What is Money?

by Mike Moffatt
September 03, 2017

The Economics Glossary defines money as follows:

Money is a good that acts as a medium of exchange in transactions. Classically it is

said that money acts as a unit of account, a store of value, and a medium of exchange.
Most authors find that the first two are nonessential properties that follow from the
third. In fact, other goods are often better than money at being intertemporal stores of
value, since most monies degrade in value over time through inflation or the
overthrow of governments.

The Purpose of Money

So, money isn't just pieces of paper. It's a medium of exchange that facilitates trade.
Suppose I have a Wayne Gretzky hockey card that I'd like to exchange for a new pair of
shoes. Without the use of money, I have to find a person, or combination of people who
have an extra pair of shoes to give up, and just happen to be looking for a Wayne
Gretzky hockey card. Quite obviously, this would be quite difficult. This is known as the
double coincidence of wants problem:

 The double coincidence is the situation where the supplier of good A wants good
B and the supplier of good B wants good A. The point is that the institution of
money gives us a more flexible approach to trade than barter, which has
the double coincidence of wants problem. Also known as dual coincidence of
wants.

Since money is a recognized medium of exchange, I do not have to find someone who
has a pair of new shoes and is looking for a Wayne Gretzky hockey card. I just need to
find someone who is looking for a Gretzky card who is willing to pay enough money so I
can get a new pair at Footlocker. This is a far easier problem, and thus our lives are a lot
easier, and our economy more efficient, with the existence of money.

How Money Is Measured

As for what constitutes money and what does not ,he following definition is provided by
The Federal Reserve Bank of New York:

 "The Federal Reserve publishes weekly and monthly data on three money supply
measures -- M1, M2, and M3 -- as well as data on the total amount of debt of the
nonfinancial sectors of the U.S. economy... The money supply measures reflect
 the different degrees of liquidity -- or spendability - that different types of money
have. The narrowest measure, M1, is restricted to the most liquid forms of
money; it consists of currency in the hands of the public; travelers checks;
demand deposits, and other deposits against which checks can be written. M2
includes M1, plus savings accounts, time deposits of under $100,000, and
balances in retail money market mutual funds. M3 includes M2 plus large-
denomination ($100,000 or more) time deposits, balances in institutional money
funds, repurchase liabilities issued by depository institutions, and Eurodollars
held by U.S. residents at foreign branches of U.S. banks and at all banks in the
United Kingdom and Canada."

So there are several different classifications of money. Note that credit cards are not a
form of money.

Note that money is not the same thing as wealth. We cannot make ourselves richer by
simply printing more money.
What is Money?
By Investopedia | Updated May 31, 2018

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.

By adding these three categories together, we arrive at a country's money supply, or the
total amount of money within an economy.

Active Money
The M1 category includes what's known as active money – that is, the total value of
coins and paper currency in circulation amongst the public. 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 classified as 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 times, following the December holiday season, for
example.

Due to the high demand from abroad, the majority of circulating U.S. cash is actually outside of
the United States.

How Money is Created

Now that we've discussed why and how money, a representation of perceived value, is
created in the economy, we need to touch on how a country's central bank (it's the
Federal Reserve in the U.S.) can influence and manipulate its money supply.
Let's look at a simplified example of how this is done. If it wants to increase the amount
of money in circulation, the central bank can, of course, simply print it, but 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 Federal Reserve pay for this?
As strange as it sounds, they simply create the money out of thin air and transfer it to
those people selling the securities! Or, it 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, 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 we are generalizing in this example to keep things
simple. (For more information, see the Federal (the Fed) Reserve Tutorial.)

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. So even though technically it can create money "out
of thin air," the central bank cannot simply print money as it wants.

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