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| So What Is Money... Really |
Introduction
Money is any item or medium of exchange that is accepted by people for the payment of goods and services, as well as the repayment of loans. Money makes the world go 'round. Economies rely on money to facilitate transactions and to power financial growth. Typically, it is economists who define money, where it comes from, and what it's worth. Here are the multifaceted characteristics of money.
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 for most people 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.
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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 and 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.
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.
How Is Money Measured?
But 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. This category of money is the narrowest of the three, and is essentially the money used to buy things and make payments
- 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.
Active Money
The M1 category includes what's known as active money—the total value of coins and paper currency in circulation.
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.
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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 (the central bank in the United States is the Federal Reserve or the Fed) can influence and manipulate the money supply.
Currency Wars
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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.
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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 stating 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. In 1690, Massachusetts also issued the first paper money calling it bills of credit.
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. Congress established a national monetary system and created the dollar as the main unit of money.
There was also a bimetallic standard, meaning that both silver and gold could be valued in and used to back paper dollars.
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.
The Bottom Line
Money has changed substantially since the days of shells and skins, but its main function hasn't changed at all. Regardless of what form it takes, money offers us a medium of exchange for goods and services and allows the economy to grow as transactions can be completed at greater speeds.
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