What is Money?
In our daily lives, we hear about money in different ways:
- “I have no Money”
- “Show me the Money”
- “He/she is full of Money”
- “That business has run out of Money”
- “The government is printing Money”
We earn Money. We spend Money. We rely on money to measure wealth, assign value to assets, and determine the costs of goods and services.
Money, a concept and technology ingrained in our daily lives, serves various purposes.
In economics, money is broadly defined as something generally accepted as a medium of exchange for goods and services. While technically anything can be considered money, the most widely accepted forms today are paper banknotes, metallic coins, and credits backed by banks.
To effectively discuss, manage, and master money, wealth, and financial freedom, I feel it is important to understand what money is by examining its three functions, five types, and seven properties. I will then cover the Money Supply and its four measurements.
Three Key Functions of Money
- Medium of Exchange: This function enables efficient transactions and trade beyond barter relations. Money, widely accepted as a form of payment, eliminates the need for a double coincidence of wants prevalent in bartering. For example, when purchasing goods at a grocery store, the confidence lies in the widely accepted nature of money as a payment method.
- Unit of Account: Serving as a common standard for measuring the value of goods and services, money facilitates easy valuation. It provides a consistent measure, allowing individuals to assess the worth of items. For instance, using U.S. dollars as a unit of account, people can easily comprehend the value of a bottle of water in monetary terms, preventing unfair or outrageous pricing.
- Store of Value: Money must retain its worth over time to function as a store of value. It should be savable, storable, and retrievable while maintaining reliability as a medium of exchange. Unlike perishable items such as produce, money, despite discussions about inflation and deflation, strives to preserve purchasing power over an extended period.
These three functions complement each other to create a cohesive monetary system. The medium of exchange facilitates transactions, the unit of account standardizes value measurements, and the store of value function allows for the preservation and transfer of wealth. Together, they contribute to the efficiency and stability of modern economies. While these functions are precise, there is no universally agreed-upon hierarchy or chronological order of importance.
Five Types of Money
Let’s now delve into the five primary types of money — Fiat Money, Commodity Money, Representative Money, Fiduciary Money, and Commercial Bank Money. Each type represents unique characteristics and roles that shape economic systems on a macro and micro scale.
- Fiat Money:
- Definition: Fiat money is a government-declared legal tender that lacks intrinsic value; its worth is essentially determined by the government’s decree.
- Characteristics: Unlike commodity money, fiat money is not backed by any physical asset. Its value is derived from the trust and confidence people have in the government that issues it.
- Examples: Modern paper currencies and coins (CASH), such as the U.S. dollar or the Euro, are classic examples of fiat money. Their value is not tied to the value of any specific commodity but is maintained by government authority.
- Commodity Money:
- Definition: Commodity money possesses intrinsic value derived from the material it is made of, usually a tangible commodity with inherent worth.
- Characteristics: Unlike fiat money, the value of commodity money is independent of any government declaration. It is directly linked to the value of the underlying commodity.
- Examples: Historical examples include gold and silver coins, where the value of the currency was based on the value of the precious metal it contained.
- Representative Money:
- Definition: Representative money is backed by a commodity and can be exchanged for a fixed amount of that commodity upon request.
- Characteristics: While not the commodity itself, representative money serves as a claim or certificate that can be redeemed for a specific quantity of the underlying commodity.
- Examples: In the past, some currencies were backed by precious metals, and individuals could exchange their paper money for a corresponding amount of gold or silver upon demand.
- Fiduciary Money:
- Definition: Fiduciary money is based on trust and the promise that it can be exchanged for fiat or commodity money by the issuing authority, typically a bank.
- Characteristics: Unlike physical money, fiduciary money includes instruments like checks or digital transactions. It relies on the trustworthiness of the issuer to fulfill the promise of conversion.
- Examples: Bank-issued checks, promissory notes, and other financial instruments fall under fiduciary money. These instruments represent a commitment to exchange for legal tender or commodity money.
- Commercial Bank Money:
- Definition: Commercial bank money, in the form of demand deposits, represents a claim against a bank for the purchase of goods and services.
- Characteristics: This type of money exists in digital or paper form as bank account balances. It allows individuals to make transactions by withdrawing in cash, writing checks, or using debit cards.
- Examples: When you deposit money into a bank account, you receive demand deposits, which can be accessed through various means. The bank is obligated to honor withdrawals or payments made through these deposits.
