Money is any object that is generally accepted as
payment for
goods and services and repayment of
debts in a given country or socio-economic context.
[1][2] The main functions of money are distinguished as: a
medium of exchange; a
unit of account; a
store of value; and, occasionally, a
standard of deferred payment.
[3][4]
Money originated as
commodity money, but nearly all contemporary money systems are based on
fiat money.
[3] Fiat money is without intrinsic
use value as a physical commodity, and derives its value by being declared by a government to be
legal tender; that is, it must be accepted as a form of payment within the boundaries of the country, for "all debts, public and private".
The
money supply of a country consists of
currency (banknotes and coins) and
demand deposits or 'bank money' (the balance held in
checking accounts and
savings accounts). These
demand deposits usually account for a much larger part of the money supply than currency.
[5][6] Bank money is intangible and exists only in the form of various bank records. Despite being intangible, bank money still performs the basic functions of money, being generally accepted as a form of payment.
[7]
History
The use of
barter-like methods may date back to at least 100,000 years ago, though there is no evidence of a society or economy that relied primarily on barter.
[8] Instead, non-monetary societies operated largely along the principles of
gift economics. When barter did occur, it was usually between either complete strangers or potential enemies.
[9]
Many cultures around the world eventually developed the use of
commodity money. The
shekel was originally a unit of weight, and referred to a specific weight of
barley, which was used as currency.
[10]. The first usage of the term came from
Mesopotamia circa 3000 BC. Societies in the Americas, Asia, Africa and Australia used
shell money – often, the shells of the money
cowry (
Cypraea moneta L. or
C. annulus L.). According to
Herodotus, the
Lydians were the first people to introduce the use of gold and
silver coins.
[11] It is thought by modern scholars that these first stamped
coins were minted around 650–600 BC.
[12]
The system of
commodity money eventually evolved into a system of
representative money.
[citation needed] This occurred because gold and silver merchants or banks would issue receipts to their depositors – redeemable for the
commodity money deposited. Eventually, these receipts became generally accepted as a means of payment and were used as money. Paper money or
banknotes were first used in
China during the
Song Dynasty. These banknotes, known as "
jiaozi" evolved from
promissory notes that had been used since the 7th century. However, they did not displace commodity money, and were used alongside coins. Banknotes were first issued in Europe by
Stockholms Banco in 1661, and were again also used alongside coins. The
gold standard, a
monetary system where the medium of exchange are paper notes that are convertible into pre-set, fixed quantities of gold, replaced the use of gold coins as currency in the 17th-19th centuries in Europe. These gold standard notes were made
legal tender, and redemption into gold coins was discouraged. By the beginning of the 20th century almost all countries had adopted the gold standard, backing their legal tender notes with fixed amounts of gold.
After
World War II, at the
Bretton Woods Conference, most countries adopted fiat currencies that were fixed to the
US dollar. The US dollar was in turn fixed to gold. In 1971 the US government suspended the convertibility of the US dollar to gold. After this many countries de-pegged their currencies from the US dollar, and most of the world's currencies became unbacked by anything except the governments' fiat of legal tender.
Etymology
The word "money" is believed to originate from a temple of
Hera, located on
Capitoline, one of Rome's seven hills. In the ancient world Hera was often associated with money. The temple of
Juno Moneta at Rome was the place where the mint of Ancient Rome was located.
[13] The name "Juno" may derive from the Etruscan goddess
Uni (which means "the one", "unique", "unit", "union", "united") and "Moneta" either from the Latin word "monere" (remind, warn, or instruct) or the Greek word "moneres" (alone, unique).
In the Western world, a prevalent term for coin-money has been
specie, stemming from Latin
in specie, meaning 'in kind'.
[14]
Functions
In the past, money was generally considered to have the following four main functions, which are summed up in a
rhyme found in older economics textbooks: "Money is a matter of functions four, a
medium, a
measure, a
standard, a store." That is, money functions as a
medium of exchange, a
unit of account, a
standard of deferred payment, and a
store of value.
[4] However, most modern textbooks now list only three functions, that of
medium of exchange,
unit of account, and
store of value, not considering a standard of deferred payment as a distinguished function, but rather subsuming it in the others.
[3][15][16]
There have been many historical disputes regarding the combination of money's functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. One of these arguments is that the role of money as a
medium of exchange is in conflict with its role as a
store of value: its role as a store of value requires holding it without spending, whereas its role as a medium of exchange requires it to circulate.
[4] Others argue that storing of value is just deferral of the exchange, but does not diminish the fact that money is a medium of exchange that can be transported both across space and time.
