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General definition of money
Bills and coins of several countries and
values.
Money is an agreement, between a community, to use something as a medium of
exchange, which acts as an intermediary market good. It can be traded and
exchanged for other goods. The agreement can either be explicit or implicit,
freely chosen, or coerced. Money is an abstract form of power. As
discussed below, money also has other characteristics.
Money itself must be a scarce good. Many items have
been used as money, from naturally scarce precious metals and conch
shells through cigarettes to entirely
artificial money such as banknotes.
Modern money (and most ancient money too) is essentially a token - an
abstraction. Paper currency is perhaps the most common type of physical money
today. However, goods such as gold or silver retain many of the essential
properties of money.
Essential Characteristics of Money
Money has the following three characteristics.
1. It must be a medium of
exchange
When an object is in demand primarily for its use in exchange -- for its
ability to be used in trade to exchange for other things -- then it has this
property.
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 criteria 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 credit and money are frequently
used interchangeably. Even in economics credit is often refered to as money. For
example bank deposits are generally included in summations of the national broad
money
supply. However any detailed study of monetary theory needs to recognise the
proper distinction between money and credit.
The rest of this article frequently uses the term money in
the looser sence of the word.
Related concepts
Desirable features of money
To function as money in a modern economy a good or token should possess a
number of features:
- It must have a stable value.
- It must be difficult to counterfeit.
- It must be easily divisible and transportable.
- It must be fungible. That is, one
artifact of the token or good must be equivalent to another.
Modern forms of money
When using money anonymously, the most common methods are 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 cheques, 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 directly affects inflation and interest
rates and hence has profound effects. 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
Before money
Prior to the introduction of money, barter was the only way to
exchange goods. Bartering has several problems, most notably timing constraints.
If you wish to trade pigs for wheat, you can only do this when the pigs and
wheat are both available at the same time and place - and without proper storage
that may be a very brief time. With a trade standard like gold, you can sell
your pigs at the "best time" and take the gold coins. You can then use that gold
to buy wheat when the harvest comes in. Thus the use of money makes all commodities
become more liquid.
Where trade is common, barter systems usually lead quite rapidly to the
emergence of several key goods with monetary properties. In the early British
colony of New South Wales in Australia, rum emerged quite soon after settlement
as the most monetary of goods. When a nation is without a fiat currency system
it is quite common for the fiat currency of a neighbouring nation to emerge as
the dominant monetary good. In some prisons where conventional money is
prohibited it is quite common for goods such as cigarettes to take on a monetary
quality. Gold has emerged naturally from the world of barter again and again to
take on a monetary function. It should be noted that the emergence of monetary
goods is not dependent on central authority or government. It is a quite natural
market phenomenon.
Commodity money
The first instances of money were objects which were useful for their intrinsic value. This
was known as commodity money and
included any commonly-available commodity that has intrinsic value; historical
examples include pigs,
rare seashells, whale's teeth, and
(often) cattle.
In medieval Iraq, bread was used as an
early form of currency.
Even in the industrialised world, in the absence of other types of money,
people have occasionally used commodities such as tobacco as money. This last
happened on a wide scale after World War II when
cigarettes became used unofficially in Europe, in parallel with other
currencies, for a short time.
Another example of "commodity money" is shell money in the Solomon Islands. Shells
are painstakingly chipped into rough circles, filed down, and threaded onto
large necklaces, which are then used during marriage proposals; for instance, a
father may charge twenty shell money necklaces for his daughter's hand in
marriage.
One interesting example of commodity money is the huge limestone coins from the Micronesian
island of Yap, quarried
at great peril from a source several hundred miles away. The value of the coin
was determined by its size — the largest of which could range from nine to
twelve feet in diameter and weigh several tons. Displaying a large coin, often
outside one's home, was a considerable status symbol and source
of prestige in that society. (Due to the great incovenience, islanders would
often trade only promises of ownership of an individual coin instead of actually
moving it. In some cases, coins which had been lost at sea were still used for
exchange in this way. These agreements could be thought of as a kind of
representative money, described below.)
An 8-foot "coin" from the village of Gachpar, on Yap.
Once a commodity becomes used as money, it takes on a value that is often a
bit different from what the commodity is intrinsically worth or useful for.
Being able to use something as money in a society adds an extra use to it, and
so adds value to it. This extra use is a convention of society, and how
extensive the use of money is within the society will affect the value of the
monetary commodity. So although commodity money is real, it should not be seen
as having a fixed value in absolute terms. Its value is still socially
determined to a large extent. A prime example is gold, which has been valued
differently by many different societies, but perhaps none valued it more than
those who used it as money. Fluctuations in the value of commodity money can be
strongly influenced by supply and demand whether current or
predicted (i.e. if you know the local gold mine is about to run out of ore, the
relative market value of gold may go up in anticipation of a shortage).
Money can be anything that the parties agree is tradable, but the usability
of a particular sort of money varies widely. Desirable features of a good basis
for money include being able to be stored for long periods of time, dense so it
can be carried around easily, and difficult to find on its own so that it is
actually worth something. Again, supply and demand play a key role in
determining value.
