Money

Money is something that is accepted as a form of payment for products or services, or for the payment of obligations. It is a medium of exchange that allows individuals within and between different cultures to cooperate.

barter

Without money, trade would have to be conducted through barter, where traders would exchange the things that they wanted more for things that they wanted less. The problem with barter is that it is difficult and time-consuming to determine the value of specific items. Additionally, most forms of barter cannot be broken down to buy things of lesser value, nor is it easily transportable. Money solves these problems of barter.

Money as a Medium of Exchange

Money is simply a common medium of exchange that everyone agrees upon, and, thus, they accept it as a form of payment for their goods and services. Money has 3 basic properties that make it desirable to use it as a medium of exchange:

1. a means of payment,
2. a unit of account,
3. and a store of value.

Means of Payment

Money is an accepted unit of exchange for goods and services or for the satisfaction of obligations, such as debt, because it is standardized into specific units with specific values; hence, it is much easier to access its value and can be readily exchanged. It is divisible into smaller units to make smaller payments, or large amounts of money can be carried with much less burden than carrying the equivalent value of barter.

Unit of Account

Because money is standardized into specific values, it can be used to price goods and services, and allows the easy comparison of prices. Because the value of money is determined by general agreement, the condition of the money is irrelevant to its value. For instance, if a farmer wanted to buy a cow and offered a horse in exchange, then obviously, the seller of the cow would want to examine the condition and age of the horse, since that would determine the value of the horse; likewise for the seller of the horse. When money is offered, only the amount matters, not its condition.

Prices provide information for consumers and producers that allocate economic resources to the most desirable uses. Items in demand command a higher price, which induces sellers to provide more of that item. Conversely, items in lower demand have a lower price, and, thus, sellers will allocate fewer economic resources to provide that item.

Store of Value

Money must keep most of its value in time; otherwise, people would not accept it for payment. This means that money has to be relatively scarce and that the supply of new money must either be difficult to produce or tightly controlled. Any increases in the money supply must be gradual and expand with the economy. Otherwise, the increase of the total quantity of money will reduce the value of money, which is a direct cause of inflation.

The currency itself must also be durable; otherwise it would eventually lose its value as money as it decays or disintegrates, and, thus, people would not keep it.

Gold

The best example of money that illustrates its properties is gold. Gold is universally accepted by most cultures as a means of payment because it is relatively scarce, and new supplies are difficult to find and mine. Being the most malleable and ductile of metals, it can also be easily cut into different sizes to correspond to specific values. It can be subdivided even more and still retain its value. It is also durable—it does not tarnish, corrode, or decay. Hence, it can be kept for a long time and still retain its value.

Commodity, Fiat, and Electronic Money

Money can be broadly classified as commodity money, fiat money, or electronic money.

Commodity Money

Commodity money has intrinsic value, such as salt in the Mediterranean region, silk in China, or gold and silver throughout the world, because these commodities have a value that is independent of its value as money. Gold, for instance, is extensively used in jewelry, and silver has many industrial uses.

Although commodity money is usable in some form other than as money, it also must satisfy the other characteristics of money. The commodity must be dividable into standardized quantities, so that different units of value can be created. It can also be subdivided into smaller pieces without losing its value. It must be durable, so that it lasts; otherwise, it wouldn't function well as a store of value and it would have to be continually replaced. Small size and light weight are desirable for easy transport.

Gold is the best example of a commodity money.

Fiat Money

Fiat money has no intrinsic value. Its value originates from government decree or fiat. The best example of fiat money is paper currency. The paper itself has very little intrinsic value, so fiat money can only serve as money if its production is tightly controlled. The production of fiat money is mostly controlled by governments. Governments maintain this control by using printing methods and materials that are difficult to reproduce, and by punishing counterfeiters with harsh penalties. For instance, in 12^th century China, where the 1^st paper currency circulated, the penalty for counterfeiting was beheading, and this was printed on the currency!

People use fiat money only if they believe that it can be used in the future and that it will not lose value. The government will also usually encourage the use of its money through the force of law. For instance, since 1862, all United States dollars were printed with the phrase "This note is legal tender for all debts, public and private."

Although the issuance of paper money in the United States began in 1690, the U.S. government did not issue paper currency with the intent that it circulate as money until 1861, when Congress approved the issuance of demand Treasury notes. All currency issued by the U.S. government since then remains legal tender, including silver certificates, which have a blue seal for the Department of the Treasury; United States notes, which have a red seal; and national bank notes, which have a brown seal. Most of the U.S. currency circulating today is in the form of Federal Reserve notes that have the green Treasury seal.

Demand Treasury note printed in 1861. These notes were the 1st paper currency printed by the United States government that were issued for the express purpose of serving as fiat money.

Silver certificate printed in 1880.

National bank note, Winters National Bank of Dayton, Ohio, printed in 1901.

A modern 20-dollar Federal Reserve note illustrating the numerous details designed to thwart counterfeiting.

Source: http://www.federalreserve.gov/

Electronic Money

Most money in most countries today exists only in electronic format, as records in a database of a financial institution. Eventually, when the technology exists at a low enough cost, all money may become electronic because of its many advantages, both to governments and to the people. Electronic money can only exist if there are strong and stable financial institutions, because, like fiat money, its creation must be tightly controlled and people must have confidence that it can work.

Inflation

Inflation results when the supply of money increases faster than the economy expands, which results in higher prices. Sometimes, governments increase the money supply as an easy way to solve fiscal problems, but too much inflation can destroy the value of money. Inflation does the most damage to money as a store of value, since its value continually declines as more money is created. Rather than keeping it, people spend it as fast as possible before it loses value.

Inflation also limits money as a unit of account because prices are continually increasing so it is difficult to compare prices that are changing constantly.

Finally, if inflation is too high, then people stop using it as a medium of exchange, and start using barter or the currency of another country.

One of the reasons why there is more United States currency outside of the United States than within (Source: The Location of U.S. Currency: How Much Is Abroad?) is because many people in certain countries do not trust their governments. They are afraid that their government will print too much money as an easy way to solve fiscal problems, which would reduce the value of the native currency held by the people. This happened in Argentina in the 1980's and Russia in the 1990's. Hence, many of these people hold their store of value as United States dollars, mostly in the form of 100-dollar bills.

Dollarization is the most extreme form of currency failure, when people lose all faith in their currency and adopt the currency of another country. Usually, United States currency is adopted because it is considered to be one of the safest currencies in the world, and because many United States immigrants send U.S. currency to their relatives abroad. Most recently, in 2000, Ecuador adopted dollarization as a policy.