Money makes the world go round. An economy depends on the exchange of money for products and services.
Economists define money, where it comes from and what it is worth. Here are the multifaceted characteristics of money.
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 persons, each having some goods, will agree to trade.
Early forms of exchange, however, did not provide the transferability and divisibility that made trade efficient.
For example, if someone has cows but wants bananas, he should find someone who wants not only bananas but also meat.
What if the person finds someone who needs meat but no bananas and can only offer potatoes?
To get the meat, the person must find someone who wants bananas and potatoes.
The lack of transferability of buying and selling goods is tiresome, confusing and inefficient.
But the problems don’t end there; Even if they find someone trading meat for bananas, they won’t consider a bunch of bananas to be a whole cow.
Such a trade requires an agreement to be made and a way to determine how many bananas are for a particular portion of the cow.
Commodity money solved these problems. Commodity money is a good form that functions as currency.
In the 17th and early 18th centuries, for example, the American colonies used beaver pelts and dried corn in practice.
With generally accepted values, these items were used to buy and sell other things.
Goods 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 precious metals such as gold.
For centuries, until the 1970s – gold was used to back paper currency.
For example, the US In the case of the dollar, this means that foreign governments can take their dollars and the U.S. They can exchange gold with the Federal Reserve at a specified rate.
Interestingly, unlike beaver pelts and dried corn (which can be used for clothing and food, respectively), gold is only valuable because people want it.
It’s not necessary – you can’t eat gold, and it won’t keep you warm at night, but most people think it’s beautiful, and they know other people think it’s beautiful.
So, gold is something that has value. Gold, therefore, serves as a physical symbol of wealth based on people’s perceptions.
This relationship between money and gold provides insight into how money derives its value – as a representation of something valuable.
Impressions create everything
Another form of money is fiat money, which does not need to be backed by physical goods.
Instead, the value of fiat currencies is set by supply and demand and the public’s belief in its value.
Fiat money developed because gold was a scarce resource and rapidly growing economies could not keep up with their money supply needs.
For a booming economy, the need for gold to provide value for money is highly inefficient, especially
When its value is actually created by people’s perceptions.
Fiat money symbolizes people’s perception of value, the basis of why money is created.
A growing economy is apparently succeeding in producing other things of value to itself and to other economies.
The stronger the economy, the stronger the money will be (and invented) and vice versa.
However, people’s perceptions must support an economy that can produce the products and services people want.
For example, in 1971, the US dollar was taken off the gold standard—the dollar was no longer redeemable in gold, and the price of gold was no longer pegged to any dollar amount.
This meant that it was now possible to create more money than gold to repay paper money; The health of the US economy supported the value of the dollar.
If the economy stagnates, the value of the US dollar will fall domestically and internationally through inflation through currency exchange rates.
The collapse of the US economy would plunge the world into an economic dark age, so many other countries and organizations are working tirelessly to ensure that never happens.
Today, the value of money (not just the dollar, but most currencies) is determined solely by its purchasing power, as determined by inflation.
That is why just printing new money will not create wealth for the country.
Money is created through a kind of enduring interaction between real, tangible things, our desire for them, and our abstract belief in things of value.
Money is valuable because we want it, but we want it because it can get us the product or service we want.
How is money calculated?
But exactly how much money is out there and what form does it take?
Economists and investors ask this question to determine whether there is inflation or deflation.
Money is divided into three categories to make it clearer for measurement purposes:
M1 – This category of money includes all physical values of coins and currency; Demand Deposit, which accounts and now checking accounts; and traveller’s cheques.
This category of money is the narrowest of the three and is essentially money used to buy goods and make payments (see the “Active Money” section below).
M2 – With broad criteria, this category combines all money found in M1 into all time-related deposits, savings account deposits and non-institutional money market funds. This category represents money that can be easily transferred in cash.
M3 – The broadest class of money, M3 combines all the money found in the M2 definition and adds all large time deposits, institutional money market funds, short-term repurchase agreements, along with other large liquid assets.
Adding these three categories together, we arrive at a country’s money supply or total money in the economy.
The M1 category includes the total value of coins and paper currency in circulation, known as active money.
The amount of active money fluctuates seasonally, monthly, weekly and daily. In the United States, the Federal Reserve banks issue new currency for the US Treasury Department.
Banks lend money to customers, which after actively circulating becomes active money.
The variable demand for cash is the aggregate equivalent of active money that fluctuates continuously.
