to state wealth in terms of a monetary unit rather than the goods owned or produced. We can use the units of money to record the numerical value of goods to compare them to other goods that would otherwise be difficult to compare, such as a car to 1 year of private school.
Measure of Value
Money can serve to quantify the value of a good or service, and it makes it easier to compare the value of incomparable goods, such as an apple to a gallon of gas.
Basis of Credit
Since money can be used to make purchases, it can also be loaned out. If goods had to be compensated for immediately, people would have a lot harder time making large purchases like houses and cars. Other goods could be loaned out or used to repay a loan, but it would be much more complicated because those goods may not be uniform.
Standard of Postponed Payment
This is similar to money being a basis of credit and money being a medium of exchange. For more expensive purchases, money can be paid in instalments over time, and the payment over time won't become a burden to the lender or the borrower. For example, A florist agrees to provide one bouquet every week for six months to get his house painted. After two months, the painter doesn't want any more bouquets but still requires compensation.
Money is used all around the world for many different reasons. The uses mentioned in Table 1 are the formal uses that we learn in economics. If we want to learn about the uses of money in a more personal way we can look at how we use money in our own lives. Most people interact with money in one form or another every day. We may go to work and earn a wage. We need to go grocery shopping and buy food. Maybe, we stopped at the corner store to buy a candy bar for $1 or we borrowed $10 from a friend that we have to pay them back for today. We earn, spend, and save money nearly every day of our lives.
Money is useful for completing all of these tasks of daily life since it simplifies exchanges and interactions by being a medium of exchange when buying goods and services. It is a store of value when we drop our change into our piggy bank. It is a store of value and unit of account when we take our wages to the grocery store to buy food.
Classification of Money
There are four categories of money. They are fiat money, commodity money, fiduciary money, and commercial bank money. Depending on a nation's economic and political system, the society uses the types of money that best suit their transactions.
| Types of Money | Definition |
| Fiat Money | Fiat money is entirely backed by government orders rather than a physical good. It gets its status as a medium of exchange because the government declared it an official means of payment. |
| Commodity Money | This is money that is an actual commodity that has value outside of being a medium of exchange. Commodity money can be precious metals, gemstones, spices, and even coffee. |
| Fiduciary Money | This is money that is based on trust rather than the intrinsic value of the money itself with no government backing. This form of payment relies on the trust or promise that it will be accepted as a form of payment. |
| Commercial Bank Money | This is money in the economy in the form of debt created by commercial banks. Banks loan out money based on the fiat money their customers deposited to other customers to earn interest. |
Table 2 - Types of Money
Of the different types of money, fiat money and commercial bank money are what the modern world is most familiar with since they are what are currently in use in developed nations such as the U.S. and European countries. Commodity money was often used in the past when societies were moving away from strict bartering systems and moving toward more convenient ways to engage in trade.
Example of Money
Let's take a look at an example of money. There are many different shapes and forms that money can take all around the world. Different nations use different currencies to represent their nation's wealth.
In the United States, the currency used is the United States Dollar. It comes as both paper notes and coins, the paper notes being mostly uniform in size and color but with varying designs intended to indicate the values they are representing such as $1.00, $5.00, $10.00, $50.00, or $100.00. The coins are more unique in their composition of metals and sizes such as zinc, nickel, and copper.
The United States is not the only country that uses its currency. Several countries like Ecuador, Panama, and Puerto Rico use the U.S. Dollar instead of a unique currency because the U.S. Dollar is stable and backed by a stronger economy, providing those nations with stability. Other nations choose to band together to share a currency to achieve a more stable economy with their common trading partners and promote collective economic growth and integration. An example of this would be the Eurozone.
The Euro Zone is a collection of 19 countries collectively agreeing to use the same currency: The Euro. This expedites and simplifies trade between the nations of the Eurozone which provides stability and an opportunity for economic growth. The Euro comes in denominations of €5.00, €10.00, €20.00, €50.00, €100.00, €200.00, and €500.00 (although the €500 notes are no longer issued). There are €1.00 and €2.00 coins, along with 1, 2, 5, 10, 20, and 50 cent coins.
Money - Key takeaways
- Money is any asset or item that can be used as a medium of exchange to make purchases while the currency is the actual paper note or coins that are used to represent money.
- Three characteristics that make money or currency valuable are its acceptability, its use as legal tender, and its relative scarcity.
- The main uses of money are as a medium of exchange, a unit of account, and a store of value.
- The four types of money are fiat money, commodity money, fiduciary money, and commercial bank money.
- An example of currency is the U.S. Dollar and the Euro used among the 19 countries of the Eurozone.
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