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 it, and wish you had more of it. With how prevalent money is in society, people may not normally question how money works and what makes it a significant part of modern life. So, what is money? And how did it evolve into what it is today?
What Is Money?
Money only has value because people agree to give it value. Currency and financial accounts might not have any value on their own, but money becomes valuable when everybody agrees to use it.
Because money is based on an agreement, the actual currency can be anything. It can be any sort of physical item, or it could be entirely electronic. While there's a wide range of possibilities for what currency can be, most forms of money are recognizable by a common set of traits.
A Medium of Exchange
Money must be a medium of exchange. In other words, it must be something you can 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 deposit them into a bank account until you want to buy something later. This is as opposed to the barter system, in which items are directly traded.
Lack of Inherent Value
Most modern money has no inherent value—you can’t eat dollar bills, and a $100 bill is not materially different from a $20 bill. You might not even use cash. This is true for modern currencies, 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 and manufacturing uses.
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.
Bartering works well in limited situations, but it gets cumbersome in widespread practice. One limitation is the difficulty in matching needs. For bartering to work, you need to have something that the other party wants while they simultaneously have something you want. The pairing of desires and timing is unlikely to occur frequently enough to maintain current economic productivity.
Storing value is another major limitation. With the barter system, your ability to store value fluctuates significantly depending on the good or service you have. Sticking with the example of a vegetable farmer, the farmer would need to trade their goods before they spoil, or else that "money" would be lost entirely and the farmer would have no way to afford basic necessities.
Because of the logistical challenges, some anthropologists argue that a pure barter system never really existed.
Government-Issued Money in the U.S.
Government-issued money is the currency most Americans know best. Also known as “fiat” money, currencies like the U.S. dollar get their value from the government rather than from underlying demand for the product. Dollars are valuable because the government declares it to be legal tender—nobody in the nation can refuse to accept the currency for debts and obligations. You can walk into any business in the U.S. and know that they will accept U.S. dollars in return for goods or services.
The colonies that would become the U.S. first began issuing currency in 1775 as a way for the Continental Congress to fund the Revolutionary War. The first paper bills were tied to Spanish milled dollars. The next major development came with the Coinage Act of 1792, which established a monetary system that tied currency to gold, silver, and copper.
Many developments followed the Coinage Act of 1792, but money remained directly tied to precious metals until 1933. That's when the U.S. began restricting the ways that Americans could redeem dollars for gold. By the end of 1976, the U.S. had fully abandoned the gold standard.
De-linking the dollar from gold allowed the government to manipulate the economy and the value of U.S. currency. This allows the government to respond to economic events such as recessions.
The end of the gold standard meant that the government could create more money without mining more gold and finding a place to physically store it. To do the electronic equivalent of printing more money, the government can flood the markets with money by buying securities from investors.
Governments can also increase the money supply by influencing interest rates or changing bank reserve requirements. For example, the government may lower interest rates to stimulate the economy in times of economic hardship. Low interest rates translate into cheap loans for businesses and individuals. Cheap loans should, in theory, stimulate the economy. Businesses and individuals have an incentive to borrow money, and hopefully, they spend it on goods and services.
Monetary Value Can Fluctuate
Money only has value when everybody thinks it’s valuable. However, perceptions change over time, so the value of money changes, as well. That’s especially likely to happen with fiat currencies, as the value of the money is based entirely on faith in the government that issues it.
When money gets less valuable, it takes more money to buy the same things, and this is 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?
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, but this narrow figure only applies to paper and coin currency in circulation. The CIA's World Factbook estimated that the total amount of "broad money" in the world in 2017 was more than $80 trillion.
It may be easier to focus on one nation at a time. By the broadest measurement available, U.S. dollars in circulation totaled roughly $15.4 trillion in January 2020, but much of that money sits in financial institutions or electronic accounts. As of Feb. 12, 2020, paper currency accounted for $1.75 trillion of the U.S. dollars in circulation.
- M1 is liquid money. This includes the $1.75 trillion in cash circulating through the economy, as well as money in demand accounts (like checking accounts), traveler’s checks, and other forms of money that are readily accessible for spending. Of the $15.4 trillion in circulation, just under $4 trillion is included in the M1 measurement.
- M2 is a broader definition that includes M1 plus money that is slightly less accessible. This includes money in savings accounts, and time deposits—such as certificates of deposit (CDs) and money market accounts—of less than $100,000.
- M3 is the broadest measurement of money. It encapsulates M2 data, as well as larger time deposits, institutional money market funds, money market instruments, and other large cash-like assets. The Federal Reserve stopped officially publishing M3 data in 2006, but the Federal Reserve Bank of St. Louis still tracks the figure. The $15.4 trillion figure mentioned above comes from M3 data provided by the Federal Reserve Bank of St. Louis.
Is Cryptocurrency Money?
In its most basic definition, money exists whenever people agree to treat something as a vehicle for value. Therefore, it may not necessarily matter whether or not an authority (like a government body) defines something as “money.” Cryptocurrencies like Bitcoin can easily be considered money, as long as people accept Bitcoin payments in return for goods and services.
That said, every type of money has different characteristics, and you need to choose the form of currency that works best for you. Consider issues like ease of use and value stability as you choose between currencies. You won't be able to pay your taxes in Bitcoin, but if most of the places you shop accept it, it could make sense to use it as a form of money.