Everyone uses money. We all want it, work for it and think about it. If you don't know what money is, you are not like most humans. However, the task of defining what money is, where it comes from and what it's worth belongs to those who dedicate themselves to the discipline of economics. While the creation and growth of money seems somewhat intangible, money is the way we get the things we need and want. Here we look at the multifaceted characteristics of money. (Get A Short-Term Advantage In The Money Market. This investment vehicle is often the perfect stop-gap measure for growing your money.)

What is Money?
Before the development of a medium of exchange, people would barter to obtain the goods and services they needed. This is basically how it worked: two individuals each possessing a commodity the other wanted or needed would enter into an agreement to trade their goods.

This early form of barter, however, does not provide the transferability and divisibility that makes trading efficient. For instance, if you have cows but need bananas, you must find someone who not only has bananas but also the desire for meat. What if you find someone who has the need for meat but no bananas and can only offer you bunnies? To get your meat, he or she must find someone who has bananas and wants bunnies ...

The lack of transferability of bartering for goods, as you can see, is tiring, confusing and inefficient. But that is not where the problems end: even if you find someone with whom to trade meat for bananas, you may not think a bunch of them is worth a whole cow. You would then have to devise a way to divide your cow (a messy business) and determine how many bananas you are willing to take for certain parts of your cow. (It can be hard to talk about money with your children, especially when times are tough. Talking About Money When Times Are Tough has some tips to make it easy.)

To solve these problems came commodity money, which is a kind of currency based on the value of an underlying commodity. Colonialists, for example, used beaver pelts and dried corn as currency for transactions. These kinds of commodities were chosen for a number of reasons. They were widely desired and therefore valuable, but they were also durable, portable and easily stored.

Another example of commodity money is the U.S. currency before 1971, which was backed by gold. Foreign governments were able to take their U.S. currency and exchange it for gold with the U.S. Federal Reserve. If we think about this relationship between money and gold, we can gain some insight into how money gains its value: like the beaver pelts and dried corn, gold is valuable purely because people want it.

It is not necessarily useful - after all, you can't eat it, and it won't keep you warm at night, but the majority of people think it is beautiful, and they know others think it is beautiful. Gold is something you can safely believe is valuable. Before 1971, gold therefore served as a physical token of what is valuable based on people's perception. (You don't need an MBA to learn how to save money and invest in your future. Follow 8 Financial Tips For Young Adults, to find out more.)

Impressions Create Everything
The second type of money is fiat money, which does away with the need to represent a physical commodity and takes on its worth the same way gold did: by means of people's perception and faith. Fiat money was introduced because gold is a scarce resource and economies growing quickly couldn't always mine enough gold to back their money requirement. For a booming economy, the need for gold to give money value is extremely inefficient, especially when, as we already established, value is really created through people's perception.

Fiat money, then becomes the token of people's apprehension of worth - the basis for why money is created. An economy that is growing is apparently doing a good job of producing other things that are valuable to itself and to other economies. Generally, the stronger the economy, the stronger its money will be perceived (and sought after) and vice versa. But, remember, this perception, although abstract, must somehow be backed by how well the economy can produce concrete things and services that people want.

That is why simply printing new money will not create wealth for a country. Money is created by a kind of a perpetual interaction between concrete things, our intangible desire for them, and our abstract faith in what has value: money is valuable because we want it, but we want it only because it can get us a desired product or service.

How is it Measured?
Sure, money is the $10 bill you lent to your friend the other day and don't expect back anytime soon. But exactly how much money is out there and what forms does it take? Economists and investors ask this question everyday to see whether there is inflation or deflation. To make money more discernible for measurement purposes, they have separated it into three categories:

  • M1 – This category of money includes all physical denominations of coins and currency, demand deposits, which are checking accounts and NOW accounts, and travelers' checks. This category of money is the narrowest of the three and can be better visualized as the money used to make payments.
  • M2 – With broader criteria, this category adds all the money found in M1 to all time-related deposits, savings deposits, and non-institutional money-market funds. This category represents money that can be readily transferred into cash.
  • M3 – The broadest class of money, M3 combines all money found in the M2 definition and adds to it all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.

By adding these three categories together, we arrive at a country's money supply, or total amount of money within an economy.

How Money is Created
Now that we've discussed why and how money, a representation of perceived value, is created in the economy, we need to touch on how the central bank (the Federal Reserve in the U.S.) can manipulate the money supply.

Among other things, a central bank has the ability to influence the level of a country's money supply. Let's look at a simplified example of how this is done. If it wants to increase the amount of money in circulation, the central bank can, of course, simply print it, but as we learned, the physical bills are only a small part of the money supply.

Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market. When the central bank buys these government securities, it puts money in the hands of the public. How does a central bank such as the Federal Reserve pay for this? As strange as it sounds, they simply create the money out of thin air and transfer it to those people selling the securities! To shrink the money supply, the central bank does the opposite and sells government securities. The money with which the buyer pays the central bank is essentially taken out of circulation. Keep in mind that we are generalizing in this example to keep things simple. (For more information, see the Federal (the Fed) Reserve Tutorial.)

Remember, as long as people have faith in the currency, a central bank can issue more of it. But if the Fed issues too much money, the value will go down, as with anything that has a higher supply than demand. So even though technically it can create money "out of thin air," the central bank cannot simply print money as it wants.

Related Articles
  1. Investing Basics

    Why Interest Rates Affect Everyone

    Learn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
  2. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  3. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  4. Markets

    What Slow Global Growth Means for Portfolios

    While U.S. growth remains relatively resilient, global growth continues to slip.
  5. Economics

    Will a Hike in Interest Rates Affect the US Dollar?

    Learn about how rising U.S. interest rates affect the U.S. dollar and where the dollar could be heading once the rising rate cycle begins again.
  6. Retirement

    What Was The Glass-Steagall Act?

    Established in 1933 and repealed in 1999, the Glass-Steagall Act had good intentions but mixed results.
  7. Economics

    What to Expect From Mortgage Rates in 2016

    Understand the factors that influence the direction of mortgage rates, and use this information to project what will happen with rates in 2016.
  8. Economics

    The Taylor Rule: Calculating Monetary Policy

    The Taylor Rule suggests how the central bank should change interest rates to account for inflation and other economic conditions.
  9. Investing

    2 Investing Implications of Higher US Rates

    While U.S. economic data continue to come in mixed, the numbers still point to decent U.S. economic growth.
  10. Stock Analysis

    What Markets Poised to Benefit if the Fed Waits?

    Late last month, the Fed reminded that a 2015 rate hike is still a possibility; there are certain segments of the market that are more sensitive to changes.
  1. Is credit a form of fiat money?

    To understand why credit is a form of fiat money, one must first understand what money is. At its most basic level, money ... Read Full Answer >>
  2. What happens if interest rates increase too quickly?

    When interest rates increase too quickly, it can cause a chain reaction that affects the domestic economy as well as the ... Read Full Answer >>
  3. When was the last time the Federal Reserve hiked interest rates?

    The last time the U.S. Federal Reserve increased the federal funds rate was in June 2006, when the rate was increased from ... Read Full Answer >>
  4. Do lower interest rates increase investment spending?

    Lower Interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic ... Read Full Answer >>
  5. How is the Federal Reserve audited?

    Contrary to conventional wisdom, the Federal Reserve is extensively audited. Politicians on the left and right of a populist ... Read Full Answer >>
  6. Who decides when to print money in the US?

    The U.S. Treasury decides to print money in the United States as it owns and operates printing presses. However, the Federal ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center