Loading the player...

Everyone uses money. We all want it, work for it and think about it. While the creation and growth of money seems somewhat intangible, money is the way we get the things we need and desire. 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. Here we look at the multifaceted characteristics of money.

What is Money?

Before the development of a medium of exchange – i.e., money – people would barter to obtain the goods and services they needed. Two individuals, each possessing some goods the other wanted, would enter into an agreement to trade.

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...and so on.

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.

To solve these problems came commodity money: a type of good that functions as currency. In the 17th and early 18th centuries, for example, American colonialists used beaver pelts and dried corn in transactions; possessing generally accepted values, these commodities were used to buy and sell other things. The kinds of commodities used for trade had certain characteristics: They were widely desired and therefore valuable, but they were also durable, portable and easily storable.

Another, more advanced example of commodity money is a precious metal like gold – which for centuries was used to back paper currency up until the 1970s. In the case of the American dollar, for example, this meant that foreign governments were able to take their dollars and exchange them at a specified rate for gold with the U.S. Federal Reserve. What's interesting is that, unlike the beaver pelts and dried corn (which can be used for clothing and food, respectively), gold is precious 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. So, gold is something you can safely believe has worth. Gold therefore serves as a physical token of wealth, based on people's perception.

If we think about this relationship between money and gold, we can gain some insight into how money gains its value – as a representation of something valuable.

Impressions Create Everything

The second type of money is fiat money, which does away with the need for a physical commodity to back it. Instead, its value is set by supply and demand, and people's faith in its worth. Fiat money developed because gold was a scarce resource and economies growing quickly couldn't always mine enough to back their currency supply requirements. For a booming economy, the need for gold to give money value is extremely inefficient, especially when, as we already established, its value is really created through people's perception.

Fiat money becomes the token of people's perception 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.

For example, in 1971, the U.S. dollar was taken off the gold standard – the dollar was no longer redeemable in gold, and the price of gold was no longer fixed to any dollar amount. This meant that it was now possible to create more paper money than there was gold to back it; it was the health of the American economy that backs the dollar's value. If the economy takes a nosedive, the value of the U.S. dollar will drop both domestically through inflation, and internationally through currency exchange rates. Fortunately, the implosion of the U.S. economy would plunge the world into a financial dark age, so many other countries and entities are working tirelessly to ensure that never happens.

Nowadays, the value of money (not just the dollar, but most currencies) is decided purely by its purchasing power, as dictated by inflation. 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 Money Measured?

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; it's essentially the money used to buy things and make payments (see the "active money" section, below).
  • M2 – With broader criteria, this category adds all the money found in M1 to all time-related deposits, savings accounts 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 the total amount of money within an economy.

Active Money

The M1 category includes what's known as active money – that is, the total value of coins and paper currency in circulation amongst the public. The amount of active money fluctuates seasonally, monthly, weekly and daily. In the United States, Federal Reserve Banks distribute new currency for the US Treasury Department. Banks lend money out to customers which becomes classified as active money once it is actively circulated.

The variable demand for cash equates to a constantly fluctuating active money total. For example, people typically cash paychecks or withdraw from ATMs over the weekend, so there is more active cash on a Monday than on a Friday. The public demand for cash declines at times, following the December holiday season, for example.

Due to the high demand from abroad, the majority of circulating U.S. cash is actually outside of the United States.

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 a country's central bank (it's the Federal Reserve in the U.S.) can influence and manipulate its 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 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 into the marketplace, and effectively into 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! Or, it can lower interest rates, allowing banks to extend low-cost loans or credit – a phenomenon known as cheap money – and encouraging businesses and individuals to borrow and spend.

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.

The History of American Money

Currency Wars

In the 17th century, Great Britain was determined to keep control of both the American colonies and the natural resources they controlled. To do this, the British limited the money supply and made it illegal for the colonies to mint coins of their own. Instead, the colonies were forced to trade using English bills of exchange that could only be redeemed for English goods. Colonists were paid for their goods with these same bills, effectively cutting them off from trading with other countries.

In response, the colonies regressed back into a barter system using ammunition, tobacco, nails, pelts and anything else that could be traded. Colonists also gathered whatever foreign currencies they could, the most popular being the large, silver Spanish dollars. These were called pieces of eight because, when you had to make change, you pulled out your knife and hacked it into eight bits. From this, we have the expression "two bits," meaning a quarter of a dollar. (To read about money's beginnings, see The History Of Money: From Barter To Banknotes.)

Massachusetts Money

Massachusetts was the first colony to defy the mother country. In 1652, the state minted its own silver coins, including the pine-tree and oak-tree shillings. It circumvented the British law stating that only the monarch of the British empire could issue coins by dating all their coins 1652, a period when there was no monarch. In 1690, Massachusetts issued the first paper money as well, calling it bills of credit.

Tensions between America and Britain continued to mount until the Revolutionary War broke out in 1775. The colonial leaders declared independence and created a new currency called "continentals" to finance their side of the war. Unfortunately, each government printed as much money as it needed without backing it to any standard or asset, so the continentals experienced rapid inflation and became worthless. This discouraged the American government from using paper money for almost a century.

Aftermath of the Revolution

The chaos from the Revolutionary War left the new nation's monetary system a complete wreck. Most of the currencies in the newly formed United States of America were useless. The problem wasn't resolved until 13 years later in 1788, when Congress was granted constitutional powers to coin money and regulate its value. Congress established a national monetary system and created the dollar as the main unit of money. There was also a bimetallic standard, meaning that both silver and gold could be valued in, and used to back, paper dollars. (For related reading, see The Gold Standard Revisited.)

It took 50 years to get all the foreign coins and competing state currencies out of circulation. Bank notes had been in circulation all the while, but because banks issued more notes than they had coin to cover, these notes often traded at less than face value.

Eventually the U.S. was ready to try the paper money experiment again. In the 1860s, the U.S. government created more than $400 million in legal tender to finance its battle against the Confederacy in the Civil War. These were called greenbacks simply because their backs were printed in green. The government backed this currency and stated that it could be used to pay back both public and private debts. The value did, however, fluctuate according to the North's success or failure at certain stages in the war. Confederate dollars, also issued by the seceding states during the 1860s, followed the fate of the Confederacy and were worthless by the end of the war.

Aftermath of the Civil War

In February 1863, the U.S. Congress passed the National Bank Act. This act established a monetary system whereby national banks issued notes backed by U.S. government bonds. The U.S. Treasury then worked to get state bank notes out of circulation so that the national bank notes would become the only currency.

During this period of rebuilding, there was a lot of debate over the bimetallic standard. Some were for using just silver to back the dollar, others were for gold. The situation was resolved in 1900 when the Gold Standard Act was passed, which made gold the sole backing for the dollar. This meant that, in theory, you could take your paper money and exchange it for the corresponding value in gold. In 1913, the Federal Reserve was created and given the power to steer the economy by controlling the money supply and interest rates on loans.

The Bottom Line

Money has changed a lot since the days of shells and skins, but its main function hasn't changed at all. Regardless of what form it takes, money offers us a medium of exchange for goods and services and allows the economy to grow as transactions can be completed at greater speeds.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.