a medium of exchange, a unit of account, and a store of value.[2] Some authors explicitly require money to be a standard of deferred payment.Money includes both currency, particularly the many circulating currencies with legal tender status, and various forms of financial deposit accounts, such as demand deposits, savings accounts, and certificates of deposit. In modern economies, currency is the smallest component of the money supply.
Money is not the same as real value, the latter being the basic element in economics. Money is central to the study of economics and forms its most cogent link to finance. The absence of money causes a market economy to be inefficient because it requires a coincidence of wants between traders, and an agreement that these needs are of equal value, before a barter exchange can occur. The use of money is thought to encourage trade and the division of labour.
Economic characteristics
Money is generally considered to have the following characteristics, which are summed up in a rhyme found in older economics textbooks and a primer: "Money is a matter of functions four, a medium, a measure, a standard, a store." That is, money functions as a medium of exchange, a unit of account, and a store of value.[2][4][5]
There have been many historical arguments regarding the combination of money's functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. One of these arguments is that the role of money as a medium of exchange is in conflict with its role as a store of value: its role as a store of value requires holding it without spending, whereas its role as a medium of exchange requires it to circulate.[5] 'Financial capital' is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender.
Medium of exchange
Money is used as an intermediary for trade, in order to avoid the inefficiencies of a barter system, which are sometimes referred to as the 'double coincidence of wants problem'. Such usage is termed a medium of exchange.
Unit of account
A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt.
* Divisible into small units without destroying its value; precious metals can be coined from bars, or melted down into bars again.
* Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is why diamonds, works of art or real estate are not suitable as money.
* A specific weight, or measure, or size to be verifiably countable. For instance, coins are often made with ridges around the edges, so that any removal of material from the coin (lowering its commodity value) will be easy to detect.
Store of value
To act as a store of value, a commodity, a form of money, or financial capital must be able to be reliably saved, stored, and retrieved — and be predictably useful when it is so retrieved. Fiat currency like paper or electronic currency no longer backed by gold in most countries is not considered by some economists to be a store of value.
Market liquidity
Liquidity describes how easily an item can be traded for another item, or into the common currency within an economy. Money is the most liquid asset because it is universally recognised and accepted as the common currency. In this way, money gives consumers the freedom to trade goods and services easily without having to barter.
Liquid financial instruments are easily tradable and have low transaction costs. There should be no — or minimal — spread between the prices to buy and sell the instrument being used as money.
Types of money
In economics, money is a broad term that refers to any instrument that can be used in the resolution of debt. However, different types of money have different economic strengths and liabilities. Theoretician Ludwig von Mises made that point in his book The Theory of Money and Credit, and he argued for the importance of distinguishing among three types of money: commodity money, fiat money, and credit money. Modern monetary theory also distinguishes among different types of money, using a categorization system that focuses on the liquidity of money.
Commodity money
commodity money is any money whose value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity.[6] Examples of commodities that have been used as mediums of exchange include gold, silver, copper, salt, peppercorns, large stones, decorated belts, shells, alcohol, cigarettes, cannabis, and candy. Since payment by commodity generally provides a useful good, commodity money is similar to barter, but is distinct because commodity money uses a single recognized unit of exchange.
Representative money
Representative money is money that consists of token coins, other physical tokens such as certificates, and even non-physical "digital certificates" (authenticated digital transactions) that can be reliably exchanged for a fixed quantity of a commodity such as gold, silver or potentially water, oil or food. Representative money thus stands in direct and fixed relation to the commodity which backs it, while not itself being composed of that commodity.
Banknotes from all around the world donated by visitors to the British Museum, London.
Banknotes from all around the world donated by visitors to the British Museum, London.
Credit money
Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services.[6] Credit money differs from commodity and fiat money in two ways: It is not payable on demand (although in the case of fiat money, "demand payment" is a purely symbolic act since all that can be demanded is other types of fiat currency) and there is some element of risk that the real value upon fulfillment of the claim will not be equal to real value expected at the time of purchase.[6]
This risk comes about in two ways and affects both buyer and seller.
First it is a claim and the claimant may default (not pay). High levels of default have destructive supply side effects. If manufacturers and service providers do not receive payment for the goods they produce, they will not have the resources to buy the labor and materials needed to produce new goods and services. This reduces supply, increases prices and raises unemployment, possibly triggering a period of stagflation. In extreme cases, widespread defaults can cause a lack of confidence in lending institutions and lead to economic depression. For example, abuse of credit arrangements is considered one of the significant causes of the Great Depression of the 1930s.[7]
The second source of risk is time. Credit money is a promise of future payment. If the interest rate on the claim fails to compensate for the combined impact of the inflation (or deflation) rate and the time value of money, the seller will receive less real value than anticipated. If the interest rate on the claim overcompensates, the buyer will pay more than expected.
Over the last two centuries, credit money has steadily risen as the main source of money creation, progressively replacing first commodity and then representative money. In many cases credit money has been converted to fiat money (see below), as governments have backed certain private credit instruments (first banknotes from central banks, then later certain types of deposits to banks), thus converting central banknotes to legal tender, and other types of notes (deposit certificates of less than a certain value) to a status not very different from fiat money, since they are backed by the power of the central government to redeem eventually with tax collection.
A particular problem with credit money is that its supply moves in line with the business cycle. When lenders are optimistic, notably when the debt level is low, they increase their lending activity which creates new money. This may also trigger inflation and bull markets. When creditors are pessimistic (for instance, when debt level is perceived as too high, or unwise lending activity in the past has resulted in situations where defaults are expected to follow), then creditors reduce their lending activity and money becomes "tight" or "illiquid." Bear markets, characterized by bankruptcies and market recessions, then follow.
