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Money
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Money

For other uses, see Money (disambiguation).

Money is a medium of exchange which acts as an intermediary market good. It can be traded and exchanged for other goods. As discussed below, money also has other characteristics.

Money itself must be a scarce good. Many items have been used as money, from naturally scarce precious metals and conch shells through cigarettes to entirely artificial money such as banknotes.

Modern money is essentially a token - an abstraction. Paper currency is perhaps the most common type of physical money today. However, goods such as gold or silver retain many of the essential properties of money.

Table of contents
1 Essential characteristics of money
2 Related concepts
3 Desirable features of money
4 Modern forms of money
5 Money and economics
6 History of money
7 Private currencies
8 How did it come into existence ?
9 How is it destroyed ?
10 See also
11 External links

Essential characteristics of money

Money has the following three characteristics.

1. It must be a medium of exchange

When an object is in demand primarily for its use in exchange -- for its ability to be used in trade to exchange for other things -- then it has this property.

This characteristic allows money to be a standard of deferred payment, i.e., a tool for the payment of debt.

2. It must be a unit of account

When the value of a good is frequently used to measure or compare the value of other goods or where its value is used to denominate debts then it is functioning as a unit of account.

A debt or an IOU can not serve as a unit of account because its value is specified by comparison to some external reference value, some actual unit of account that may be used for settlement.

For example, if in some culture people are inclined to measure the worth of things with reference to goats then we would regard goats as the dominant unit of account in that culture. For instance we may say that a horse is worth 10 goats and a good hut is worth 45 goats. We would also say that an IOU denominated in goats would change value at much the same rate as real goats.

3. It must be a store of value

When an object is purchased primarily to store value for future trade then it is being used as a store of value. For example, a sawmill might maintain an inventory of lumber that has market value. Likewise it might keep a cash box that has some currency that holds market value. Both would represent a store of value because through trade they can be reliably converted to other goods at some future date. Most non-perishable goods have this quality.

Many goods or tokens have some of the characteristics outlined above. However no good or token is money unless it can satisfy all three criteria.

Credit is often referred to as money. For example bank deposits are often included in some summations of the national money supply. However credit only satisfies items one and three of the above criteria. It completely fails criteria number two. Hence to be strictly accurate credit is a money substitute and not money proper.

Related concepts

Desirable features of money

To function as money in a modern economy a good or token should possess a number of features:

Modern forms of money

When using money anonymously, the most common methods are cash (either coin or banknotes) and stored-value cards.

When using money substitutes in such a way as to leave a financial record of the transaction, the most common methods are cheques, debit cards, credit cards, and digital cash.

Money and economics

Money is one of the most central topics studied in economics and forms its most cogent link to finance.

The amount of money in an economy directly affects inflation and interest rates and hence has profound effects. A monetary crisis can have very significant economic effects, particularly if it leads to monetary failure and the adoption of a much less efficient barter economy. This happened in Russia (for instance) during the 1990s.

Modern economics also faces a difficulty in deciding what exactly 'is' money. See money supply

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. These arguments are covered in financial capital which is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender.

History of money

Before money

Prior to the introduction of money, barter was the only way to exchange goods. Bartering has several problems, most notably timing constraints. If you wish to trade pigs for wheat, you can only do this when the pigs and wheat are both available at the same time and place - and without proper storage that may be a very brief time. With a trade standard like gold, you can sell your pigs at the "best time" and take the gold coins. You can then use that gold to buy wheat when the harvest comes in. Thus the use of money makes all commodities become more liquid.

Where trade is common, barter systems usually lead quite rapidly to the emergence of several key goods with monetary properties. In the early British colony of New South Wales in Australia, rum emerged quite soon after settlement as the most monetary of goods. When a nation is without a fiat currency system it is quite common for the fiat currency of a neighbouring nation to emerge as the dominant monetary good. In some prisons where conventional money is prohibited it is quite common for goods such as cigarettes to take on a monetary quality. Gold has emerged naturally from the world of barter again and again to take on a monetary function. It should be noted that the emergence of monetary goods is not dependent on central authority or government. It is a quite natural market phenomenon.

Commodity money

The first instances of money were objects which were useful for their intrinsic value. This was known as commodity money and included any commonly-available commodity that has intrinsic value; historical examples include pigs, rare seashells, whale's teeth, and (often) cattle. In medieval Iraq, bread was used as an early form of currency.

