We all use it almost every single day not only to secure basic needs, such as buying food, but to pay for everything from movies, to shopping, to modern essentials like our internet connections. Despite filling this major role in our lives, very few people can actually say what money is. This is curious since, if we're being honest, money holds a very unique position among all other things. Money can get pretty much anything done if there's enough of it piled up in the right places.
If someone were to ask you what money is, the obvious answer would be to point to the cash in your pocket and simply say “that”. While that might technically be true, it's sort of like saying a person is their physical appearance – there's a bit more you're not quite getting at. Indeed, there is something abstract about money that makes it valuable to us, a sort of agreement between people that those papers and coins in your pockets are something special.
In the interest of helping our readers to impress people by having a real answer to a question that is pretty fundamental to our lives, the following article explains what we consider money, what it's supposed to do, and how it goes about doing that. It's important to note that this is a bit of a simplified version of these answers... but either way, you'll be wowing people with your economic know-how by the end.
How Much Money is There?
The most obvious answer to this question would be to say that money is just the cash in your pocket, or the numbers in your bank account. This is one way to measure money, known as the money supply.
There are basically three levels: M0, M1, and M2. M0 is real money, the money that actually is in your pocket, the money that has actually been minted. M1 is all the spendable money, which includes not only everything in your pocket, but also everything you can convert into a cheque, or any other form of immediate payment that you possess. M2 goes in further and includes everything in M1, plus all the money that can conceivably be converted into spendable money, like savings.
But knowing the money supply isn’t enough. It doesn’t explain what money is, or how it lets us buy all of our favorite things. The money supply doesn't tell us what money actually does.
The Money Checklist
To be considered money, any candidate has to fulfill at least the following three basic functions: first, it has to be a store of value, meaning that whatever the money is, it can be saved and collected, like piles of gold, for example. Second, it must provide a unit of account, meaning it can be standardized, convenient, and divisible without loss of value. Again, big piles of gold would work. Third, money has to provide a medium of exchange, which means it can represent any number of goods, but with different values. Once more, gold piles can work just fine.
This last function really gets to the heart of the question of what money is. If we go with the example of gold as currency, what this means is that any number of goods will have its own worth that is measurable in a different amount of gold. In other words, instead of having to trade a new pair of shoes for ten cups of coffee, I can just sell the shoes for X amount of gold and then go buy the coffees with that gold. This is much better than bartering for coffee with my shoes, because the number of coffee makers willing to trade for shoes is probably quite limited.
Essentially, you are able to buy things with your money because whoever you're giving it to thinks that it has some value. But it's hard to think of how much a dollar is worth when we think of everything else in dollars. For example, how much is a latte worth? Maybe about 3-5 dollars, depending on how good it is. So, in a way, we can say that a dollar is worth a fifth to a third of a latte. That's basically how the value of money was determined for a long time.
Obviously, our ancestors didn't peg the value of money to something as wonderful as coffee, but that’s not because coffee can't be stored or divided or any of that. If you're going to say your dollar is worth X of something, the something can’t be a thing that won't exist in a year, a day, or the next hour. Not only that, but some people have not yet seen the light and may not see the value of coffee. Because of that, they will find my dollar useless.
The Types and Value of Money
At its core, money is basically just something that does those three things and that society gives some special value. In a way, that means money isn't actually a thing. This is even more the case in today's economy than even 50 years ago.
In one of our earlier examples, gold played the role of what is known as “commodity money”. Basically, it is a substance or material that is given a monetary value. Literally anything at all can be money if enough people believe in it: gold, silver, coffee beans, gems, time - anything. Like a barter system, though, we start to run into problem of inconvenience and disagreement. Gold and silver are heavy and unruly, some misguided and lost people may not want coffee, and not everyone finds the same gems pretty.
The solution to this is to create “representative money”. In this situation, we find something pretty much everyone loves. In pretty much every economy since economies were first established, this has meant gold and silver. Then, we print paper notes and mint coins that represent a certain amount of that thing. How much each piece of paper and coin represents is determined by how much is printed, how much gold there is, and how much people are willing to pay. This system works rather well because it means your money always represents something real and valuable.
To take the US as an example, before 1971 you could take your American dollars to the federal reserve and exchange them for a set amount of gold. This works so long as everyone likes gold (not a problem) and there is enough gold in reserve to cover the amount of money in circulation (maybe a bit of a problem). If the gold runs out, or too many people want their gold too fast, or the desire for gold diminishes, there are problems.
To avoid these issues, which can tie the hands of governments when dealing with inflation and economic dips, our current global economy uses “fiat money”, literally money the government says is worth something just because (though there is still gold in reserves as a backup). This money has value based on how much we want it, how much of it is printed, and how much stuff there is that it will buy. In other words, its value is literally non-existent beyond our believing that it exists.
And that's what our money is: paper notes and metal coins minted by the government and that we collectively believe has value. If we all decided right now that money was worthless, it would be. It would be as if we were all corner store vendors who refuse to accept hundred dollar bills. If that happened, those notes would be nothing. Basically, money is government and business-funded make believe.