July 22, 2012 5 Comments
What is money?
That is a question that comes up in my Money and Capital Markets class every semester. Money is just slips of paper and bits of metal to many people but that doesn’t really sound like an answer. In fact that is more of a description of currency (which makes up money) but not money itself.
Types of Money
Money is defined as anything that is accepted as payment for goods or services or as repayment of debt. Money can be based on an actual item of value such as a gold coin or a carved shell. In this case we refer to it as commodity money because it has a value intrinsic to itself. In most economies today, money is based on nothing more than the good faith of the issuing authority. We refer to this as fiat money. Fiat is Latin for “let it be” so we can tell by the name that fiat money has value because the legal authority in that specific economy says that it has value.
Uses of Money
Now that we have an idea of what money actually is, we should also keep in mind what for what we use money.
- Medium of Exchange
- Unit of Account
- Store of value
As a medium of exchange, we can give money to anyone for a good or service and that person can then go and purchase the goods and services that they wish to purchase. Without having money to act as a medium of exchange I have to find someone to barter with that both has what I want and wants what I have. In economics, we call this the double coincidence of wants.
As a unit of account, we are saying that money has some standard measure of value. Each US dollar is equal in value to every other US dollar. Exactly 100 of those US dollars can be exchanged for a $100USD bill. This relationship is required or people could not set a specific price.
As a store of value, we can put money aside and then come back in the future to reclaim that value. There is a great deal of discussion about the true ability of fiat money to act as a store of value because the value is only true as long as it can be accepted for payment. This is further compounded by the inflation that occurs in modern economies which further erodes the stored value of money.
In a future post I will discuss the transition from commodity money to fiat money and the role of the Federal Reserve.