What Is Money?

Money is an economic unit that functions as a generally recognized medium of exchange for transactional purposes in an economy. Money provides the service of reducing transaction cost, namely the double coincidence of wants. Money originates in the form of a commodity, having a physical property to be adopted by market participants as a medium of exchange. Money can be: market-determined, officially issued legal tender or fiat moneys, money substitutes and fiduciary media, and electronic cryptocurrencies

Understanding Money

Money is commonly referred to as currency. Economically, each government has its own money system. Cryptocurrencies are also being developed for financing and international exchange across the world.

Money is a liquid asset used in the settlement of transactions. It functions based on the general acceptance of its value within a governmental economy and internationally through foreign exchange. The current value of monetary currency is not necessarily derived from the materials used to produce the note or coin. Instead, value is derived from the willingness to agree to a displayed value and rely on it for use in future transactions. This is money's primary function: a generally recognized medium of exchange that people and global economies intend to hold as and are willing to accept as payment for current or future transactions.

Economic money systems began to be developed for the function of exchange. The use of money as currency provides a centralized medium for buying and selling in a market. This was first established to replace bartering. Monetary currency helps to provide a system for overcoming the double coincidence of wants. The double coincidence of wants is a ubiquitous problem in a barter economy, where in order to trade, each party must have something that the other party wants. When all parties use and willingly accept an agreed-upon monetary currency, they can avoid this problem.

In order to be most useful as money, a currency should be: 1) fungible, 2) durable, 3) portable, 4) recognizable, and 5) stable. These properties ensure that the benefit of reducing or eliminating the transaction cost of the double coincidence of wants is not outweighed by other types of transaction costs associated with that specific good.

Fungible

Units of the good should be of relatively uniform quality so that they are interchangeable with one another. If different units of the good have different qualities, then their value for use in future transactions may not be reliable or consistent. Trying to use a non-fungible good as money results in transaction costs of individually evaluating each unit of the good before an exchange can take place.

Durable

The physical character of the good should be durable enough to retain its usefulness in future exchanges and be reused multiple times. A perishable good or a good that degrades quickly with use in exchanges will not be as useful for future transactions. Trying to use a non-durable good as money conflicts with money's essentially future-oriented use-value. 

Portable

It should be divisible into small quantities so that people appreciate its original use value highly enough that a worthwhile quantity of the good can be conveniently carried or transported. An indivisible good, immovable good, or good of low original use-value can create issues. Trying to use a non-portable good as money could produce transaction costs of either physically transporting large quantities of the low value good or defining practical, transferable ownership of an indivisible or immobile object.  

Recognizable

The authenticity and quantity of the good should be readily ascertainable to the users so that they can easily agree to the terms of an exchange. Trying to use a non-recognizable good as money produces transaction costs of agreement on the authenticity and quantity of the goods by all parties to an exchange. 

Stable

The value that people place on a good in terms of the other goods that they are willing to trade should be relatively constant or increasing over time. A good whose value varies widely up and down over time or consistently loses value over time is less suitable. Trying to use a non-stable good as money produces transaction costs of repeatedly revaluing the good in each successive transaction and the risk that the exchange value of the good might drop below its other direct use-value or not be useful at all, in which case it will no longer circulate as money. 

Key Takeaways

  • Money is a generally accepted, recognized, and centralized medium of exchange in an economy that is used to facilitate transactional trade for goods and services.
  • The use of money eliminates issues from the double coincidence of wants that can occur in bartering.
  • Economically, each government has its own money system, defined and monitored by a central authority.
  • Cryptocurrencies represent a new form of money, with international exchange opportunities.

Functions of Money

As stated above, money primarily functions as a medium of exchange. However, it also has developed secondary functions that derive from its use as a medium of exchange. These other functions include: 1) a unit of account, 2) a store of value, and 3) a standard of deferred payment.

Unit of Account

Due to its use as a medium of exchange for both buying and selling and its use to assign prices to all kinds of other goods and services, money can be used to keep track of the money gained or lost across multiple transactions and to compare money values of various combinations of different quantities of different goods and services mathematically. This makes things such as accounting for profit and loss of a business, balancing a budget, or valuing the total assets of a company all possible.

Store of Value

Because money's usefulness as a medium of exchange in transactions is inherently future-oriented, it provides a means to store value obtained through current production or trade for use in the future, in the form of other goods and services. In particular trading their non-fungible, non-durable, non-portable, non-recognizable, or non-stable goods or services for money here and now, people can store the value of those goods to trade for goods at other times and places. This facilitates saving for the future and engaging in transactions over long distances possible. 

Standard of Deferred Payment

To the extent that money is accepted as a general medium of exchange and serves as a useful store of value, it can be used to transfer value for exchange use at different times between people through the tools of credit and debt. One person can loan a quantity of money to another for a period of time to use and repay another agreed-upon quantity of money at a future date. The stored value represented by the loaned money is transferred from the lender to the borrower in exchange for an agreed quantity of stored value in the future. The borrower can then use and enjoy the value of other goods and services that they can now purchase in exchange for payment at a later date. The lender in effect is able to loan the current use of real goods and services, which he does not himself originally possess, to the borrower. The sellers of the goods are able to receive payment for their goods now instead of loaning the goods directly to the borrower in hope of future return or repayment. 

Types of Money

There are several types of money.

