Information about Money

Money is any token or other object that functions as a medium of exchange that is socially and legally accepted in payment for goods and services and in settlement of debts. Money also serves as a standard of value for measuring the relative worth of different goods and services and as a store of value. Some authors explicitly require money to be a standard of deferred payment.^[1]

Money includes both currency, particularly the many circulating currencies with legal tender status, and various forms of financial deposit accounts, such as demand deposits, savings accounts, and certificates of deposit. In modern economies, currency is the smallest component of the money supply.

Money is not the same as real value, the latter being the basic element in economics. Money is central to the study of economics and forms its most cogent link to finance. The absence of money causes an economy to be inefficient because it requires a coincidence of wants between traders, and an agreement that these needs are of equal value, before a barter exchange can occur. The efficiency gains through the use of money are thought to encourage trade and the division of labour, in turn increasing productivity and wealth.

Economic characteristics

Money is generally considered to have the following characteristics, which are summed up in a rhyme found in older economics textbooks and a primer: "Money is a matter of functions four, a medium, a measure, a standard, a store."

There have been many historical arguments 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. '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

Main article: Medium of exchange

Unit of account

Main article: 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 pre-requisite for the formulation of commercial agreements that involve debt.

• Divisible into small units without destroying its value; precious metals can be coined from bars, or melted down into bars again.
• Fungible: that is, one unit or piece must be exactly equivalent to another, 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 made with ridges around the edges, 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 value

To act as a store of value, a commodity, a form of money, or financial capital must be able to be reliably saved, stored, and retrieved - and be predictably useful when it is so retrieved. Fiat currency like paper or electronic currency no longer backed by gold in most countries is not considered by some economists to be a store of value.

Market liquidity

Main article: Market liquidity

It is important for any economy to move beyond a simple system of bartering. 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.

Types of money

In economics, money is a broad term that refers to any instrument that can be used in the resolution of debt. However, different types of money have different economic strengths and liabilities. Theoretician Ludwig von Mises made that point in his book The Theory of Money and Credit, and he argued for the importance of distinguishing among three types of money: commodity money, fiat money, and credit money. Modern monetary theory also distinguishes among different types of money, using a categorization system that focuses on the liquidity of money.

Commodity money

Main article: Commodity money

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Commodity money is any money that is both used as a general purpose medium of exchange and as a tradable commodity in its own right.^[1]

Commodity based currencies are often viewed as more stable, but this is not always the case. The value of a commodity based currency as a medium of exchange depends on its supply relative to other goods and services available in the economy. Historically, gold, silver and other metals commonly used in commodity based monetary systems have been subject to regular and sometimes extraordinary fluctuations in purchasing power. This not only damages its stability as a medium of exchange; it also reduces its effectiveness as a store of value. In the 1500s and 1600s huge quantities of gold and even larger amounts of silver were discovered in the New World and brought back to Europe for conversion into coin. As a result, the purchasing power of those coins fell by 60% to 80%, i.e. the prices of goods rose, because the supply of goods did not keep pace with the increased supply of money.^[2] In addition, the relative value of silver to gold shifted dramatically downward.^[3] Such discoveries of huge sources of gold or silver are a thing of the past, and lend to their supply stability. More recently, from 1980 to 2001, gold was a particularly poor store of value, as gold prices dropped from a high of $850/oz. ($27.30 /g) to a low of $255/oz. ($8.20 /g). It should be noted that gold was not a currency at this time, and was fluctuating due to its status as a final store of value — that is, the price never goes to zero as fiat currencies inevitably do. The advantage of gold and silver, however, lies in the fact that, unlike fiat paper currency, the supply cannot be increased arbitrarily by a central bank.

It is also possible for the trading value of a commodity money to be greater than its value as a medium of exchange when governments attempt to fix exchange rates between different commodity monies. When this happens people will often start melting down coins and reselling the metal used to make them. This has happened periodically in the United States, eventually causing it to move away from pure silver nickels and pure copper pennies. Shipping coins from one jurisdiction to another so that they could be reminted was sometimes a lucrative trade before the advent of trusted paper money.

