What Is Money?
Money is any item or medium of exchange that symbolizes perceived value. As a result, it is accepted by people for the payment of goods and services, as well as for the repayment of loans. Economies rely on money to facilitate transactions and to power financial growth.
Key Takeaways
- Money is a medium of exchange. It allows people and businesses to obtain what they need to live and thrive.
- Bartering was one way that people exchanged goods for other goods before money was created.
- Like gold and other precious metals, money has worth because it represents something valuable.
- Fiat money is government-issued currency that is not backed by a physical commodity but by the stability of the issuing government.
- Above all, money is a unit of account – a socially accepted standard unit with which things are priced.
Medium of Exchange
Before the development of a medium of exchange—that is, 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.
The Myth of Barter
Keep in mind that this situation is only a hypothetical model used to understand our modern economic system. In reality, there is no anthropological proof of such a barter economy existing in the past yet.
Commodity money solved these problems. Commodity money is a type of good that functions as currency. In the 17th and early 18th centuries, for example, American colonists used beaver pelts and dried corn in transactions.1 Possessing generally accepted values, these commodities were used to buy and sell other things. The commodities used for trade had certain characteristics: they were widely desired and, therefore, valuable, but they were also durable, portable, and easily stored.
This relationship between money and gold provides 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 not require backing by a physical commodity. Instead, the value of fiat currencies is set by supply and demand as well as people’s faith in its worth. Fiat money developed because gold was a scarce resource, and rapidly growing economies growing couldn’t always mine enough to back their currency supply requirements.3 For a booming economy, the need for gold to give money value is extremely inefficient, especially when its value is really created by people’s perceptions.
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 succeeding in producing other things that are valuable to itself and other economies. The stronger the economy, the stronger its money will be perceived (and sought after) and vice versa. However, people’s perceptions must be supported by an economy that can produce the products and services that people want.
Today, 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 real, tangible things, our desire for them, and our abstract faith in what has value. Hence, money is valuable because it can get us a desired product or service.
How Is Money Measured?
Exactly how much money is out there, and what forms does it take? Economists and investors ask this question to determine whether there is inflation or deflation. Money is separated into three categories so that it is more discernible for measurement purposes:
- 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. It also includes other forms of liquid deposits and assets such as savings accounts. This category of money is the narrowest of the three. It is essentially the money used to buy things and make payments (see the “active money” section below).
- M2 – With a broader criteria, this category adds all the money found in M1 to all time-related deposits, many types of retirement accounts, and non-institutional money market funds. This category represents money that can be readily transferred into cash.5
- 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. M3 indicates a country’s money supply or the total amount of money within an economy.6
Active Money
The M1 category includes what’s known as active money—the total value of coins and paper currency in circulation as well as liquid deposits and accounts.5 The amount of active money fluctuates seasonally, monthly, weekly, and daily. In the United States, Federal Reserve Banks distribute new currency for the U.S. Treasury Department. Banks lend money out to customers, which becomes active money once it is actively circulated.
The variable demand for cash equates to a constantly fluctuating active money total. For example, people typically cash paychecks or withdraw from ATMs over the weekend so there is more active cash on a Monday than on a Friday. The public demand for cash declines at certain times—following the December holiday season, for example.
How Money Is Created
We have discussed why and how money, a representation of perceived value, is created in the economy, but another important factor concerning money and the economy is how a country’s central bank can influence and manipulate the money supply.
If the Federal Reserve (Fed), the United States’ central bank, wants to increase the amount of money in circulation, perhaps to boost economic activity, the central bank can, of course, print it. However, the physical bills are only a small part of the money supply.
Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market. When the central bank buys these government securities, it puts money into the marketplace, and effectively into the hands of the public. How does a central bank, such as the Fed, pay for this? As strange as it sounds, the central bank simply creates the money and transfers it to those selling the securities.7 Alternatively, the Fed can lower interest rates allowing banks to extend low-cost loans or credit—a phenomenon known as cheap money—and encouraging businesses and individuals to borrow and spend.