The Seven Properties of Money
All five types of Money share seven Properties that underscore the essential characteristics that contribute to the efficacy of money in facilitating economic activities.
- Definition: Money is fungible when interchangeable with other units of currency.
- Example: Each dollar bill holds the same value as another, irrespective of any imperfections, unlike non-monetary items, such as bruised apples in barter transactions.
- Definition: Money should be divisible into smaller units.
- Example: A dollar bill can be easily divided into quarters, each maintaining equal value.
- Definition: Money must withstand the wear and tear associated with regular use.
- Example: It needs to endure the physical interactions of being passed from hand to hand.
- Definition: Money should be easily carried and transported.
- Example: The convenience of transporting money is essential for its practical use.
- Definition: The value of money must be easily identifiable.
- Example: Dollar bills are marked with denominations like “1” or “10,” facilitating quick recognition and comparison of their worth.
- Stability of Value:
- Definition: The value of money should remain relatively constant over an extended period.
- Example: Maintaining a stable value ensures consistency in its purchasing power.
- Limited Supply:
- Definition: Money should be relatively scarce and not easily obtainable.
- Example: Government-regulated control over the money supply ensures its scarcity and, consequently, the maintenance of its value. In certain scenarios, such as depicted in apocalyptic TV shows, other commodities like water may serve as money due to their scarcity.
Money Supply and Money Measurements (M0, M1, M2, M3)
What is Money Supply, and what helps understanding the concept of Money?
In macroeconomics, the money supply (money stock) refers to the total volume of money held by the public at a particular point in time. As we have seen, there are several ways to define money. Let’s now focus on cash (currency in circulation) and deposits at Financial Institutions. National Central Banks keep records of the Money Supply.
While the precise definition may vary from country to country, depending on the financial tradition of local institutions, economists refer to four main empirical measures of money supply, known as:
- M0 is the smallest and most liquid measure. It is strictly currency in circulation plus commercial bank reserve balances at Federal Reserve Banks; M0 is often referred to as the “monetary base.”
- M1 is defined as the sum of currency in circulation, demand deposits at commercial banks, and other liquid deposits; it is often referred to as “narrow money.“
- M2 is everything included in M1 plus savings accounts, time deposits (under $100,000), and retail money market funds.
- M3 is everything in M2 plus larger time deposits and institutional money market funds. (Because the cost of estimating M3 was thought to outweigh its value, the American Federal Reserve stopped reporting it in 2006.)
To summarise, the four measures are nested: M3 includes M1 and M2; M2 includes M0 and M1.
The main feature distinguishing the four measures is the liquidity of their components (how easily one can exchange the asset for cash).
In addition, “there is a relationship between the components of these measures of money supply and how they are primarily used as a medium of exchange or a store of value” (Anna Schwartz):
- M0 and M1: The components of the most liquid measures of the money supply, M0 and M1, all act as a medium of exchange in the economy
- M2: the added components of M2 are used primarily as a store of value.
Therefore, we can recognize a positive relationship between the medium of exchange property and liquidity.
The largest part of the money supply consists of deposits in commercial banks. Currency (cash) issued by central banks makes up a small part of the total money supply in modern economies. The public’s demand for currency and bank deposits and commercial banks’ supply of loans are consequently important determinants of money supply changes.
Rooted in its fundamental functions—acting as a medium of exchange, a unit of account, and a store of value—money serves as the lifeblood of transactions, enabling us to trade, measure, and preserve wealth.
Given its “wide” meaning and use, correctly understanding the term “money” will help you make informed financial decisions.
– Are you buying gold? You are probably buying it as a “potential” store of value, as investment assets, and not as a means of exchange or unit of account.
– Are you buying Crypto Currencies? You are probably buying it as a speculative investment asset, not as a store of value, means of exchange, or unit of account.
– Are you keeping a lot of your Money in Cash? Cash is an excellent means of exchange and unit of account, but in the long term, it is not a great store of value (due to inflation).
– Are you measuring your wealth? Money will be used as a unit of account for all your different asset classes (cash, real estate, stock, bonds, commodities, collectibles)
The bottom line is that NOT all Money is Equal!
When you talk about money, it is important to understand the context (macroeconomy or micro-economy; technical discussion or generic one) and identify the underlying functions, types, and properties of Money on a case-by-case basis.
For wealth creation and financial freedom, I bet it is critical to focus on Productive/Investment Assets (that generate and store value). By mastering Money and Assets, you will understand what JP Morgan meant by saying:
“Gold is Money. Anything else is credit.”