Money is anything that is commonly accepted as payment for goods and services. Having money in an economy makes people better off because it simplifies exchange. In the absence of money, people would need to barter to trade with others; that is, trade goods and services for other goods and services. Bartering complicates exchange because it requires a double coincidence of wants. A double coincidence of wants is a situation in which two parties making a trade each has what the other wants. For example, suppose that a farmer who grows wheat needs a new tractor. In the absence of money, the farmer would have to find a tractor seller who wants the wheat that the farmer grows. Money eliminates this issue. With money, the farmer can find individuals who would like to exchange money to purchase wheat. Then the farmer can take that money to the tractor seller to purchase a tractor.
Money has six characteristics: durability, portability, divisibility, uniformity, acceptability, and limited supply.
- Durability: Money remains at or near its original state over time. It does not easily take damage.
- Portability: Money can easily be carried and transported. Most economies now use paper cash to increase the portability of money.
- Divisibility: Cash of large denominations can be broken into smaller denominations that have equal total value. For example, a $20 bill can be exchanged for two $10 bills.
- Uniformity: Bills or coins of equal denomination are all alike, or nearly alike. One bill has no more or less value than any other.
- Acceptability: Any seller will accept money in exchange for goods or services. In the United States, sellers are required by law to accept any form of U.S. cash.
- Limited supply: The amount of money in circulation is controlled in order to retain its value. In the United States, the Federal Reserve controls the amount of money in circulation.
Throughout history, money has taken different forms. The earliest forms of money were goods that had value in most barter-style trades: cattle, grain, and so forth. These forms did not meet many of the characteristics above (durability, divisibility, and so on) and were later replaced with coins made of precious metals. Coins have been very common throughout history and are still used in most countries in modern times. However, coins made of precious metals can be melted down or shaved in order for the metal to be extracted. To counteract these problems, governments now use bank notes, also called paper money. These notes have only the value the government assigns them.
Note that the definition of money requires it to be something commonly accepted as payment for goods and services. Therefore, assets such as cars and homes are part of an individual's wealth but are not considered money. In the past, money in circulation was commodity money. Commodity money is a form of money that has value in itself, such as gold or silver coins. However, today, the money in circulation in the United States is fiat money. Fiat money is a form of money that is not backed by any physical commodity but is mandated by the government to be acceptable as payment for goods and services. Paper currency (which is a system of money in use within an economy) is an example of fiat money. It has value because people know they can use it to purchase the things they want.
Functions of Money
Money plays several important roles in the economy. Money is defined as the set of assets in the economy that people regularly use to buy goods and services in an economy. The existence of money makes trade easier and more efficient. Today credit card transactions, gift cards, and cash are all considered money, and all facilitate trade between individuals in the economy. This is referred to as a medium of exchange, the function of money that helps individuals trade goods and services more easily.
Money's second role in the economy is to serve as a unit of account, which means that people can use money to measure the value of goods and services. Money enables people to compare apples and oranges by providing a common unit such as price with which to compare value of one against the other. It provides a common language across individuals as well, making trade clearer. When a seller describes the value of her product, she can do so by using dollars (as the currency is called in the United States). The buyer then will have a good idea what that value means.
Another important function of money is that it serves as a store of value, which means that money is a way to hold wealth or that it is an asset. If people wish, they can hold all their wealth in the form of money. Of course, there is an opportunity cost of doing so: they will forgo interest they could have earned by holding their wealth in another form. In addition, in times of inflation, the value of money erodes.
Money also serves as a standard of deferred payment, the function of money through which it serves as a method for paying off both public and private debts. This function of money also enables individuals to contract for future payments and receipts. In fact, U.S. paper currency (also known as Federal Reserve Notes) says, "This note is legal tender for all debts, public and private." This statement is how the U.S. government has decreed that its fiat money has value. Saying the government will accept this paper from citizens who owe it provides assurance that this paper is, in fact, worth something.