What money is
The three jobs money does, commodity versus fiat money, how the money supply is measured, and what a central bank does.
FinanceEveryday economicsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Name and explain the three functions of money
- Tell commodity money from fiat money
- Describe what counts in the money stock and what a central bank does
Builds toward: Run your own money. Budget so there's room to save, spot and clear costly debt, compare savings and loan offers, and see what interest and inflation do to your money.
Everyday economics: news, prices and choices: lesson 7 of 11
- Everyday economics
- Trade-offs and opportunity cost 5 min
- Thinking at the margin and incentives 5 min
- Models and the circular flow 5 min
- Positive and normative statements 6 min
- Demand and what shifts it 5 min
- Supply, equilibrium and shifts 6 min
- What money is 5 min
- What GDP counts 6 min
- Real and nominal GDP 5 min
- Measuring unemployment 5 min
- The costs of inflation 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 16
What it is
Money is the set of assets that people regularly use to buy goods and services from each other. Without it, people would have to barter, swapping goods directly, which works only when each side happens to want what the other has: a "double coincidence of wants".
The three functions of money:
- Medium of exchange: what buyers give sellers in return for goods and services.
- Unit of account: the yardstick for posting prices and recording debts.
- Store of value: a way to carry purchasing power from today into the future. Money is not the only store of value (shares, bonds and houses are others), and it is an imperfect one when prices are rising.
Liquidity is how easily an asset can be turned into the medium of exchange. Money is the most liquid asset; shares and bonds are fairly liquid; a house or a painting is not.
Kinds of money:
- Commodity money has intrinsic value: it would be valuable even if it weren't money. Gold is the classic example; when gold (or paper money convertible into gold) is used as money, the economy is on a gold standard. Mankiw notes that cigarettes served as money in prisoner-of-war camps and in Moscow as the Soviet Union broke up.
- Fiat money has no intrinsic value. It is money because the government decrees it, and people accept it because they expect others to.
Quick check
Tap an answer to check it.
A shop lists its prices in euros. Which function of money is this?
- That is about paying, not pricing
- That is about holding purchasing power over time
Show answer
Unit of account. Prices and debts are measured in the unit of account.
Why it matters
Measuring the money stock. Money includes more than notes and coins (currency). It also includes demand deposits, bank balances that can be spent at once by cheque or debit card. Wider measures add savings deposits and similar accounts. The US Federal Reserve publishes two common measures: M1 (narrower) and M2 (wider). Mankiw notes that his analysis doesn't depend on the difference; what matters is that money includes bank deposits that can easily be spent. Credit cards are not money: they are a way of deferring payment.
Central banks. An economy using fiat money needs an institution to oversee it. A central bank oversees the banking system and regulates the quantity of money. In the US it is the Federal Reserve (the Fed); others include the Bank of England, the Bank of Japan and the European Central Bank.
- The Fed's Board of Governors has seven members. Monetary policy is set by the Federal Open Market Committee, made up of the seven governors and five of the twelve regional bank presidents. It meets about every six weeks.
- The Fed has two main jobs: regulating banks and ensuring the health of the banking system (including acting as a lender of last resort), and controlling the money supply.
- Its main tool is open-market operations: buying government bonds from the public adds money to the economy; selling them takes money out.
Worked example
Money in a small economy (billions, made up):
| Item | Amount |
|---|---|
| Currency held by the public | 60 |
| Demand deposits (current accounts) | 240 |
| Savings deposits | 400 |
| Unused credit-card limits | 500 |
| Government bonds held by the public | 300 |
- A narrow measure (like M1): currency + demand deposits = 60 + 240 = 300.
- A wider measure (like M2): add savings deposits: 300 + 400 = 700.
- Credit-card limits and government bonds are not money: the first is a way to borrow, the second is not a medium of exchange.
Common mistake
Counting credit cards as money. A card payment is a short-term loan from the card issuer, paid off later with money from a bank account. A debit card, by contrast, draws directly on a deposit, which is money.
Key terms
- money
- the assets people regularly use to buy goods and services from each other
- medium of exchange
- what buyers give sellers when they buy goods and services
- unit of account
- the yardstick for posting prices and recording debts
- store of value
- an item that carries purchasing power from the present into the future
- liquidity
- how easily an asset can be converted into the medium of exchange
- commodity money
- money that takes the form of a commodity with intrinsic value
- fiat money
- money without intrinsic value, used as money by government decree
- currency
- notes and coins in the hands of the public
- demand deposits
- bank balances that can be spent on demand
- central bank
- an institution that oversees the banking system and regulates the quantity of money
- money supply
- the quantity of money available in the economy
Practise the key terms
Tap a card to turn it over. 11 cards.
| Front | Back |
|---|---|
| money | the assets people regularly use to buy goods and services from each other |
| medium of exchange | what buyers give sellers when they buy goods and services |
| unit of account | the yardstick for posting prices and recording debts |
| store of value | an item that carries purchasing power from the present into the future |
| liquidity | how easily an asset can be converted into the medium of exchange |
| commodity money | money that takes the form of a commodity with intrinsic value |
| fiat money | money without intrinsic value, used as money by government decree |
| currency | notes and coins in the hands of the public |
| demand deposits | bank balances that can be spent on demand |
| central bank | an institution that oversees the banking system and regulates the quantity of money |
| money supply | the quantity of money available in the economy |
Practice
Work it through
Currency 50, demand deposits 150, savings deposits 300, credit-card balances owed 80 (billions).
- 50 + 150
- 200 + 300
Sort it
Which group does this belong to?
Paying for a coffee with notes
Money handed over in a purchaseShow answer
Medium of exchange. Money handed over in a purchase
A menu showing prices in pounds
Prices measured in moneyShow answer
Unit of account. Prices measured in money
Keeping savings in a bank account for next year
Holding purchasing power over timeShow answer
Store of value. Holding purchasing power over time
A loan agreement written in dollars
Debts recorded in moneyShow answer
Unit of account. Debts recorded in money
Quick quiz
Tap an answer to check it.
What makes fiat money valuable?
- That is commodity money
Show answer
Government decree and the expectation that others will accept it. Fiat money has no use apart from being money.
How does the Fed increase the money supply through open-market operations?
- That takes money out
Show answer
It buys government bonds from the public. Paying for the bonds puts new money into the economy.
In short
- Money is a medium of exchange, a unit of account and a store of value.
- Commodity money has intrinsic value; fiat money is money by decree.
- The money stock includes currency and bank deposits; credit cards are not money.
- A central bank oversees banks and controls the money supply, mainly through open-market operations.
Mastery check
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Check yourself
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Name the three functions of money.
Show answer
Medium of exchange, unit of account and store of value.
What is liquidity?
Show answer
How easily an asset can be turned into the economy's medium of exchange.
Who sets US monetary policy?
Show answer
The Federal Open Market Committee of the Federal Reserve.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 16.
- On this site: Banks and the money supply.
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