Metals like gold
and silver have
been used as commodity money for thousands of years, being in the form of metal
dust, nuggets, rings, bracelets and assorted pieces. Eventually the Lydians began
coining gold and silver around 650BC.
Gold and silver are both quite soft metals, and coins minted from the pure
metals suffer from wear or deformation in daily use. Fortunately these metals
are also easily alloyed with a less expensive
metal, frequently copper, in order to improve the durability of the resulting
coins. Typically alloys of sterling silver, 24
carat, or coinage metal are used to
make coins more durable. These are all alloys of 90% or more pecious metal.
Alloys of less than 90% do not improve hardness or durability very much, and so
are typically considered to be on the slippery slope into monetary
debasement.
Standardized coinage
It was the discovery of the touchstone that paved the way
for metal-based commodity money and coinage. Any soft metal can be tested for
purity on a touchstone, allowing one to quickly calculate the total content of a
particular metal in a lump. Gold is a soft metal, which is also hard to come by,
dense, and storable. For these reasons gold as a money spread very quickly from
Asia
Minor where it first gained wide use, to the entire world.
Using such a system still required several steps and some math. The
touchstone allowed you to estimate the amount of gold in an alloy, which was then multiplied
by the weight to find the amount of gold alone in a lump.
To make this process easier, the concept of standard coinage was introduced.
Coins were
pre-weighed and pre-alloyed, so as long as you were aware of the origin of the
coin, no use of the touchstone was required. Coins were typically minted
by governments in a carefully protected process, and then stamped with an emblem
that guaranteed the weight and value of the metal. It was however extremely
common for governments to assert that the value of such money lay in its emblem
and to subsequently debase the currency by lowering the content of valuable
metal.
Although gold and silver were commonly used to mint coins, other metals could
be used. Ancient Sparta minted coins from iron to discourage its
citizens from engaging in foreign trade. In the early seventeenth century Sweden
lacked more precious metal and so produced "plate money," which were large slabs
of copper approximately 50cm or more in length and width, appropriately stamped
with indications of their value.
Metal based coins had the advantage of carrying their value within the coins
themselves — they induced on the other hand manipulations:the clipping of coins
in attempts to get and recycle the precious metal. The bigger problem was the
simple co-existence of gold, silver and copper coins in Europe's nations.
English and Spanish traders valued gold coins at a higher rate of silver coins
than their neighbours would do, with the effect that the English gold-based
guinea coin began to rise against the English silver based crown in the 1670s
and 1680s and with the consequence that silver was ultimately pulled out of
England for dubious amounts of gold coming into the country at a rate no othe
European nation would share. The effect was worsened with Asian traders not
sharing the European appreciation of gold altogether — gold left Asia and silver
left Europe in quanties European observers like Isaac
Newton, Master of the Royal Mint observed with uneasiness (http://www.pierre-marteau.com/currency/ed/newton-1717-09-25.html;).
Stability came into the system with national Banks guaranteeing to change
money into gold at a promised rate, it did, however, not come easily. The Bank
of England risked a national financial catastrophe in the 1730s when customers
demanded their money to be changed into gold in a moment of crisis. Eventually
London's merchants saved the bank and the nation with financial guarantees.
See also:Roman currency, coinage
metal, for conversions of the European coins before the introduction of
paper money:The Marteau Early
18th-Century Currency Converter (http://www.pierre-marteau.com/currency/converter.html).
Representative money
An example of representative money, this 1896 note could be
exchanged for five US Dollars worth of silver.
The system of commodity money in many
instances evolved into a system of representative
money. In this system, the material that constitutes the money itself had
very little intrinsic value, but none the less such money achieves significant
market value through being scarce as an artefact.
Paper currency and non-precious
coinage was backed by a government or bank's promise to redeem it for a given
weight of precious metal, such as silver. This is the origin of the term
"British Pound" for instance; it was a unit of money backed by a Tower
pound of sterling silver - hence
the currency Pound Sterling.
For much of the nineteenth and twentieth centuries, many currencies were
based on representative
money through the use of the gold standard.
Fiat money
An example of fiat money is the new, international
currency, the Euro.
Its introduction changed the face of money, superseding many of the world's
oldest currencies.
Fiat
money refers to money that is not backed by reserves of another commodity.
The money itself is given value by government fiat (Latin for "let it be done") or
decree, enforcing legal tender laws, previously known as "forced
tender", whereby debtors are legally relieved of the debt if they (offer to) pay
it off in the government's money. By law the refusal of "legal tender" money in
favor of some other form of payment is illegal, and has at times in history
(Rome under Diocletian, and post-revolutionary France during the collapse of the
assignats) invoked the death penalty.
Governments through history have often switched to forms of fiat money in
times of need such as war, sometimes by suspending the service they provided of
exchanging their money for gold, and other times by simply printing the money
that they needed. When governments produce money more rapidly than economic
growth, the money supply overtakes economic value. Therefore, the excess money
eventually dilutes the market value of all money issued. This is called inflation. See
open market
operations.
