Money

Money is any marketable good or token used by a society as a medium of exchange, store of value and unit of account. Since the needs arise naturally, societies organically create one or several money objects when none exists. In other cases, a central authority creates a single money object and compels its use; this is more frequently the case in modern societies with paper money.

Money

Money is any marketable good or token used by a society as a medium of exchange, store of value and unit of account. Since the needs arise naturally, societies organically create one or several money objects when none exists. In other cases, a central authority creates a single money object and compels its use; this is more frequently the case in modern societies with paper money.

The value of money emerges in no small part from its utility as a medium of exchange, however its utility as a medium of exchange depends on it having recognised market value. Hence these two aspects of money are interdependent.

Commodity money was the first form of money to emerge. Under a commodity money system, the object used as money has inherent value. It is usually adopted to simplify transactions in a barter economy; thus it functions first as a medium of exchange. It quickly begins functioning as a store of value, since holders of perishable goods can easily convert them into durable money. In modern economies, commodity money has also been used as a unit of account. Gold-backed currency notes are a common form of commodity money.

Fiat money is a relatively modern invention. A central authority (government) creates a new money object that has minimal inherent value. The widespread acceptance of fiat money is most frequently enhanced by the central authority mandating the money's acceptance under penalty of law and demanding this money in payment of taxes or tribute. At various times in history government issued promisory notes have later become fiat currencies (US dollar) and fiat currencies have gone on to become a form of commodity currency (Swiss Dinar).

Contents:
1 Essential characteristics of money
2 Credit as money
3 Desirable features of money
4 Modern forms of money
5 Money and economics
6 History of money
7 Private currencies
8 Money supply
8.1 Growing the money supply
8.2 Shrinking the money supply (M3)

Essential characteristics of money

Money has all of the following three characteristics:

1. It must be a medium of exchange

When an object is consistently used as an intermediate object of trade, as opposed to direct barter, then it is regarded as a medium of exchange. The utility of such an object in simplifing the process of trade leads to direct demand for the object.

In order for a single object to become or to remain dominant in this function requires either coercion or faith.

When people are coerced to use or alternatively they trust an object and demand it in order to do their exchanges and trades, then this object is considered to be money.

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 today 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 as money

Credit is often loosely referred to as money. However credit only satisfies items one and three of the above "Essential Characteristics of Money" criteria. Credit completely fails criterion number two. Hence to be strictly accurate credit is a money substitute and not money proper.

This distinction between money and credit causes much confusion in discussions of monetary theory. In lay terms, and when convenient in academic discussion, credit and money are frequently used interchangeably. For example bank deposits are generally included in summations of the national broad money supply. However any detailed study of monetary theory needs to recognize the proper distinction between money and credit.

The rest of this article frequently uses the term money in the looser sense of the word.

Desirable features of money

To function as money, the monetary item should possess a number of features:

To be a medium of exchange:

It should be liquid, easily tradable, with a low spread between the prices to buy and sell. A low spread typically occurs when an item is fungible.
It should be easily transportable; precious metals have a high value to weight ratio. This is why oil, copper, or bricks are not suitable as money. Paper notes have proved highly convienient in this regard.

To be a unit of account:

It should be divisible into small units without destroying its value; precious metals can be coined from bars, or melted down into bars again. This is why leather, or animals are not suitable as money.
It should be fungible: that is, one unit or piece must be equivalent to another, which is why diamonds or real estate are not suitable as money.
It must be a certain weight, or measure, to be verifiably countable.

To be a store of value:

It should be long lasting, durable, it must not be perishable or subject to decay. This is why food items, expensive spices, or even fine silks, are not generally suitable as money.
It should have a stable value; a value intrinsic in itself, such as a luxury item, scarce, or rare.
It should be difficult to counterfeit, and the genuine must be easily recognizable.
These reasons are why paper, or electronic credits, are often not desirable as money.

For these reasons, gold and silver have been chosen again and again throughout history as money in more societies and in more cultures and over longer time periods than any other items; and when embraced as money, those societies inevitibly propser under what is often called a golden age.

One key benefit of these features of money is that it facilitates and encourages trade; because barter is inefficient.

Modern forms of money

When using money anonymously, the most common methods are gold, 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 checks, 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 affects inflation and interest rates and hence has profound effects. The monetary policy of government aims to manage money, inflation and interest to affect output and employment.

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

Main article: History of money

Money has developed over the years from conch shells to sophisticated international banking systems.

The history of money has generally seen commodity money replaced by more formal systems, as money has been progressively brought under the control of governments.

Private currencies

Main article: Private currency

In many countries, the issue of private paper currencies has been severely restricted by law.

A private 1 dollar note, issued by the "Delaware Bridge Company" of New Jersey 1836-1841.

In the United States, the Free Banking Era lasted between 1837 and 1866, during which almost anyone could issue their own paper money. States, municipalities, private banks, railroad and construction companies, stores, restaurants, churches and individuals printed an estimated 8,000 different monies by 1860. If the issuer went bankrupt, closed, left town, or otherwise went out of business the note would be worthless. Such organizations earned the nickname of "wildcat banks" for a reputation of unreliability and that they were often situated in far-off, unpopulated locales that were said to be more apt to wildcats than people. On the other hand, according to Lawrence H. White's article in [1] "it turns out that “wildcat” banking is largely a myth. Although stories about crooked banking practices are entertaining—and for that reason have been repeated endlessly by textbooks—modern economic historians have found that there were in fact very few banks that fit any reasonable definition of wildcat bank." The National Bank Act of 1863 ended the "wildcat bank" period.