To shrink the money supply, perhaps to reduce inflation, the central bank does the opposite and sells government securities. The money with which the buyer pays the central bank is essentially taken out of circulation.
Keep in mind that these examples are generalized to keep things simple.
A central bank cannot print money without end. If too much money is issued, the value of that currency will drop consistent with the law of supply and demand.
Remember, as long as people have faith in the currency, a central bank can issue more of it. But if the Fed issues too much money, the value will go down, as with anything that has a higher supply than demand. Therefore, the central bank cannot simply print money as it wants.
The History of American Money
Currency Wars
In the 17th century, Great Britain was determined to keep control of both the American colonies and the natural resources they controlled. To do this, the British limited the money supply and made it illegal for the colonies to mint coins of their own. Instead, the colonies were forced to trade using English bills of exchange that could only be redeemed for English goods. Colonists were paid for their goods with these same bills, effectively cutting them off from trading with other countries.
In response, the colonies regressed to a barter system using ammunition, tobacco, nails, pelts, and anything else that could be traded. Colonists also gathered whatever foreign currencies they could, the most popular being the large, silver Spanish dollars. These were called pieces of eight because, when you had to make change, you pulled out your knife and hacked it into eight bits. From this, we have the expression “two bits,” meaning a quarter of a dollar.89
Massachusetts Money
Massachusetts was the first colony to defy the mother country. In 1652, the state minted its own silver coins, including the Oak Tree and Pine Tree shillings. The state circumvented the British law, which stated that only the monarch of the British empire could issue coins, by dating all their coins in 1652, a period when there was no monarch.10Â In 1690, Massachusetts also issued the first paper money calling it bills of credit.9
Tensions between America and Britain continued to mount until the Revolutionary War broke out in 1775. The colonial leaders declared independence and created a new currency called Continentals to finance their side of the war. Unfortunately, each government printed as much money as it needed without backing it to any standard or asset, so the Continentals experienced rapid inflation and became worthless. This experience discouraged the American government from using paper money for almost a century.11
Aftermath of the Revolution
The chaos from the Revolutionary War left the new nation’s monetary system a complete wreck. Most of the currencies in the newly formed United States of America were useless. The problem wasn’t resolved until 13 years later, in 1788, when Congress was granted constitutional powers to coin money and regulate its value. In 1792, the Coinage Act was passed, establishing the first national mint which created a national monetary system and unit of money, the dollar.12Â There was also a bimetallic standard, meaning that both silver and gold could be valued in and used to back paper dollars.13
It took years to get all the foreign coins, as well as competing state and local bank currencies, out of circulation. Banks issued their own notes during this time period, which was technically illegal as only Congress and the federal government had this power. Most of these banks issued more notes than they had coin to cover. As a result, these notes often traded at less than face value.1415
The Civil War
In the 1860s, the U.S. government created $450 million in legal tender to finance its battle against the Confederacy in the American Civil War.16 These were called greenbacks because their backs were printed in green. The government backed this currency and stated that it could be used to pay back both public and private debts. The value did, however, fluctuate according to the North’s success or failure at certain stages in the war.1517
Confederate dollars, issued by the seceding states during the 1860s, followed the fate of the Confederacy and were worthless by the end of the war.18
Aftermath of the Civil War
In February 1863, the U.S. Congress passed the National Bank Act. This act established a monetary system whereby national banks issued notes backed by U.S. government bonds. The U.S. Treasury then worked to get state bank notes out of circulation so that the national bank notes would become the only currency.19
During this period of rebuilding, there was debate over the bimetallic standard. Some advocated using just silver to back the dollar, while others advocated for gold. The situation was resolved in 1900 when the Gold Standard Act was passed, which made gold the sole backing for the dollar. This backing meant that, in theory, you could take your paper money and exchange it for the corresponding value in gold. In 1913, the Federal Reserve was created and given the power to steer the economy by controlling the money supply and interest rates on loans.20
