You may think you understand money, but do you? 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 struggle to make ends meet?
Let's take a closer look at money.
Currency vs. Money
Before you can understand money, you have to understand the difference between currency and money.
The first thing you need to know is that the physical currency in your pocket, wallet, or purse is not money at all. It is fiat money, or currency – a promise to pay money. But not money itself.
Money is an asset that has value, whereas currency is a representation of that value. Currency is only a claim on money.
Money is a means of exchange
A means of exchange is anything you can use to trade for goods and services. Money is an excellent means of exchange; however, it is not the only thing you can use for this purpose. You can also purchase goods and services with currency or exchange 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 has, they need another 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, easily recognizable, easy to store, and 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 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 later for goods and services without losing its value. For example, gold is an excellent store of value because it retains value over long periods of time. If you had a gold coin from the time of Julius Caesar, you could still exchange it for goods and services today. 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. It does this because it is not limited in supply.
Properties of Money
Money can measure, spend, and store economic value because it has certain properties that other things do not have. It is portable, durable, divisible, fungible, and limited in supply.
Money is portable
You can carry money in your pocket or purse. You can easily transport it from one place to another. In this sense, money is more portable than goods and services.
Money is durable
Money can last for a long time. It doesn't rust or decay with time. It is not easily destroyed. You can spend money without having to worry about it being damaged. Gold, silver, and even paper currency are all durable.
Money is divisible
You can divide money into smaller units. If a dollar is worth 100 pennies, you can exchange a dollar for 100 pennies. Gold can be divided into grams, ounces, or even smaller units, and Bitcoin can be divided into satoshis.
Money is fungible
The fungibility of money means that one unit of money is as good as another unit of money. For example, one dollar is as good as another dollar. This is not true for goods and services. For example, one apple is not always as good as another apple.
Money is limited in supply
There is a limit to how much money can be created. This is an essential characteristic of money. A good or service only qualifies as money if it is limited in supply. In contrast, governments and central banks can print any quantity of currency.
Currency is a representation of money, such as coins, paper bills, or the dollars in your bank account. While money has intrinsic value - a value of its own. Currency has no intrinsic value - its value is based entirely on the trust you have in it.
The major difference between money and currency is that money is limited in supply while currency is not. Currency acts as an IOU or a promise to pay money at a later date. However, banks and governments can print more currency at any time. This is why banks can loan out money that doesn't exist, and why the government can too.
The Origin of Money
Before currency or fiat money, there was commodity money, which was money in the form of a valuable commodity, such as gold or silver. Gold has been used as money for thousands of years. It's valuable, it's rare, it's durable, and it's divisible. It's also used in electronics, dentistry, and other fields.
Today, most currency is actually debt. It's debt created by a central bank, such as the Federal Reserve. The central bank creates currency out of thin air, and lends it to the government. If the government wants to spend more than it has, it borrows the money from the central bank. The government then spends the currency into circulation, where it is used for transactions. The government has to pay back the debt, with interest, to the central bank.
This system of debt money is how the US government finances its operations. It's also how it causes inflation.
The reason this debt based currency system 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.
The financial system is based on the notion that the government and its allies (banks) won't print too much money. However, as we've seen in recent years, inflation has been a concern for many.
No one creates real money. It has value because it has an intrinsic value of its own. Precious metals like gold are an example of real money - miners can extract it from the ground, but they cannot conjure it into existence.
Currency and paper money represent money, but since they do not have a fixed supply or intrinsic value, they can be created by issuing authorities such as the federal reserve bank at will. Other financial institutions such as commercial banks can also increase the money supply through fractional reserve banking, where new currency can be created in the form of bank account balances or bank deposits.
Since the government or central bank can issue as much currency or legal tender as they want, they can create inflation. If the government or central bank print too much currency, the value of the currency falls. Ultimately, this causes inflation and, in some extreme examples, hyperinflation.
The purchasing power of a currency is a product of supply and demand, i.e., the more currency that is available, the less purchasing power it has. The government or central bank manages the supply of currency through its process of monetary policy. At the same time, its users determine the demand for a currency through their desire to hold or use it as either a medium of exchange or store of value.
Inflation is the result of an increased supply of currency. When the central bank or government prints new currency, they dilute the value of the existing currency by increasing its supply. If the currency supply gets too big or grows too fast, the currency can become worthless.
When the central bank or government creates new currency, it does not create new value. Instead, value is redirected from the existing currency holders and transferred to the government, banks, and other institutions. Many people view inflation as a hidden tax that extracts wealth from the working class and redirects it to the banking and financial class. This is why it is crucial to protect your wealth from inflation by putting it to work.
Frequently Asked Questions:
What is the function of money?
Money is a measure of wealth. It's a tool we use to trade for goods and services. The primary function of money is to act as a medium of exchange, store of value, and unit of account.
Is money the same as currency?
Money is not the same as currency. Currency is an IOU, a promise to pay money at a later date. Currency is circulated to facilitate trade, but it is not money. Money is the actual thing that has value, not just a promise of something that has value. Good examples of money include gold, silver, and Bitcoin. Paper currency is not money, but a representation of money.
What is fiat currency?
Fiat currency is currency that is not backed by anything of intrinsic value. The currency in most countries is fiat currency. In the United States, fiat currency is issued by the Federal Reserve and backed by the "full faith and credit" of the United States government. In other words, fiat currency is a claim check on the goods and services that the government has the power to tax.
How is money created?
Money cannot be created but currency can be created through debt. The government expands the money supply by borrowing newly created currency from a central bank, and then it spends it into the economy. The government then collects taxes or borrows more currency to pay back the debt. This is called 'debt-based' currency.
Can money buy happiness?
Money can buy you the freedom to do the things you want. It can buy you a comfortable home. It can buy you the clothes and shoes and cars and gadgets you always wanted. But money can't buy you happiness. Happiness comes from within. It comes from doing what you love and living life to the fullest.