Even in the industrialised world, in the absence of other types of money, people have occasionally used commodities such as tobacco as money. This last happened on a wide scale after World War II when cigarettes became used unofficially in Europe, in parallel with other currencies, for a short time.

Another example of "commodity money" is shell money in the Solomon Islands. Shells are painstakingly chipped into rough circles, filed down, and threaded onto large necklaces, which are then used during marriage proposals; for instance, a father may charge twenty shell money necklaces for his daughter's hand in marriage.

Once a commodity becomes used as money, it takes on a value that is often a bit different from what the commodity is intrinsically worth or useful for. Being able to use something as money in a society adds an extra use to it, and so adds value to it. This extra use is a convention of society, and how extensive the use of money is within the society will affect the value of the monetary commodity. So although commodity money is real, it should not be seen as having a fixed value in absolute terms. Its value is still socially determined to a large extent. A prime example is gold, which has been valued differently by many different societies, but perhaps none valued it more than those who used it as money. Fluctuations in the value of commodity money can be strongly influenced by supply and demand whether current or predicted (i.e. if you know the local gold mine is about to run out of ore, the price of gold will go up in anticipation of a shortage).

Money can be anything that the parties agree is tradable, but the usability of a particular sort of money varies widely. Desirable features of a good basis for money include being able to be stored for long periods of time, dense so it can be carried around easily, and difficult to find on its own so that it is actually worth something. Again, supply and demand play a key role in determining value. When governments print more banknotes, they are increasing the supply of money without any underlying increase in value. Therefore, the money may become worth less than before the new banknotes were issued. See open market operations.

For these reasons metals like gold and silver have often been used for a commodity money. However, these metals are also easily alloyed with a less expensive metal, which has at some times in history made their value less reliable than it might have otherwise been!

Standardized coinage

It was the discovery of the touchstone that paved the way for metal-based commodity money and coinage. Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. For these reasons gold as a money spread very quickly from Asia Minor where it first gained wide use, to the entire world.

Using such a system still required several steps and some math. The touchstone allowed you to estimate the amount of gold in an alloy, which was then multiplied by the weight to find the amount of gold alone in a lump.

To make this process easier, the concept of standard coinage was introduced. Coins were pre-weighed and pre-alloyed, so as long as you were aware of the origin of the coin, no use of the touchstone was required. Coins were typically minted by governments in a carefully protected process, and then stamped with an emblem that guaranteed the weight and value of the metal. It was however extremely common for governments to assert that the value of such money lay in its emblem and to subsequently debase the currency by lowering the content of valuable metal.

Although gold and silver were commonly used to mint coins, other metals could be used -- in the early seventeenth century Sweden lacked more precious metal and so produced "plate money," which were large slabs of copper approximately 50cm or more in length and width, appropriately stamped with indications of their value. The unwieldiness of this plate money no doubt contributed to Sweden's becoming the first European country to issue paper currency, in 1661.

See also: Roman currency.

Representative money

The system of commodity money in many instances evolved into a system of representative money. In this system, the material that constitutes the money itself had very little intrinsic value, but none the less such money achieves significant market value through being scarce as an artefact.

Paper currency and non-precious coinage was backed by a government or bank's promise to redeem it for a given weight of precious metal, such as silver. This is the origin of the term "British Pound" for instance; it was a unit of money backed by a Tower pound of sterling silver - hence the currency Pound Sterling.

For much of the nineteenth and twentieth centuries, many currencies were based on representative money through the use of the gold standard.

Fiat money

Fiat money refers to money that is not backed by reserves of another commodity. The money itself is given value by government fiat (Latin for "let it be done") or decree, enforcing legal tender laws whereby debtors are legally relieved of the debt if they (offer to) pay it off in the government's money.

Governments through history have often switched to forms of fiat money in times of need such as war, sometimes by suspending the service they provided of exchanging their money for gold, and other times by simply printing the money that they needed.

In 1971 the US finally switched to fiat money indefinitely. At this point in time many of the economically developed countries' currencies were fixed to the US dollar (see Bretton Woods Conference), and so this single step meant that much of the western world's currencies became fiat money based.

Following the first Gulf War the president of Iraq, Saddam Hussein, repealed the existing Iraqi fiat currency and replaced it with a new currency. However, the old currency continued to be used in the politically isolated Kurdish regions of Iraq. Despite having no backing by a commodity and with no central authority mandating its use or defending its value it continued to circulate within this Kurdish region. It became known as the Swiss Dinar. This currency remained relatively strong and stable for over a decade. It was formally replaced following the second Gulf War.