In Australia, the Bank Notes Tax 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.

In Scotland and Northern Ireland private sector banks are licensed to print their own paper money by the government.

Today privately issued electronic money is in circulation. Some of these private currencies are backed by historic forms of money such as gold, as in the case of digital gold currency. Transactions in these currencies represent an annual turnover value in billions of US dollars.

It is possible for privately issued money to be backed by any other material, although some people argue about perishable materials. After all, gold, or platinum, or silver, have in some regards less utility than previously (their electrical properties notwithstanding), while currency backed by energy (measured in joules) or by transport (measured in kilogramme*kilometre/hour) or by food [2] is also possible and may be accepted by the people, if legalised. It is important to understand though that, as long as money is above all an agreement to use something as a medium of exchange, its up to the community (or to the minority which holds the power) to decide whether money should be backed by whatever material or should be totally virtual.

Though these private, especially digital, monies has had some modest success, governments have established a coercive monopoly on what currency may be used in lending by enacting legal tender laws. One may borrow a private currency but repay the loan with a legal tender that has subsequently devalued against the private alternative, with the lender being required by law to accept it. This large and apparently insurmountable risk to lenders severely limits the proliferation of private money, as the interest rate would have to be exhorbitant to compensate for this tremendous risk premium.

Money supply

Main article: Money supply

The money supply is the amount of money available within a specific economy available for purchasing goods or services. The supply is usually considered as four escalating categories M0, M1, M2 and M3. The categories grow in size with M3 representing all forms of money (including credit) and M0 being just base money (coins, bills, and central bank deposits). M0 is also money that can satisfy private banks' reserve requirements. In the United States, the Federal Reserve is responsible for controlling the money supply (monetary policy).

Growing the money supply

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:

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

Thus, all debt denominated in dollars -- mortgages, money markets, credit card debt, travelers cheques -- is money. However, the creation of dollar-denominated debt (or any generic obligation) only creates money when a bank (as opposed to a credit card company) is granting the debt. "High powered" money (M0) is created when the elected government spends money into the economy. The money created in the bank loan process is bank money and these two forms of money trade at par one with the other. Banks are limited in the amount of loans they can grant and thus in the amount of bank money (credit) they can create by both the net assets of the bank and by reserve requirements (M0). For most intents and purposes the aggregate of M0 multiplied by the reserve requirement will be an indicator of (but this is somewhat greater than) the aggregate of loans. If additional money is needed in the banking system to allow more loans the Federal Reserve will create money by purchasing Bonds or T-bills with money created from the other. No matter who sells the bonds the money will end up in the banking system as M0. The Fed could purchase lolly pops if that would accomplish the purpose of expansion better than a purchase of Bonds.

Shrinking the money supply (M3)

Perhaps the most obvious way money can be destroyed is if paper bills are burned or taken out of circulation by the central bank. But, it should be remembered that legal tender usually constitutes less than 4% of the broad money supply.

Another way money can be destroyed is when any bank loan is paid off or any government bond or T-Bill is purchased by the private sector. The money value of the contract or bond is destroyed — taken out of circulation. If a bank loan is defaulted upon then the "interest" paid by other borrowers will be employed to cover the default. A very large part of the "interest" paid on bank loans is actually a finance charge employed to cover bad loans. The group of good borrowers pay the loan instead of the original borrower. In cases where the default is huge such as loans to foreign governments Fed intervention has, in the past, rescued the banks. In this instance it would seem that the taxpayers and/or money holders (savers) will pay the debt. The effects on the money supply will be controlled, again, by the level of bond purchase or redemption or the level of T-Bill sales or purchases by the Treasury.

Money can be destroyed if savers withdraw funds from a bank, in which case that money can no longer be used for lending. Bank savings are actually a kind of loans — savers loan their money to a bank at a low interest rate or merely in exchange for the benefit of convenience or its security (accepting that they lose a small amount of value to inflation). The bank may use this loan to manage its liabilities (its deposit liabilities created by loans). It must be recalled that the federal reserve banking system is mostly a closed system. A check written on bank A gets deposited in Bank B and a check written on bank B gets deposited in Bank C and a check on bank C gets deposited in bank A. At the end of the day the bankers go have a beer and see who needs to borrow from whom:) On a good day very little borrowing needs to be done because a bank gets as much in new deposits as it does in paid out funds. Even if a bank is short of reserves it can borrow the reserves from another bank at the discount rate.

In extreme forms, a bank run or panic may drive a bank into insolvency and, if uninsured, the savings of all its depositors are lost. Such bank failures were a major cause of the tremendous contraction in the money supply that occurred during the Great Depression, particularly in the United States. In that country many banking reforms were subsequently enacted during the New Deal, including the creation of the Federal Deposit Insurance Corporation to guarantee private bank deposits.

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