Commodity money's ability to function as a store of value is also limited by its very nature. Copper and tin risk rust and corrosion. Gold and silver are soft metals that can lose weight through scratches and abrasions, but this is nothing by comparison to fiat currencies, where billions of dollars can be injected ("printed") into the market within moments.

Stability aside, commodity-based currencies may have a tendency to restrain growth in a very active economy. For example, in order to maintain the price level, the supply of money in an any economy must be equal or greater than the volume of goods and services produced. If commodities are used as money, then the total production can easily outstrip the supply of those commodities, which leads to price deflation. The lower prices of goods would signal to their producers to reduce the supply of goods, hence restoring the price level. As such, production within commodity-based economies tends to be limited by the supply of the commodity currency.[citation needed]

This problem is compounded by the fact that money also serves as a store of value. This encourages hoarding (in other circumstances known as "saving")and takes the commodity money out circulation, reducing the supply. The supply of circulating commodity currency is further reduced by the fact that commodity moneys also have competing non-monetary uses. For example, gold and silver are used in jewelry, and nickel and copper have important industrial uses.

Commodity based currencies also limit the geographic extent of the trading market. To make large purchases either a large volume or a high weight or both of the commodity must be transported to the seller. The cost of transportation of the currency raises the transaction cost and makes long distance sales less attractive.

Fiat money

Main article: Fiat money

Fiat money is any money whose value is determined by legal means rather than the relative availability of goods and services. Fiat money may be symbolic of a commodity or government promises.^[1]

Fiat money provides solutions to several limitations of commodity money. Depending on the laws, there may be little or no need to physically transport the money - an electronic exchange may be sufficient. Its sole use is as a medium of exchange so its supply is not limited by competing alternate uses. It can be printed without limit, so there is no limit on trade volumes.

Fiat money, especially in the form of paper or coins, can be easily damaged or destroyed. However, it has an advantage over 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 US government will replace mutilated paper money if at least half of the bill can be reconstructed.^[4]. By contrast commodity money is gone for good.

Paper money is especially vulnerable to everyday hazards: from fire, water, termites, and simple wear and tear. Money in the form of minted coins is sometimes destroyed by children placing it on railroad tracks or in amusement park machines that restamp it. In order to reduce replacement costs, many countries are converting to plastic bills. For example, Mexico has changed its twenty and fifty pesos notes, Singapore its $2, $5, $10 and $50 bills, Malaysia with RM5 bill, and Australia and New Zealand their $5, $10, $20, $50 and $100 to plastic for the increased durability.

Some of the benefits of fiat money can be a double-edged sword. For example, if the amount of money in active circulation outstrips the available goods and services for sale, the effect can be inflationary. This can easily happen if governments print money without attention to the level of economic activity or counterfeiters are allowed to flourish.

Perhaps the biggest criticism of paper money relates to the fact that its stability is highly dependent on the stability of the legal system backing the currency. Should the legal system fail, so would the currency that depends on it.

Credit money

Main article: Credit money

Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services^[1]. Credit money differs from commodity and fiat money in two important ways: It is not payable on demand and there is some element of risk that the real value upon fulfillment of the claim will not be equal to real value expected at the time of purchase<ref name="Mises" />.

This risk comes about in two ways and affects both buyer and seller.

First it is a claim and the claimant may default (not pay). High levels of default have destructive supply side effects. If manufacturers and service providers do not receive payment for the goods they produce, they will not have the resources to buy the labor and materials needed to produce new goods and services. This reduces supply, increases prices and raises unemployment, possibly triggering a period of stagflation. In extreme cases, widespread defaults can cause a lack of confidence in lending institutions and lead to economic depression. For example, abuse of credit arrangements is considered one of the significant causes of the Great Depression of the 1930s. ^[6]

The second source of risk is time. Credit money is a promise of future payment. If the interest rate on the claim fails to compensate for the combined impact of the inflation (or deflation) rate and the time value of money, the seller will receive less real value than anticipated. If the interest rate on the claim overcompensates, the buyer will pay more than expected.

