Money has been central to human society for thousands of years. From seashells to precious metals, paper money to digital dots and even giant limestone wheels called lyons, money has existed in many forms. Despite its ubiquity, money can be a little hard to pin down. Learn more about what money is (and what it isn’t).
What is money?
Money is anything that has a recognized value that can act as a medium of exchange, often in the form of paper notes, coins, or digital money. A medium of exchange is a means used to buy and sell goods and services. Money also acts as a store of value for use in future transactions.
Money helps facilitate trade: in a barter system, you exchange goods directly (for example, exchanging a goat for a jar of oil), whereas in a monetary system, you exchange goods for accepted intermediate goods (for example, exchanging a goat for a certain amount of money, which you can later use to buy a jar of oil or other things).
Characteristics of money
In order for money to be exchanged for goods, it needs to have a widely accepted value. Money usually has several important characteristics that distinguish early money from the money used in modern economies.
Recognizable
For money to be widely accepted, it must be recognizable. Because the purchasing power of a currency comes from an agreed-upon value, it must be consistent and easily identifiable to be commonly accepted.
durability
Throughout history, money has been durable. Whether it be gold coins, silver coins, non-precious metal standardized coins, or even paper money, physical money needs to last long enough to represent and continue to store value. If money is not durable enough, it can lose value if users are unwilling to hold it or accept it as payment.
Substitutable
Money is fungible, or exchangeable, meaning that holders of the currency can trade and exchange it for another currency, a physical commodity, or something of equal or similar value.
Stable
Money is useful when its value is relatively stable. When a currency’s value fluctuates wildly, trust is eroded and its usefulness as a medium of exchange decreases. This is the main reason why cryptocurrencies, whose value fluctuates wildly, are of little use in everyday commerce.
portable
Physical money is portable and can be taken to many places. If money is too heavy or fragile to carry, it’s not very useful. Digital currency, which involves an electronic representation of money in an online checking account, works well if it can be accessed in many places.
The Function of Money
Money has three basic functions:
Medium of exchange
Money allows people to buy goods and services without having to immediately provide an equivalent product or service; instead, they can exchange money in lieu of physical goods.
Store of value
Money is a store of value because it maintains its purchasing power over time. For example, if you hold precious metals, you can be pretty sure that they will become more valuable in the future, so they act as a store of value. The same is true for dollars, euros, pesos, and yuan.
Unit of Calculation
Money is an expression of value or wealth. As a unit of account, it measures the amount of value or wealth held by an individual or business. It also helps measure profits and losses, determine the valuation of a business or asset, and facilitates comparisons of the value of goods and services.
Types of Money
As a functional medium of exchange, money comes in several varieties, both in form and underlying system. Most money falls into one of four categories:
Commodity currency
Money is determined by organic economic activity, and as a result, markets establish their own types of money based on scarce natural resources. For example, gold and other precious metals are accepted as valuable in markets and cultures around the world. Valuable goods such as salt, tools, and tobacco can become de facto currency in the marketplace, even without the backing of a government or institution.
Representative money
Representative money (in the form of paper money or physical banknotes) is money that is backed by a commodity that has value but has no value in itself.
For example, under the gold standard, money was backed by gold, a valuable commodity, so every dollar bill printed or coin minted contained an equivalent amount of gold held by the government that printed it. In this system, money is a representation of an existing commodity. Many countries have abandoned the gold standard and now issue fiat currency.
Fiat currency
Fiat currency is another type of government-issued currency, but it is not backed by any physical value such as gold or silver. Instead, the value of fiat currency is backed by the government that issues it. The value of fiat currency is determined by the stability and widespread trust in the government that issues it. Both fiat currency and government-issued paper money backed by physical assets can be designated as legal tender and are guaranteed to be accepted by all government institutions.
Trust money
Have you ever written a check? Then you have used a money substitute, or trust money. A money substitute is a convenient alternative to carrying large amounts of cash. For example, a check is an accepted substitute for money that will be given to you later.
The advantages of trust money are its convenience and portability, but it also carries risks because you may create or receive fiduciary funds that promise more than the amount backing the fiduciary funds (for example, writing a check for more money than you have in your bank account).
How do economists measure the money supply?
Economists use formal measurement tools called monetary aggregates to measure the amount of money in circulation. These tools help economists understand the health of the economy and help central banks, such as the Federal Reserve, set monetary policy. In the United States, there are three categories of monetary aggregates that help measure the economy’s money supply:
- M0 (Monetary Base). This category refers to all currency in circulation, including bank notes and coins, as well as bank reserves held by central banks.
- M1. All M0’s include traveller’s checks and current accounts (deposits in a bank that can be withdrawn without notice). Common examples of current accounts are checking and savings accounts.
- M2. All of M1 plus current accounts and money market shares pool together investor money safely, usually in short-term government bills or highly rated corporate bonds.
Tracking monetary aggregates like these three measures can provide insight into economic activity, growth, and inflation risks.
What is Money? FAQ
What is a good definition of money?
Money is an intermediate store of value, a medium of exchange, and a unit of account that is any physical or digital object that has a universally recognized value. Money allows people to exchange goods without possessing the physical goods desired, as in a barter system.
Why was money created?
Money was created as an intermediary good to facilitate trade and store value. Unlike goods and objects, the monetary value of money can be separated from its functional use. In other words, paper money with dollars, euros, and yuan printed on it has little value beyond its value as a monetary unit.
What are the four types of money?
There are four types of money: commodity money, representative money, fiat money, and fiat money or money substitutes. A fifth type of money is considered cryptocurrency, but there is debate as to whether it qualifies as money, as its value fluctuates widely and it is relatively rarely used as a means of exchange.
Is money always just notes and coins?
No. Money can be any physical or digital object that has a perceived value. Throughout history, societies have used everything from metal crosses to gemstones to salt as money.