In 1971 the US
finally switched to fiat money indefinitely. At this point in time many of the
economically developed countries' currencies were fixed to the US dollar
(see Bretton Woods
Conference), and so this single step meant that much of the western world's
currencies became fiat money based.
Following the first Gulf War the president of Iraq,
Saddam Hussein, repealed
the existing Iraqi fiat currency and replaced it with a new currency. However,
the old currency continued to be used in the politically isolated Kurdish regions of Iraq. Despite
having no backing by a commodity and with no central authority mandating its use
or defending its value it continued to circulate within this Kurdish region. It
became known as the Swiss
Dinar. This currency remained relatively strong and stable for over a
decade. It was formally replaced following the second Gulf War.
Credit money
Credit money often exists
in parallel with other money such as fiat money or commodity money, and from the
user's point of view is indistinguishable from it. Most of the western world's
money is credit money derived from national fiat money currencies.
Strictly speaking a debt is not money, primarily because debt can not act as
a unit of account. All
debts are denominated in units of something external to the debt. Hence credit
money is not strictly money at all. However, credit money certainly acts as a
money substitute when it comes to the other functions of money (medium of
exchange and store of value). As such the existence of credit money may dampen
demand for the real money and in so doing alter the dynamics of money's market
value.
When paper money is merely an IOU for something such as gold, then the paper
itself is not a unit of account but merely a convenient medium of exchange.
Under a rigid gold-standard with convertiblity, paper currency is merely a debt
instrument. However, when paper money floats, its value is not defined by
reference to an external unit of account. It is no longer a debt instrument but
rather it becomes purely monetary and its value is a product of the dynamics of
supply and demand. Typically a central bank forces supply and the private sector
forces demand. See open market
operations.
Credit money tends to arise as a byproduct of lending and borrowing money.
The following example illustrates this.
Imagine you have deposited some gold coins in a bank vault. The bank might
lend the coins to a second person based on a promise to pay equivalent coins
back with a few extra at a time in the future. The second person can in the
meantime use the coins normally as money. But you still own the coins, and you
also could still use them - you could transfer their ownership to another person
to pay for something you have bought by telling the bank to transfer them from
your account to the other person's account. You might do this by writing a
check. So in this simple example there are two people using the same coins as
money at the same time. It's as if new money has been created by the act of
lending. Taking it another step, if the second person spends the coins at a
shop, and they end up being deposited back into the bank by the shopkeeper, the
bank can lend them again. Now you and the shopkeeper can use the coins in the
same way, by writing checks or the equivalent in this example, and whoever
borrows the coins a second time can use the coins directly as money. So there
are three people with financial use of the coins. This can go on with many
people ending up simultaneously using the same coins financially, but for each
extra user there is a promise to pay equivalent coins back. These arrangements
where many people use the same money simultaneously are in many respects the
same as if there was extra money. The extra money that there appears to be is
known as credit money. It is in
regulating the amount of money a bank can lend that the controlling authority
can set the money supply and change monetary policy. The
credible promises to repay in a reasonable time give the extra money its value.
It tends to exist in parallel with another form of money such as fiat money or
commodity money, wherever banking-style loans are used,
and occurs as a by-product of lending. It could occur without banks, but banks
provide a degree of stability to the whole process by taking and evaluating the
risk involved in each loan.
During the Crusades in Europe, precious
goods would be entrusted to the Catholic Church's Knights Templar, who
effectively created a system of modern credit accounts. Over time this system
grew into the credit money that we know today, where banks create money by
approving loans - although the risk and reserve policies of each national central
bank sets a limit on this, requiring banks to keep reserves of fiat money
to back their deposits. Sometimes, as in the U.S.A. during the Great Depression or the
Savings and Loan
crisis, trust in bank policies drops very low and government must intervene
to keep the industry of credit in operation.
Private currencies
In many countries, the issue of private paper currencies has been severely
restricted by law.
A private $1 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. The National
Bank Act of 1863 ended this period.
In Australia, the Notes 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.
Today there are several privately issued digital currencies in circulation
that function as money. Transactions in these currencies represent an annual
turnover value in billions of US dollars.
Many of these private currencies are backed by older forms of money such as
gold.
Some examples of digital gold
currencies include:-
In Scotland private banks are
licensed to print their own paper money by the government.
How did it come into existence ?
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:
A. Bank notes - paper issued by banks as an interest-bearing loan. (These
were common in the 19th century but not seen anymore.)
B. 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.
C. 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.)
How is it destroyed ?
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 defaulted upon or any
government bond is redeemed the money value of the contract or bond is destroyed
— taken out of circulation.
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. The bank then uses this
loan to loan to other people, at a higher rate of interest (so it can make a
profit). When this happens the money exists in two (or more) places at once, and
so the money suppy increases. When a saver withdraws money, the loan is "paid
off" and it can no longer exist in more than one place at once, and this "double
money" disappears.
In extreme form, a bank run or panic may drive a
bank into insolvency,
and if uninsured the savings of all its depositors are destroyed. 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 FDIC
to guarantee private bank deposits.
Quotes about money
See also
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