You may think you understand money, but do you really? Do you know where money comes from, how it's created, and how it gets into your hands? Do you know why we have recessions, why we have inflation, why we have depressions? Do you know why some people become fabulously wealthy, while others have to struggle to make ends meet?
Let's take a closer look at money.
What is Money?
The first thing you need to know is that the money in your pocket, wallet, or purse is not money at all. It is currency – a promise to pay money, not money itself. The only difference is that your promise is considered to be as good as money, while other promises are not.
This is why banks can loan out money that doesn't exist, and why the government can, too.
Money vs Currency
Before you can understand money, you have to understand the difference between money and currency.
Money is a means of exchange, a unit of account, and a store of value. Put simply, money is a way of measuring, storing, and spending economic value.
Currency is a representation of money, such as coins, paper bills, or the dollars in your bank account.
The major difference between money and currency is that money has an intrinsic value - a value of its own. Currency, on the other hand, has no intrinsic value - its value is based entirely on the trust you have in it. The only reason currency works is because you believe that it's money. If people stopped believing that the notes in their pocket were money, they'd be worthless.
Money is a means of exchange
A means of exchange is anything that facilitates the exchange of goods and services. It is not necessary that money be used as a means of exchange. Goods and services can also be exchanged for other goods and services.
So for example, if Jack has apples and Jill has oranges, and they both agree that one apple is worth an orange, they can exchange the apples and oranges directly. But if they want to exchange the apples and oranges for something neither of them have, then they need some other means of exchange.
To solve this problem, they could use money to facilitate the exchange. If Jack has some gold and Jill has some silver, they can exchange the gold and silver for goods and services. The gold and silver have become money.
Money is an efficient medium of exchange because it is divisible, it is easily recognizable, it is easy to store and it is easy to measure.
Money is a unit of account
A unit of account is a uniform measure of value. It is the standard in terms of which the value of goods and services is expressed. The unit of account is often a form of money, but it could also be a unit of weight, time or any other measure of value. For example, Jack could trade one hour of labor for one of Jill's oranges.
We live in a world of specialization. Most of us do not grow or make the goods or services that we need; we buy them. We want to exchange our goods or services for the goods or services of others. If we did not have a way of comparing the value of one good or service to another, we could not have a system of exchange. We need a method to compare one set of goods with another set of goods. The unit of account performs this function. It is a standard, uniform measure of value that can be used to compare the value of one good or service with another.
Money is a unit of account because it is widely used as a measure of value. Money represents a certain number of hours of Jack or Jill's labor, or a certain amount of apples or oranges.
Money is a store of value
A store of value is anything that can be saved and exchanged at a later time for goods and services. For example, grain could be stored for future needs.
Money is a good store of value because it retains value over long periods of time. Money does not degrade or depreciate in value.
Note that while money is a good store of value, currency is not. Currency depreciates in value over time due to inflation.
Real money is not created by anyone. It has value because it has an intrinsic value of its own. Gold is an example of real money - it can be extracted from the ground, but it cannot be conjured into existence.
Currency is a representation of money but since it does not have a fixed supply or intrinsic value it can be created by issuing authorities at will.
Since the government can issue as much currency as it wants, it can create inflation. If the government prints too much currency, the value of the currency will go down. Ultimately, this will cause inflation and in some extreme examples, hyperinflation.
The purchasing power of currency is determined by its supply and demand, i.e., the more currency is available, the less purchasing power it has. The supply of currency is determined by the process of currency creation. The demand for currency is determined by the demand for it as a medium of exchange.
Inflation is the result of an increased supply of currency. This occurs when the government or central bank prints currency. The value of existing currency will be diluted as a result of the increased supply. If the money supply gets too big, the currency can become worthless.
When new currency is created, no new value is created. Value is simply taken from the existing currency holders and transferred to the government or central bank.
The inflation rate is a measure of expanding currency supply, as well as a metric for calculating the resulting loss of purchasing power of the currency.