[17] The term 'financial capital' is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender.
Medium of exchange
When money is used to intermediate the exchange of goods and services, it is performing a function as a
medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the '
double coincidence of wants' problem.
Unit of account
A
unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt. To function as a 'unit of account', whatever is being used as money must be:
- Divisible into smaller units without loss of value; precious metals can be coined from bars, or melted down into bars again.
- Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is why diamonds, works of art or real estate are not suitable as money.
- A specific weight, or measure, or size to be verifiably countable. For instance, coins are often milled with a reeded edge, so that any removal of material from the coin (lowering its commodity value) will be easy to detect.
Store of value
Main article:
Store of valueTo act as a
store of value, a money must be able to be reliably saved, stored, and retrieved – and be predictably usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time. In that sense,
inflation by reducing the value of money, diminishes the ability of the money to function as a store of value.
[3]
Standard of deferred payment
While
standard of deferred payment is distinguished by some texts,
[4] particularly older ones, other texts subsume this under other functions.
[3][15][16] A "standard of deferred payment" is an accepted way to settle a
debt – a unit in which debts are denominated, and the status of money as
legal tender, in those jurisdictions which have this concept, states that it may function for the discharge of debts. When debts are denominated in money, the real value of debts may change due to
inflation and
deflation, and for sovereign and international debts via
debasement and
devaluation.
Money supply
Main article:
Money supplyIn economics, money is a broad term that refers to any
financial instrument that can fulfill the functions of money (detailed above). These financial instruments together are collectively referred to as the
money supply of an economy. Since the money supply consists of various financial instruments (usually currency, demand deposits and various other types of deposits), the amount of money in an economy is measured by adding together these financial instruments creating a
monetary aggregate. Modern monetary theory distinguishes among different types of monetary aggregates, using a categorization system that focuses on the liquidity of the financial instrument used as money.
Market liquidity
Market liquidity describes how easily an item can be traded for another item, or into the common currency within an economy. Money is the most liquid asset because it is universally recognised and accepted as the common currency. In this way, money gives consumers the
freedom to trade goods and services easily without having to barter.
Liquid financial instruments are easily
tradable and have low
transaction costs. There should be no (or minimal)
spread between the prices to buy and sell the instrument being used as money.
Measures of money
The money supply is the amount of financial instruments within a specific economy available for purchasing goods or services. The money supply is usually measured as three escalating categories M1, M2 and M3. The categories grow in size with M1 being currency (coins and bills) and checking account deposits. M2 is currency, checking account deposits and savings account deposits, and M3 is M2 plus
time deposits. M1 includes only the most liquid financial instruments, and M3 relatively illiquid instruments.
Another measure of money, M0, is also used, although unlike the other measures, it does not represent actual
purchasing power by firms and households in the economy. M0 is
base money, or the amount of money actually issued by the
central bank of a country. It is measured as currency plus deposits of banks and other institutions at the central bank. M0 is also the only money that can satisfy the
reserve requirements of
commercial banks.
Types of money
Currently, most modern monetary systems are based on fiat money. However, for most of history, almost all money was commodity money, such as gold and silver coins. As economies developed, commodity money was eventually replaced by
representative money, such as the
gold standard, as traders found the physical transportation of gold and silver burdensome. Fiat currencies gradually took over in the last hundred years, especially since the breakup of the
Bretton Woods system in the early 1970s.
Commodity money
Many items have been used as
commodity money such as naturally scarce
precious metals,
conch shells,
barley, beads etc., as well as many other things that are thought of as having
value. Commodity money value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity.
[18] Examples of commodities that have been used as mediums of exchange include
gold,
silver,
copper,
rice, salt, peppercorns, large stones, decorated belts, shells, alcohol, cigarettes, cannabis, candy, etc. These items were sometimes used in a metric of perceived value in conjunction to one another, in various commodity valuation or
Price System economies. Use of commodity money is similar to barter, but a commodity money provides a simple and automatic
unit of account for the commodity which is being used as money. Although some
gold coins such as the
Krugerrand are considered
legal tender, there is no record of their face value on either side of the coin. The rationale for this is that emphasis is laid on their direct link to the prevailing value of their
fine gold content.
[19] American Eagles are imprinted with their gold content and legal tender
face value.
[20]
Representative money
In 1875 economist
William Stanley Jevons described what he called "
representative money," i.e., money that consists of
token coins, or other physical tokens such as certificates, that can be reliably exchanged for a fixed quantity of a commodity such as
gold or
silver. The value of representative money stands in direct and fixed relation to the commodity that backs it, while not itself being composed of that commodity.
