Everyone uses money. We all want it, work for it and think about it. While the creation and growth of money seems somewhat intangible, money is the way we get the things we need and desire. The task of defining what money is, where it comes from and what it’s worth belongs to those who dedicate themselves to the discipline of economics. Here we look at the multifaceted characteristics of money.
Medium of Exchange
Before the development of a medium of exchange – i.e., money – people would barter to obtain the goods and services they needed. Two individuals, each possessing some goods the other wanted, would enter into an agreement to trade.
This early form of barter, however, does not provide the transferability and divisibility that makes trading efficient. For instance, if you have cows but need bananas, you must find someone who not only has bananas but also the desire for meat. What if you find someone who has the need for meat but no bananas and can only offer you bunnies? To get your meat, he or she must find someone who has bananas and wants bunnies…and so on.
The lack of transferability of bartering for goods, as you can see, is tiring, confusing and inefficient. But that is not where the problems end: Even if you find someone with whom to trade meat for bananas, you may not think a bunch of them is worth a whole cow. You would then have to devise a way to divide your cow (a messy business) and determine how many bananas you are willing to take for certain parts of your cow.
To solve these problems came commodity money: a type of good that functions as currency. In the 17th and early 18th centuries, for example, American colonialists used beaver pelts and dried corn in transactions; possessing generally accepted values, these commodities were used to buy and sell other things. The kinds of commodities used for trade had certain characteristics: They were widely desired and therefore valuable, but they were also durable, portable and easily storable.
Another, more advanced example of commodity money is a precious metal like gold – which for centuries was used to back paper currency up until the 1970s. In the case of the American dollar, for example, this meant that foreign governments were able to take their dollars and exchange them at a specified rate for gold with the U.S. Federal Reserve. What’s interesting is that, unlike the beaver pelts and dried corn (which can be used for clothing and food, respectively), gold is precious purely because people want it. It is not necessarily useful – after all, you can’t eat it, and it won’t keep you warm at night, but the majority of people think it is beautiful, and they know others think it is beautiful. So, gold is something you can safely believe has worth. Gold therefore serves as a physical token of wealth, based on people’s perception.
If we think about this relationship between money and gold, we can gain some insight into how money gains its value – as a representation of something valuable.
Impressions Create Everything
The second type of money is fiat money, which does away with the need for a physical commodity to back it. Instead, its value is set by supply and demand, and people’s faith in its worth. Fiat money developed because gold was a scarce resource and economies growing quickly couldn’t always mine enough to back their currency supply requirements. For a booming economy, the need for gold to give money value is extremely inefficient, especially when, as we already established, its value is really created through people’s perception.
Fiat money becomes the token of people’s perception of worth, the basis for why money is created. An economy that is growing is apparently doing a good job of producing other things that are valuable to itself and to other economies. Generally, the stronger the economy, the stronger its money will be perceived (and sought after) and vice versa. But, remember, this perception, although abstract, must somehow be backed by how well the economy can produce concrete things and services that people want.
For example, in 1971, the U.S. dollar was taken off the gold standard – the dollar was no longer redeemable in gold, and the price of gold was no longer fixed to any dollar amount. This meant that it was now possible to create more paper money than there was gold to back it; it was the health of the American economy that backs the dollar’s value. If the economy takes a nosedive, the value of the U.S. dollar will drop both domestically through inflation, and internationally through currency exchange rates. Fortunately, the implosion of the U.S. economy would plunge the world into a financial dark age, so many other countries and entities are working tirelessly to ensure that never happens.
Nowadays, the value of money (not just the dollar, but most currencies) is decided purely by its purchasing power, as dictated by inflation. That is why simply printing new money will not create wealth for a country. Money is created by a kind of a perpetual interaction between concrete things, our intangible desire for them, and our abstract faith in what has value. Money is valuable because we want it, but we want it only because it can get us a desired product or service.
How is Money Measured?
But exactly how much money is out there and what forms does it take? Economists and investors ask this question everyday to see whether there is inflation or deflation. To make money more discernible for measurement purposes, they have separated it into three categories:
M1 – This category of money includes all physical denominations of coins and currency; demand deposits, which are checking accounts and NOW accounts; and travelers’ checks. This category of money is the narrowest of the three; it’s essentially the money used to buy things and make payments (see the “active money” section, below).
M2 – With broader criteria, this category adds all the money found in M1 to all time-related deposits, savings accounts deposits, and non-institutional money market funds. This category represents money that can be readily transferred into cash.
M3 – The broadest class of money, M3 combines all money found in the M2 definition and adds to it all large time deposits, institutional money market funds, short-term repurchase agreements, along with other larger liquid assets.