Credit money

Credit money often exists in parallel with other money such as fiat money or commodity money, and from the user's point of view is indistinguishable from it. Most of the western world's money is credit money derived from national fiat money currencies.

Strictly speaking a debt is not money, primarily because debt can not act as a unit of account. All debts are denominated in units of something external to the debt. Hence credit money is not strictly money at all. However, credit money certainly acts as a money substitute when it comes to the other functions of money (medium of exchange and store of value). As such the existence of credit money may dampen demand for the real money and in so doing alter the dynamics of money's market value.

When paper money is merely an IOU for something such as gold, then the paper itself is not a unit of account but merely a convenient medium of exchange. Under a rigid gold-standard with convertiblity, paper currency is merely a debt instrument. However, when paper money floats, its value is not defined by reference to an external unit of account. It is no longer a debt instrument but rather it becomes purely monetary and its value is a product of the dynamics of supply and demand. Typically a central bank forces supply and the private sector forces demand. See open market operations.

Credit money tends to arise as a byproduct of lending and borrowing money. The following example illustrates this.

Imagine you have deposited some gold coins in a bank vault. The bank might lend the coins to a second person based on a promise to pay equivalent coins back with a few extra at a time in the future. The second person can in the meantime use the coins normally as money. But you still own the coins, and you also could still use them - you could transfer their ownership to another person to pay for something you have bought by telling the bank to transfer them from your account to the other person's account. You might do this by writing a check. So in this simple example there are two people using the same coins as money at the same time. It's as if new money has been created by the act of lending. Taking it another step, if the second person spends the coins at a shop, and they end up being deposited back into the bank by the shopkeeper, the bank can lend them again. Now you and the shopkeeper can use the coins in the same way, by writing checks or the equivalent in this example, and whoever borrows the coins a second time can use the coins directly as money. So there are three people with financial use of the coins. This can go on with many people ending up simultaneously using the same coins financially, but for each extra user there is a promise to pay equivalent coins back. These arrangements where many people use the same money simultaneously are in many respects the same as if there was extra money. The extra money that there appears to be is known as credit money. It is in regulating the amount of money a bank can lend that the controlling authority can set the money supply and change monetary policy. The credible promises to repay in a reasonable time give the extra money its value. It tends to exist in parallel with another form of money such as fiat money or commodity money, wherever banking-style loans are used, and occurs as a by-product of lending. It could occur without banks, but banks provide a degree of stability to the whole process by taking and evaluating the risk involved in each loan.

During the Crusades in Europe, precious goods would be entrusted to the Catholic Church's Knights Templar, who effectively created a system of modern credit accounts. Over time this system grew into the credit money that we know today, where banks create money by approving loans - although the risk and reserve policies of each national central bank sets a limit on this, requiring banks to keep reserves of fiat money to back their deposits. Sometimes, as in the U.S.A. during the Great Depression or the Savings and Loan Scandal, trust in bank policies drops very low and government must intervene to keep the industry of credit in operation.

Private currencies

In many countries, the issue of private paper currencies has been severely restricted by law. In Australia the Notes Act of 1910 basically shut down the circulation of private currencies by imposing a prohibitive tax on the practice. Many other nations have similar such policies that eliminate private sector competition.

Today there are several privately issued digital currencies in circulation that function as money. Transactions in these currencies represent an annual turnover value in billions of US dollars.

Many of these private currencies are backed by older forms of money such as gold.

Some examples of digital gold currencies include:-

How did it come into existence ?

Historically money was a metal (gold, silver, etc,) or other object that was difficult to duplicate, but easy to transport and divide. Later it consisted of paper notes, now issued by all modern governments. With the rise of modern industrial capitalism it has gone through several phases including but not limited to:

A. Bank notes - paper issued by banks as an interest-bearing loan. (These were common in the 19th century but not seen anymore.)

B. Paper notes, coins with varying amounts of precious metal (usually called legal tender) issued by various governments. There is also a near-money in the form of interest bearing bonds issued by governments with solid credit ratings.

C. Bank credit through the creation of chequable deposits in the granting of various loans to business, government and individuals. (It is critical that we understand that when a bank makes a loan, that is new money and when a loan is paid off that money is destroyed. Only the interest paid on it remains.)

How is it destroyed ?

When any bank loan is paid off or any government bond is redeemed the money value of the contract or bond is destroyed - taken out of circulation. This destruction also happens if any paper bills are burned or taken out of circulation by the central bank. (But it should be remembered that legal tender constitutes less than 4% of the money supply.)

See also

External links