What Is Money?
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By Investopedia
Updated Jun 26, 2019
Money makes the world go around. Economies rely on the exchange of money for products
and services. Economists define money, where it comes from, and what it's worth. Here are
the multifaceted characteristics of money.
Key Takeaways
Money is a medium of exchange; it allows people to obtain what they need to live.
Bartering was one way that people exchanged goods for other goods before money
was created.
Like gold and other precious metals, money has worth because for most people it
represents something valuable.
Fiat money is government-issued currency that is not backed by a physical
commodity but by the stability of the issuing government.
Medium of Exchange
Before the development of a medium of exchange—that is, 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.
Early forms of bartering, however, do not provide the transferability and divisibility that
makes trading efficient. For instance, if someone has cows but needs bananas, they MUST
find someone who not only has bananas but also the desire for meat. What if that individual
finds someone who has the need for meat but no bananas and CAN only offer potatoes? To
get meat, that person MUST find someone who has bananas and wants potatoes, and so on.
The lack of transferability of bartering for goods is tiring, confusing, and inefficient. But
that is not where the problems end; even if the person finds someone with whom to trade
meat for bananas, they MAY not consider a bunch of bananas to be worth a whole cow.
Such a trade requires coming to an agreement and devising a way to determine how many
bananas are worth certain parts of the cow.
Commodity money solved these problems. Commodity money is a type of good that
functions as currency. In the 17th and early 18th centuries, for example, American colonists
used beaver pelts and dried corn in transactions.1 Possessing generally accepted values,
these commodities were used to buy and sell other things. The commodities used for trade
had certain characteristics: they were widely desired and, therefore, valuable, but they were
also durable, portable, and easily stored.
Another, more advanced example of commodity money is a precious metal such as gold.
For centuries, gold was used to back paper currency—up until the 1970s.2 In the case of the
U.S. 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—you CAN'T eat gold, 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
that has worth. Gold, therefore, serves as a physical token of wealth based on people's
perceptions.
This relationship between money and gold provides insight into how money gains its value
—as a representation of something valuable.
What Is Currency?
While it may seem obvious, since we all use it on almost a daily basis, the exact meaning of
money CAN also be elusive and nuanced.
Imagine you make shoes for a living and need to buy bread to feed your family. You
approach the baker and offer a pair of shoes for a specific number of loaves. But as it turns
out, he doesn’t need shoes at the moment. You’re out of luck unless you CAN find another
baker—one who happens to be short on footwear—nearby.
According to mainstream economics, money alleviates this problem. It provides a universal
store of value that CAN be readily used by other members of society. Proporciona un
depósito de valor universal que PUEDE SER utilizado fácilmente por otros miembros de la
sociedad. That same baker MIGHT need a table instead of shoes. In general, transactions
CAN happen at a much quicker pace because sellers have an easier time finding a buyer
with whom they want to do business.
Most importantly, money HAS TO be the unit of account, or numeraire, which is a fancy
term for the unit that things are priced in within a society. In the U.S. that is the dollar.
Once there is a unit of account, people CAN indeed exchange on credit without the use of
physical money.
Currency is the physical paper notes and coins in circulation. By accepting the currency, a
merchant CAN sell his or her goods and have a convenient way to pay their trading
partners. There are other important benefits of currency too. The relatively small size of
coins and dollar bills makes them easy to transport. Consider a corn grower who WOULD
have to load a cart with food every time he needed to buy something. Additionally, coins
and paper have the advantage of lasting a long time, which is something that CAN’T be
said for all commodities. A farmer who relies on direct trade, for example, may only have a
few weeks before his assets spoil. With money, she CAN accumulate and store her wealth.