[21]
Fiat money
Fiat money or fiat currency is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has value only by government order (fiat). Usually, the government declares the fiat currency (typically notes and coins from a central bank, such as the
Federal Reserve System in the U.S.) to be
legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, public and private.
[22][23]
Some
bullion coins such as the
Australian Gold Nugget and
American Eagle are legal tender, however, they trade based on the
market price of the metal content as a
commodity, rather than their legal tender
face value (which is usually only a small fraction of their bullion value).
[20][24]
Fiat money, if physically represented in the form of currency (paper or coins) can be accidentally damaged or destroyed. However, fiat money has an advantage over representative or commodity money, in that the same laws that created the money can also define rules for its replacement in case of damage or destruction. For example, the U.S. government will replace mutilated
Federal Reserve notes (U.S. fiat money) if at least half of the physical note can be reconstructed, or if it can be otherwise proven to have been destroyed.
[25] By contrast, commodity money which has been lost or destroyed cannot be recovered.
Commercial bank money
Main article:
Demand depositCommercial bank money or
demand deposits are claims against financial institutions that can be used for the purchase of goods and services. A demand deposit account is an account from which funds can be withdrawn at any time by check or cash withdrawal without giving the bank or financial institution any prior notice. Banks have the legal obligation to return funds held in demand deposits immediately upon demand (or 'at call'). Demand deposit withdrawals can be performed in person, via checks or bank drafts, using
automatic teller machines (ATMs), or through
online banking.
[26]
Commercial bank money is created through
fractional-reserve banking, the banking practice where
banks keep only a
fraction of their
deposits in
reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand.
[27][28] Commercial bank money differs from commodity and fiat money in two ways, firstly it is non-physical, as its existence is only reflected in the account ledgers of banks and other financial institutions, and secondly, there is some element of risk that the claim will not be fulfilled if the financial institution becomes insolvent. The process of fractional-reserve banking has a cumulative effect of
money creation by commercial banks, as it expands
money supply (cash and demand deposits) beyond what it would otherwise be. Because of the prevalence of fractional reserve banking, the
broad money supply of most countries is a multiple larger than the amount of
base money created by the country's
central bank. That multiple (called the
money multiplier) is determined by the
reserve requirement or other
financial ratio requirements imposed by financial regulators.
The
money supply of a country is usually held to be the total amount of currency in circulation plus the total amount of checking and savings deposits in the commercial banks in the country.
Monetary policy
When gold and silver are used as money, the money supply can grow only if the supply of these metals is increased by mining. This rate of increase will accelerate during periods of
gold rushes and discoveries, such as when Columbus discovered the new world and brought back gold and silver to Spain, or when gold was
discovered in California in 1848. This causes inflation, as the value of gold goes down. However, if the rate of
gold mining cannot keep up with the growth of the economy, gold becomes relatively more valuable, and prices (denominated in gold) will drop, causing deflation. Deflation was the more typical situation for over a
century when gold and paper money backed by gold were used as money in the 18th and 19th centuries.
Modern day monetary systems are based on fiat money and are no longer tied to the value of gold. The control of the amount of money in the economy is known as monetary policy. Monetary policy is the process by which a
government, central bank, or
monetary authority manages the
money supply to achieve specific goals. Usually the goal of monetary policy is to accommodate
economic growth in an environment of stable prices. For example, it is clearly stated in the
Federal Reserve Act that the
Board of Governors and the
Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
[29]
A failed monetary policy can have significant detrimental effects on an economy and the society that depends on it. These include
hyperinflation,
stagflation,
recession, high
unemployment, shortages of imported goods, inability to export goods, and even total monetary collapse and the adoption of a much less efficient barter economy. This happened in Russia, for instance, after the
fall of the Soviet Union.
Governments and central banks have taken both regulatory and
free market approaches to monetary policy. Some of the tools used to control the money supply include:
In the US, the
Federal Reserve is responsible for controlling the money supply, while in the
Euro area the respective institution is the
European Central Bank. Other central banks with significant impact on global finances are the
Bank of Japan,
People's Bank of China and the
Bank of England.
For many years much of monetary policy was influenced by an
economic theory known as monetarism.
Monetarism is an economic theory which argues that management of the money supply should be the primary means of regulating economic activity. The stability of the demand for money prior to the 1980s was a key finding of
Milton Friedman and
Anna Schwartz[30] supported by the work of
David Laidler,
[31] and many others. The nature of the demand for money changed during the 1980s owing to technical, institutional, and legal factors and the influence of monetarism has since decreased.
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