How Money Works and Changes Over Time
Money is something that probably affects you every day. You might work for it, worry about it, spend some of it, and even wish you had more of it. But we rarely examine how money works and what makes it a significant part of our lives. So, what is money, and how did it get so important?
What Is Money?
Money has value only because people agree to give it value. It is a medium of exchange, and a way to store value. Currency and financial accounts might not have any value on their own, but money becomes valuable when everybody agrees to use it.
- Medium of Exchange: A medium of exchange is something you trade for something else. Both parties in a transaction agree that money has value, so it’s an efficient tool for any trade.
- Store of Value: A store of value is anything that can hold value for you until later. If you sell something for money, you can keep those funds in cash or a bank account and use the funds to buy something later.
- Intrinsic Value: Most modern money has no inherent value: You can’t eat dollar bills or use them for anything useful, and a $100 bill is not materially different from a $20 bill. You might not even use cash. But historically, some forms of money were useful. For example, beaver hides can keep you warm in the winter, and metals like gold are valued for their appearance (in the modern world, those metals are also valuable in manufacturing).
- Anything Works: Because money is based on an agreement, the actual currency can be anything—physical or electronic. Residents in what is now Micronesia used large stones as currency, and seashells were also popular in some areas. Currently, money is mostly electronic, so your bank and other financial institutions keep track of how much you have.
Why Not Just Barter?
The barter system involves trading goods and services directly instead of using a medium of exchange. For example, if you grow vegetables and you want a table, you can search for a carpenter who is willing to build you a table in exchange for vegetables. Alternatively, you might know somebody with an extra table on hand and a need for vegetables.
Bartering works well in limited situations, but it gets cumbersome in practice.
- Matching Needs: For barter to work, you need to have something that the other party needs and they need to have something you want—and those needs need to occur simultaneously. It’s unlikely that the planets will align over and over.
- Storing Value: With the barter system, it can be harder to store value. Using the example of vegetables, you need to trade your goods before they spoil, and you might not need anything at harvest time (or the things you want might not be available then).
Because of the logistical challenges, some anthropologists argue that a pure barter system never really existed.
Government-issued money is probably the currency you’re most familiar with. Also known as “fiat” money, currencies like the U.S. dollar have no intrinsic value. Instead, they’re valuable because the government issues money and declares it to be legal tender—nobody in the nation can refuse to accept the currency for debts and obligations.
In the late 1700s, U.S. currency was based on the value of gold and silver, and eventually only gold backed U.S. dollars. Coins were minted from precious metals, and you could even exchange paper bills for physical gold. But in 1971, the U.S. abandoned the gold standard—a move that is still controversial, and which typically gets the blame for inflation.
De-linking the dollar and gold allowed the government to manipulate the economy and the value of U.S. currency.
- Printing Money: Without needing to mine or buy physical gold, governments can create money out of thin air by printing more currency. To do the electronic equivalent, they can flood the markets with money by buying securities from investors.
- Easy Money: Governments can also increase the money supply by influencing interest rates or changing bank reserve requirements. When rates are low, businesses and individuals have an incentive to borrow, and they typically spend that money to buy things or invest in growth (building a new factory and creating jobs, for example).
Value Can Increase or Decrease
Money only has value when everybody thinks it’s valuable. But perceptions can fade, so the value of money might evaporate or change over time. That’s most likely to happen with fiat currencies, as there is no physical commodity to support a value that’s based entirely on faith. When money gets less valuable, it takes more money to buy the same things (commonly known as inflation). Eventually, money can become worthless. The opposite is also true—money can get more valuable when it’s in high demand.
How Much Money Exists?
Worldwide: Keeping track of money is hard, especially when economies constantly change. In 2017, the Bank of International Settlements estimated that $5 trillion worth of currency exists worldwide.
U.S. Currency: It may be easier to focus on one nation at a time. The CIA World Factbook estimates that there are 14 trillion U.S. dollars. But much of that sits in financial institutions or electronic accounts. The Fed, the country’s central bank, breaks the money supply into several categories:
- M1 is liquid money. That includes cash in circulation, money in demand accounts (like checking accounts), traveler’s checks, and other forms of money that are readily accessible for spending.
- M2 is a broader definition that includes M1 plus money that is slightly less accessible. Examples include money in savings accounts, small certificates of deposit (CDs), money market accounts, and similar instruments.
- M3 includes M2, plus more significant time deposits, institutional money market funds, money market instruments, and other large cash-like assets. Altogether, M3 amounts to roughly $14 trillion, as described above.
Is Cryptocurrency Money?
Money exists whenever people agree to treat something as money—whether or not an authority (like a government body) defines something as “money.” Cryptocurrencies like Bitcoin can easily be considered money because people use those digital currencies as money: for trade and a store of value.
That said, every type of money has different characteristics, and you need to choose which forms of currency work best for you. As you make that decision, consider the relevant laws and norms in the area you live and trade in, the risk and benefits of using a given currency, the ease of use, and other significant factors.
Whether or not governments officially accept Bitcoin as money, some people use it as such (although it can be more volatile than other options).