Market-Determined Money

Money originates as a feature of the spontaneous order of markets through the practice of barter (or direct exchange), where people trade one good or service directly for another good or service. In order for a trade to occur in barter, the parties to the exchange must want the good or service that their counterparties have to offer. This is known as the double coincidence of wants, and it sharply limits the scope of transactions that can occur in a barter economy. 

However certain goods in a barter economy will be generally desired by more people in trade for whatever they have to offer in barter. These tend to be goods that have the best combination of the five properties of money listed above. Over time these special kinds of goods can come to be desired in trade partly for their wide acceptance, as a means to overcome the problem posed by the double coincidence of wants in future transactions with others. Eventually, people can come to desire a good mostly or solely for its use-value in reducing transaction costs in future exchanges.

Such a good can then be called money because it is generally recognized by participants in the economy as a valuable good for its use as a medium to indirectly exchange other goods and services between multiple parties. The physical commodity will still have some other use-value, but the primary use of any source of value has in the market is for its use as money. Historically, precious metals like gold and silver were adopted as these kinds of market-determined moneys.

Legal Tender and Fiat Money

Sometimes a market-determined money is officially recognized as legal money by a government. Under some circumstances, goods that do not necessarily meet the five properties of optimal market-determined money outlined above can be used to fulfill the functions of money in an economy. Typically this involves a legal mandate to use a specific good as money (known as a legal tender law) or some kind of prohibition on the use of money (such as the use of cigarettes as a medium of exchange among prison inmates). Legal tender laws specify a certain good as legal money, which courts will recognize as a final means of payment in contracts and the legal means of settling tax bills. By default, the legal tender will typically be used as a medium of exchange by market participants within the political jurisdiction of the authority that declares it to be money.

The term fiat money or fiat currency is generally associated with a classification of money that has been authorized for use by a country's government.

Legal tender laws do not always adopt market-determined money as legal tender. A new medium of exchange that does not serve any original non-money use as an economic good can be imposed to replace market-determined money by legal declaration. This type of legal tender can also be called fiat money. Fiat money becomes a medium of exchange through legal imposition on the market, rather than through the process of adoption by the market for easing transactions. Fiat money often does not meet the general characteristics of money and the market-determined money that it replaces. Because the fiat money tends to be less suitable for use as money, market participants may be reluctant to adopt it as money. Prohibitions (or even confiscation) of market-based money are sometimes enacted as part of legal tender laws that impose fiat money on an economy.

Fiat moneys can lead to increased economic transaction costs, market distortions, and unintended consequences to the extent that they do not meet the characteristics that make a particular good suitable to serve as money. For example, in modern times, most countries' legal tender moneys consistently lose value over time, sometimes rapidly, leading to the social costs associated with inflation.

Governmental currencies fall under the category of fiat money. Internationally, the International Monetary Fund and World Bank serve as global watchdogs for the exchange of currencies between countries. Governments establish their own money system which is monitored primarily by the central bank and Treasury authorities. A governmental currency will have an intranational value and an international value. Established governmental currencies trade 24 hours a day seven days a week on the foreign exchange market, which is the largest financial trading market worldwide. Governments can establish formal and informal trade relations to peg currency values to one another for reduced volatility. Governmental currencies may also be free-floating.

Money Substitutes and Fiduciary Media

Physical units of currency (cash) can circulate from hand to hand in the course of economic transactions or by being reassigned from person to person for accounting purposes while being held on deposit at a bank or similar institution. In the second case, tokens or paper notes that substitute for and represent the deposited money are passed from person to person in daily transactions and settled later by financial institutions. Paper notes and checks are examples of these kinds of money substitutes. The use of money substitutes can increase the portability and durability of money, as well as reducing other risks. Money substitutes enhance the function of money by allowing people to simultaneously enjoy the use of their money in day-to-day transactions while also keeping the money secure from theft or physical damage. 

Normally, however, banks issue a larger (often much larger) quantity of money substitutes than the amount of physical currency entrusted to them by depositors. By simultaneously issuing money substitutes corresponding to the same units of physical money to both the depositors and borrowers to whom the bank makes loans, in a process known as fractional reserve banking, banks can dramatically expand the supply of money available for transactions beyond the available supply of physical money. The new money substitutes that do not correspond to new units of physical money are called fiduciary media of exchange since they exist solely as entries in the accounting and financial system of the banks. Though widely accepted today, the use of fiduciary media has been controversial. Some economists believe that the (over)issuance of a fiduciary is to blame for business cycles and economic recessions, while others welcome it as a means to allow the expansion of money supply to suit the needs of the economy. 

In the U.S. the Federal Reserve and the Treasury Department monetary several types of money supply for the purpose of regulating and mitigating monetary issues.

Cryptocurrencies

Cryptocurrencies are peer-based money, such as bitcoin. This type of money is electronically based on electronic accounting entries that can be used as a medium of exchange. Cryptocurrencies share many characteristics of both market-determined money and fiat money.

Cryptocurrencies are a type of money that can be used to facilitate international transactions.

Cryptocurrencies first originated as accounting units assigned to users as compensation in return for helping to process and verify transactions in a cryptocurrency blockchain. They have also evolved to become a new form of coin offering that helps to serve as financing for new technological business initiatives and companies. Cryptocurrencies are becoming more widely used and adopted as a medium of exchange for daily transactions. However, cryptocurrencies do pose many risks. As such, they are being researched and regulated by authorities on an ongoing basis.