Note: This is the latest entry in the Acton blog series, “What Christians Should Know About Economics.” For other entries in the series see this post.
The Term: Money
What it Means: In economics, money is a broad term that refers to any financial instrument that can fulfill the functions of money (more on that in a moment).
There are three basic ways to exchange goods and services: gifting (e.g., I give you a banana, expecting nothing in return); barter (e.g., I give you a banana, in exchange you give me an apple); by using money (e.g., I give you a banana, in exchange you give me $1). Money was invented (and reinvented in every culture) because it makes exchanges easier than the barter system.
What Money Is: Money is a shared belief system used to simplify exchanges of goods and services. To be used as money people have to share a belief that the item —whether paper, gold, rocks, etc. — can perform three main functions: be a store of value, be used as a unit of account, and serve as a medium of exchange.
In the next section we’ll examine these functions. For now, here are two examples of how money serves as a shared belief system:
In the Caroline Islands of the western Pacific Ocean there is an island called Yap. For centuries the island had neither paper currency, nor metals such as gold, silver, or copper to use for minting coins. Instead, the islanders used limestone, which they had discovered on another island four hundred miles away. Because this stone was the most beautiful and precious commodity in the area, they made it their money.
Laborers would travel to that distant island to carve thick stone wheels called “rai” which range in height from one to twelve feet. At their center a hole would be cut so that a pole could be inserted for transport. Even with this change, though, the stones were too big and bulky to be carried to the local market. Instead, when payment was made, everyone would simply acknowledge that the rai belonged to the new owner and the stone would remain on the former owner’s premises.
One time a work crew was transporting a giant stone coin back to Yap on a raft and was met by a violent storm. To save their own lives, the workers dumped the stone into the ocean. As anthropologist William Henry Furness III wrote in 1910:
When they reached home, they all testified that the [rai] was of magnificent proportions and of extraordinary quality, and that it was lost through no fault of the owner. Thereupon it was universally conceded in their simple faith that the mere accident of its loss was too trifling to mention, and that a few hundred feet of water off shore ought not to affect its marketable value, since it was all chipped out in proper form. The purchasing power of that stone remains, therefore, as valid as if it were leaning visibly against the side of the owner’s house.
The concept of considering a stone on the bottom of the ocean—a stone that few people have ever seen—as a legitimate currency might seem absurd. But as the late economist Milton Friedman has noted, this story isn’t as unusual as it might sound. For instance, when the United States was on the gold standard, the Bank of France asked the Federal Reserve of New York to convert its dollar assets to gold. Rather than ship the gold across the Atlantic Ocean, the Federal Reserve requested that the gold remain in the Bank of France’s accounts. The French bankers went into their gold vaults and changed the labels to mark the gold as the property of France. After the relabeling, everyone involved considered the U.S. currency owned by the French, to be sufficiently backed by gold.
Both the stones of Yap and the gold in France reveal, said Friedman, how much unquestioned belief is necessary in monetary matters.
What money does: Money serves three essential functions: a store of value, a unit of account, and a medium of exchange.
Store of value – Imagine you got paid for your work in bananas. You’d need to spend them quickly since they’d rot within a few weeks. Bananas don’t work well as money because they don’t store value. To serve as money, an item needs to be durable, which is why cloth (like in dollar bills) and metal are often used as currency. (Money is not a perfect store of value, though, since inflation slowly erodes purchasing power over time.)
Unit of account – Money needs to be a store of value. But there also needs to be a way to measure that value. That’s why money also needs to be a unit of account — a standard monetary unit of measurement used for describing the value of something. The important characteristics of a unit of account includes (a) standardized and easily recognizable (e.g., all dollar bills look alike), (b) stability (e.g., as long as people trust the U.S. government, they’ll trust $1 is worth a dollars worth of goods and services), and (c) able to be broken up into components of equal value without losing value (e.g., a dollar can be divided into one hundred parts: one hundred cents = $1; a gold bar can be divided by weight).
Medium of exchange – Money serves as a medium of exchange when it is widely accepted as a method of payment (this where the shared belief system kicks in). A dollar bill is money because the U.S. government says so – and most people throughout the world agree to act as if it is money. Your personal check is also money because your bank will exchange it for currency. Gold was frequently used as money because people share the belief that it has value.
Types of money: The main two types of money are fiat money and commodity money.
Most global currencies are fiat money—money that has value only because of government regulation or law. Fiat money is not convertible by law into anything other than itself, such as gold or silver, and has no fixed value in terms of an objective standard—it’s value can fluctuate based on numerous economic factors.
In contrast, commodity money is a medium of exchange that may be transformed into a commodity, useful in production or consumption. Commodity money can be based on minerals (e.g., gold or silver), found objects (e.g., shells or stones), consumer good (e.g., cigarettes in prison or POW camps), or even digital bits (e.g., Bitcoin).
Although commodity money was the dominant medium for exchange for thousands of years (think gold and silver), it has fallen out of favor because it limits the scope for monetary policy and other actions that alter the value of money.
Other Stuff You Might Want to Know:
• Legal tender is money recognized by a legal system to be valid for meeting a financial obligation. Paper currency and coins are common forms of legal tender in many countries.
• The “money supply” is all the financial instruments (items that can serve as money) within an economy. Financial instruments can be added together to form “monetary aggregates,” which are subsets of the total money supply.
• The most commonly used monetary aggregates are designated M1, M2 and M3. M1 is currency (coins and bills) plus demand deposits (such as checking accounts); M2 is M1 plus savings accounts and certificates of deposit (i.e., bank CDs) under $100,000; and M3 is M2 plus larger time deposits and similar institutional accounts.
• In the American economy, only about 10 percent of the money supply is in physical currency.
• The money supply is expanded through the modern banking system in two ways:
1) Central bank money — all money created by the central bank (i.e., Federal reserves) such as banknotes, coins, electronic money, etc.)
2) Commercial bank money — money created by fractional reserve borrowing and lending.
Note: Future articles will address related concepts such as central banks, fractional reserve banking, inflation, quantitative easing, gold standard etc.