For example, people withdraw paychecks or ATMs on the weekend, so there is more active cash on Monday than on Friday.
Public demand for cash decreases at certain times—for example, after the December holidays.
How money is made
We have discussed why and how money is created, a representation of perceived value in the economy.
But another important factor related to money and the economy is how a country’s central bank (the central bank in the United States is the Federal Reserve or Fed) can influence and manipulate the money supply.
If the Fed wants to increase the amount of money in circulation, perhaps to stimulate economic activity, the central bank, of course.
It can print. However, physical bills are a small part of the money supply.
Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market.
When the central bank buys these government securities, it puts money into the market and effectively into the hands of the people.
How does a central bank like the Fed pay for it? As strange as it sounds, a central bank simply creates money and transfers it to those who sell securities.
Alternatively, the Fed can lower interest rates which allows banks to extend low-cost loans or credit – a phenomenon known as cheap money – and encourages businesses and individuals to borrow and spend.
To reduce the money supply, perhaps to reduce inflation, the central bank does the opposite and sells government bonds.
The money with which the buyer pays the central bank is essentially taken out of circulation. Note that we are generalizing in this example to keep things simple.
Remember, as long as people trust the currency, the central bank can issue more of it.
But if the Fed issues too much money, the value will go down, as with anything with more supply than demand.
Therefore, the central bank cannot print money as it wants.
A History of American Money
In the 17th century, Great Britain was determined to control American colonies and natural resources.
To do this, the British limited the money supply and made it illegal for the colonies to mint their own coins.
Instead, the colonies were forced to trade using English bills of exchange that could only be redeemed for English goods.
Colonies were paid for their goods with these bills, which effectively cut them off from trading with other countries.
In response, the colonies turned to a barter system, using ammunition, tobacco, nails, pelts, and anything else that could be traded.
Colonists collected whatever foreign currency they could find, the most popular being the large, silver Spanish dollar.
It was called bits of eight because, when you had to make a change, you took out your knife and hacked it into eight bits.
From this, we have the expression “two bits”, meaning a quarter of a dollar.
Massachusetts was the first colony to defy the mother country. In 1652, the state minted its own silver coins, including oak tree and pine tree shillings.
The kingdom broke British law that only the monarch of the British Empire could issue coins by dating all their coins to 1652, a time when there was no monarch.
In 1690, Massachusetts also issued the first paper money called bills of credit.
Tensions between America and Britain continued to rise until the Revolutionary War broke out in 1775.
Colonial leaders declared independence and created a new currency called Continentals to finance their side of the war.
Unfortunately, each government printed as much money as needed without any standard or asset backing, so the Continentals experienced rapid inflation and became worthless.
This experience discouraged the US government from using paper money for almost a century.
After the revolution
The chaos of the Revolutionary War led to the complete destruction of the new nation’s monetary system.
Most of the currency of the newly formed United States of America was worthless.
This issue was not resolved until 13 years later in 1788 when Congress was given constitutional authority to regulate the coinage and value of money.
Congress established a national monetary system and created the dollar as the main unit of money.
There was also a bimetallic standard, meaning that both silver and gold could be valued in paper dollars and used to redeem them.
It took years to acquire all the foreign coins and compete for state currencies.
Bank notes were always in circulation, but because banks issued more notes than they had to cover them, these notes often traded at less than face value.
Eventually, the United States returned to using paper money.
In the 1860s, the US government created over $400 million in legal tender to finance the fight against the Confederacy in the American Civil War.
They were called greenbacks because their backs were printed in green.
The government supported the currency and said it could be used to pay off public and private debt.
However, at certain stages of the war the value fluctuated depending on the success or failure of the North.
Post-Civil War Situation
In February 1863, the US Congress passed the National Bank Act.
This act established a currency system whereby national banks issued notes backed by US government securities. The US Treasury then worked to eliminate state bank notes from circulation so that only national bank notes became the currency.
During this period of reconstruction the bimetallic standard was debated.
Some advocated using only silver to back the dollar, while others advocated gold.
The situation was resolved in 1900 when the Gold Standard Act was passed, making gold the sole basis of the dollar.
This backing meant that, in theory, you could take your paper money and exchange it for the corresponding value of gold.
In 1913, the Federal Reserve was created and given the power to steer the economy by controlling the money supply and interest rates on loans.
Money has changed a lot since the days of shells and skins, but its core function hasn’t changed at all.
Regardless of the form it takes, money provides us with a means of exchange for goods and services and allows the economy to grow because transactions can be completed more quickly.