“Money” has an everyday familiarity to it. Most days, we spend it. Some days we earn it. On bad days we don’t have enough of it. But what is money, really?

Money serves 3 key functions in an economy:

• Medium of exchange (payment)
• Unit of account (a single price)
• Store of value (safe, liquid means of saving)

In other words, “Money is a medium of exchange”, “Money is a unit of account”, and “Money is a store of value.” The term “money” should not be confused with related terms like “wealth” and “income.”

Prior to the invention of money, people used barter to exchange goods. A barter system is an economic system in which people exchange goods for other goods without the use of money. The biggest limitation of a barter system is the “double coincidence of wants.” Each person needs to want what the other person has.

Early forms of money were in the forms of commodities. A commodity in the world of finance is a physical asset like oil, metal, or grain. Commodity money is the use of a physical commodity as a form of money. For instance, some early agricultural societies used agricultural assets like cattle as a form of money. However, precious metals quickly emerged as an ideal form of commodity money due to their durability, malleability, and transportability. Gold is the most well-known form of commodity money. Unique forms of commodity money can emerge in unique situations. For instance, prisoners have been known to use cigarettes as a commodity money in prison.

Commodity money eventually transitioned into paper money. Today, we refer to “cash.” This can refer to paying in cash or cash as an asset on a balance sheet. The term “cash” is often used as a synonym for currency, which is the combination of paper bills and coins. We sometimes use the phrase “paper money” to refer to money that is not real (like Monopoly money). However, most of the physical currency that we use is paper money. This raises interesting questions about what money is worth. Some people associate gold with intrinsic value, but as a metal is not particularly useful. It really only has value because it is scarce and people want to own it. Paper clearly has no intrinsic value. At one time, paper money was backed by gold, meaning that paper money could be exchanged for gold. This was referred to as the gold standard, which is the backing of a sovereign, fiat currency by gold. However, the U.S. dollar is no longer backed by gold, which means that it is no longer on the gold standard. Fiat currency is money that only has value “by decree” (fiat). The U.S. dollar is an example of a fiat currency. This form of money is based on trust in the government.

Early in history, money was controlled by the rulers of civilization. Sovereign is another name for a government and sovereign currency is a currency associated with government. The Roman Empire used the “coin” as a form of metal money in the economy. One record of this is in the Christian Bible. In a story from the New Testament, Jesus is asked about paying taxes. He says, “Show me the coin used for the tax” and he is given a denarius. “Whose likeness is this?” he asks, “and whose inscription?” The people gathered with him say, “Caesar’s.” Jesus replies, “Give to Caesar what is Caesar’s…”

The history of sovereign currency lives on today in our most familiar currencies. Federal Reserve Notes are “cash” – acceptable, standardized, durable, valuable, divisible. This is the money of the U.S. government. The supply of the U.S. dollar is controlled by the Federal Reserve, the central bank of the United States.

Economists have developed measures for the amount of money circulating in an economy. Monetary aggregates are measures of the quantity of money. They include currency, which is physical money in the form of paper and coins. However, they also include money in the form of money-like accounts. The most basic monetary aggregate is M1. M1 is the sum of currency, checking account deposits, and traveler’s checks. It is considered a “narrow” measure of money, because it only includes categories of money that function as a medium of exchange. A “broad” measure of money is M2. M2 is the sum of M1 plus savings accounts, certificates of deposit (CDs), and money market mutual funds. These additional categories of money in M2, like savings accounts, are associated with money as a store of value.

The value of money can be measured in prices. As prices go up, the value of money goes down. Inflation is a measure of the price level that has a positive value when prices are increasing. Economies are typically associated with inflation, because prices are usually rising from one year to the next. For example, a can of Coca-Cola is more expensive today than it was 25 years ago. Inflation is a decline in the purchasing power of money. Most goods and services are becoming more expensive, including housing, a college education, and cars. This is the phenomenon measured by inflation. Specifically, inflation is measured as the percentage change in the price level over a period of time.

By managing the money supply, central banks have the power to influence inflation. When money is scarce, it tends to have more value. This is why gold is valuable. While the supply of gold is relatively fixed, the supply of fiat currency can be increased or decreased by a central bank. The central bank of the United States is called the Federal Reserve (the “Fed” for short). The Federal Reserve can increase the supply of U.S. dollars in circulation, which reduces the value of the U.S. dollar, or it can decrease the supply of U.S. dollars in circulation, which increases the value of the U.S. dollar. A reduction in the value of the currency increases inflation and an increase in the value of the currency reduces inflation. In this way, a central bank uses money supply as a tool for maintaining low, steady inflation.

Stable prices are important for a healthy economy. But prices are not always stable. Hyperinflation is extremely high inflation. When hyperinflation occurs, prices are rising out of control, which means that the value of the currency is plummeting. This incentivizes people to spend money as quickly as possible to convert it into other assets. These periods are typically associated with a central bank increases the supply of money at a very high rate, such post-WWII Germany or Zimbabwe. Deflation is negative inflation. This occurs when an economy is slowing, consumer demand is declining, money is not circulating, and prices are falling. Japan in the late 20th century is an example of a country that struggled with deflation. This incentivizes people to save money, because the value of the currency is increasing over time. Neither hyperinflation or deflation are good for an economy, because the uncertainty about prices can distort economic decisions. Price stability is a low, steady rate of inflation. This is beneficial for an economy to have efficient economic decisions without distortions from the price level. Price stability reduces uncertainty in consumption and investment decisions.

Glossary:

Barter system. An economic system in which people exchange goods for other goods without the use of money

Commodity money. The use of a physical commodity as a form of money

Currency. Money in the form of paper and coins

Deflation. Negative inflation

Fiat currency. Money that only has value “by decree” (fiat)

Gold standard. The backing of a sovereign, fiat currency by gold

Hyperinflation. Extremely high inflation

Inflation. A measure of the price level that has a positive value when prices are increasing

Monetary aggregates. Measures of the quantity of money

Price stability. A low, steady rate of inflation