Types of Money

What’s the difference between gold and cash as a type of money? Why do we use cash and not other types of money to perform transactions? Who says that the dollar you have in your pocket is valuable? You will know a lot more about these questions after reading our article on the types of money.

Types of money and monetary aggregates

Money has always been used regardless of the form. Additionally, money has had the same functions and characteristics throughout time. The main types of money include fiat money, commodity money, fiduciary money, and commercial banks money. Some of these types of money serve an important role in the economy, which is to measure the aggregate supply of money.

The Federal Reserve (commonly known as the Fed) uses monetary aggregates to measure the money supply in the economy. Monetary aggregates measure the amount of money that circulates in the economy.

There are two types of monetary aggregates used by the Fed: M1 and M2 monetary aggregates.

M1 aggregates consider the money in its most basic form, the currency that circulates in an economy, checkable bank deposits, and traveler's checks.

M2 aggregates include all the money supply M1 covers and add some other assets such as saving accounts and time deposits. These additional assets are known as near-money and are not as liquid as those covered by the M1.

You also have M0, which is the monetary base in an economy, which covers the entire currency that is either at the hands of the public or in bank reserves. Sometimes, M0 is also labeled as MB. M0 is included in M1 and M2.

In contrast to a currency backed by gold, which has inherent value due to the need for gold in jewelry and ornamentation, fiat money can decline in value and can even become worthless.

Commodity money and its importance

Fig 1. - Gold Coin

Commodity money is a medium exchange with intrinsic value due to its use for purposes other than money. Examples of this include gold like the one in Figure 1 and silver. There will always be a demand for gold as it can be used in jewelry, making computers, Olympic medals, etc. Furthermore, gold is durable, which adds even more value to it. It is hard for gold to lose its function or decay with time.

You can think of commodity money as a good that can be used as money.

Other examples of goods that have been used as commodity money include copper, corns, tea, shells, cigarettes, wine, etc. Several forms of commodity money were employed relative to the needs that certain economic circumstances created.

Although the use of commodity money has been historically wide in conducting trade between countries, especially using gold, it makes it significantly hard and inefficient to perform transactions in the economy. One main reason for that is the transportation of these goods that will serve as a medium of exchange. Imagine how hard it is to move gold worth millions of dollars around the world. It is pretty costly to arrange the logistics and transportation of large bars of gold. Moreover, it can be risky as it could be hijacked or stolen.

Representative money with examples

Representative money is a type of money that is issued by the government and backed by commodities such as precious metals like gold or silver. The value of this type of money is directly linked to the value of the asset that is backing the money.

Representative money has been around for a long time. Furs and agricultural commodities such as maize were employed in trade transactions throughout the 17th and early 18th centuries.

Before 1970, the world was governed by the gold standard, which allowed people to swap the currency they owned for gold at any time. Countries that adhered to the gold standard established a fixed price for gold and traded gold at that price, therefore maintaining the gold standard. The value of the currency was determined based on the fixed price established.

The difference between fiat money and representative money is that fiat money's value depends on its demand and supply. In contrast, the value of representative money depends on the value of the asset that it is backed by.

Furthermore, if individuals lose confidence in a country's currency, the money will no longer have any purchasing power.

Fiduciary money with examples

Fiduciary money is a type of money that gets its value from both parties accepting it as a medium of exchange in a transaction. Whether fiduciary money is worth anything is decided by the anticipation that it will be widely recognized as a future means of trade.

Because it has not been recognized as legal tender by the government, as opposed to fiat money, individuals are not obligated to accept it as a form of payment under the law as a result. Instead, if the bearer demands it, the issuer of fiduciary money offers to swap it for a commodity or fiat money at the issuer's discretion. People may use fiduciary money in the same way as conventional fiat or commodity money, as long as they are convinced that the guarantee will not be breached.

Commercial bank money and its importance

Commercial bank money refers to money in an economy that is created through debt issued by commercial banks. Banks take client deposits into savings accounts and then loan a portion to other clients. The reserve requirement ratio is the portion banks cannot lend to different clients from their savings accounts. The lower the reserve requirement ratio, the more funds will be loaned to other people, creating commercial bank money.

Commercial bank money is important because it helps create liquidity and funds in an economy. It ensures that the money deposited in saving accounts is efficiently used to generate more funds in the economy that could be used for investment and development.

Consider what happens when Lucy visits Bank A, and she deposits $1000 dollars in her checking account. Bank A can keep $100 aside and use the rest to lend it to another client, John. The reserve requirement, in this case, is 10% of the deposit. John then uses the $900 to purchase an iPhone from another customer, Betty. Betty then deposits the $900 into Bank A.

The table below shows all the transactions that Bank A has had to help us keep track of them. This table is called the bank's T-account.

All in all, $1900 is traveling around in circulation, having started with only $1000 in fiat money. Since both M1 and M2 include checkable bank deposits. The money supply increases by $900 in this example. The additional $900 has been generated as debt by the bank and reflects commercial bank money.