Over the last two centuries, credit money has steadily risen as the main source of money creation, progressively replacing first commodity then fiat money.

The main problem with credit money is that its supply moves in line with credit booms and bust. When lenders are optimistic (notably when the debt level is low), they increase their lendings activity, thus creating new money and triggering inflation, when they are pessimistic (for instance because the debt level is perceived as so high that defaults can only follow), they reduce their lending activities, bankruptcies and deflation follows.

Money supply

Main article: Money supply

The money supply is the amount of money within a specific economy available for purchasing goods or services. The supply in the US is usually considered as four escalating categories M0, M1, M2 and M3. The categories grow in size with M3 representing all forms of money (including credit) and M0 being just base money (coins, bills, and central bank deposits). M0 is also money that can satisfy private banks' reserve requirements. 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.

When gold is used as money, the money supply can grow in either of two ways. First, the money supply can increase as the amount of gold increases by new gold mining at about 2% per year, but it can also increase more during periods of gold rushes and discoveries, such as when Columbus discovered the new world and brought gold back to Spain, or when gold was discovered in California in 1848. This kind of increase helps debtors, and causes inflation, as the value of gold goes down. Second, the money supply can increase when the value of gold goes up. This kind of increase in the value of gold helps savers and creditors and is called deflation, where items for sale are less expensive in terms of gold. Deflation was the more typical situation for over a century when gold and credit money backed by gold were used as money in the US from 1792 to 1913.

Monetary policy

Main article: 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.” ^[7]

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:

• currency purchases or sales
• increasing or lowering government spending
• increasing or lowering government borrowing
• changing the rate at which the government loans or borrows money
• manipulation of exchange rates
• taxation or tax breaks on imports or exports of capital into a country
• raising or lowering bank reserve requirements
• regulation or prohibition of private currencies

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 ^[8] supported by the work of David Laidler^[9], 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.

History of money

Main article: History of money

The first golden coins in history were coined by Lydian king Croesus, around 560 BC. The first Greek coins were made initially of copper, then of iron because copper and iron were powerful materials used to make weapons. Pheidon king of Argos, around 700 BC, changed the coins from iron to a rather useless and ornamental metal, silver, and, according to Aristotle, dedicated some of the remaining iron coins (which were actually iron sticks) to the temple of Hera[1]. King Pheidon coined the silver coins at Aegina, at the temple of the goddess of wisdom and war Athena the Aphaia (the vanisher), and engraved the coins with a Chelone, which is to this day as a symbol of capitalism. Chelone coins[2] were the first medium of exchange that was not backed by a real value good. They were widely accepted and used as the international medium of exchange until the days of Peloponnesian War, when the Athenian Drachma replace them. According other fables, inventors of money were Demodike(or Hermodike) of Kymi (the wife of Midas), Lykos (son of Pandion II and ancestor of the Lycians) and Erichthonius, the Lydians or the Naxians.

See also

• Economics
• List of finance topics
• Coin of account
• Counterfeit, for Counterfeiting of Money
• Credit money
• Currency market
• Debt-based monetary system
• Electronic money
• World currency
• Federal Reserve
• Fractional reserve banking
• Full reserve banking
• Labor-time voucher
• Local Exchange Trading Systems
• Numismatics - Collection and study of money
• Seignorage
• Standard of deferred payment
• Free Market
• Gift economy
• Wealth
• Usury

References

External links

• Current Currency Exchange Rates by boc
• Linguistic and Commodity Exchanges by Elmer G. Wiens. Examines the structural differences between barter and monetary commodity exchanges and oral and written linguistic exchanges.

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