What Is Money? How Money Works in the Economy

Money has been a central part of human society for thousands of years. It has taken many forms, from sea shells to precious metals, paper bills to digital blips—even giant carved limestone wheels called rai stones. Despite its ubiquity, the definition of money can be a little hard to pin down. Learn more about what money is (and isn’t).

What is money?

Money is anything with a perceived value that can act as a medium of exchange—often in the form of paper money, coin money, or digital money. A medium of exchange is an instrument used to sell and purchase goods and services. Money also serves as a store of value for use in future transactions.

Money is useful for facilitating trade. Unlike a barter system, where goods are exchanged directly (for example, a goat in exchange for a pot of oil), a monetary system allows the exchange of goods for an accepted intermediary item (for example, a goat in exchange for a certain amount of money, which could be spent later on a pot of oil or anything else).

Characteristics of Money

Money needs to have a widely accepted value for it to function as an exchange for goods. It typically has several other important characteristics, distinguishing the early forms of money from the ones used in a modern economy:

Recognizable

Money must be recognizable for it to be widely accepted. A currency’s purchasing power comes from a consensual value, so it must be consistent and readily identifiable to be generally accepted.

Durable

Throughout history, money has been durable. Whether you’re dealing with gold coins, silver coins, non-precious standardized coins, or even paper currency, physical money must last long enough to continue to represent and store value. If money isn’t durable enough, it could lose value if users are unwilling to hold onto it or accept it as payment.

Fungible

Money is fungible, or interchangeable, allowing the holder of the currency to trade and exchange it for another currency, a physical commodity, or anything with an equal or similar value.

Stable

Money is effective when its valuation is relatively stable. Wide fluctuations in a currency’s value can undermine confidence, reducing its utility as a medium of exchange. This is a major reason cryptocurrencies, which fluctuate widely in valuation, have almost no use in daily commerce.

Portable

Physical money is portable and can be carried from place to place. If money was too heavy or fragile to transport, it wouldn’t be very useful. Digital currencies, which include the electronic representations of money in your online checking account, are effective if they’re accessible in many locations.

Functions of money

Money has three basic functions:

Medium of exchange

Money allows people to purchase goods and services without having to immediately offer an equal good or service in exchange. Instead, they can exchange money in place of physical goods.

Store of value 

Money that maintains its purchasing power over time is a store of value. If you hold a precious metal, for example, you can be fairly certain that it will be worth something in the future, so it functions as a store of value. The same goes for dollars, euros, pesos, or renminbi.

Unit of account

Money is a representation of value or wealth. As a unit of account, it measures the amount of value or wealth a person or business holds. It also can figure in measuring profit and loss, determining a company or asset’s valuation, and facilitating value comparisons between goods and services.

Types of money

As a functional medium of exchange, there are several types of money both in form and underlying systems. Most money falls into one of the four following categories:

Commodity money

Money can be determined by organic economic activity, resulting in a market establishing its own types of money, often based on scarce natural resources. For example, gold and other precious metals have been accepted as valuable in markets and cultures around the world. Valuable objects such as salt, tools, or even cigarettes can become a de facto currency in a market without the support of a government or institution.

Representative money

Representative money—in the form of paper money or physical notes—is money that is backed by a valuable commodity but is not itself valuable.

Under the gold standard, for instance, money was backed by the valuable commodity of gold, so each dollar printed or coin minted would have a corresponding amount of gold held by the government that printed the money. In this system, money is a representation of an existing good. Many countries have abandoned the gold standard, and they now issue fiat money.

Fiat money

Fiat money is another type of government-issued currency, but it isn’t backed by anything of physical value, such as gold or silver. Instead, the value of a fiat currency is backed by the government that issued it. Fiat money’s value is determined by the stability and widespread trust in the government that issued it. Both fiat money and government-issued money backed by a physical asset can be designated as legal tender, which ensures acceptance by all governmental bodies.

Fiduciary money

Have you ever written a check? Then you’ve used a money substitute, or fiduciary money. Money substitutes can be a convenient alternative to carrying a lot of cash. Written checks, for instance, can be accepted as a substitute for money that will change hands later.

The advantages of fiduciary money are convenience and portability; however, it can also be risky, because it is possible to create or receive money substitutes that promise more money than underpins the substitute. For example, you can write a check for more money than you have in your bank account.

How do economists measure the money supply?

Economists use a formalized measurement tool known as monetary aggregates to gauge the amount of money in circulation. These tools help economists understand the health of the economy and let central banks like the Federal Reserve craft monetary policy. In the US, there are three categories of monetary aggregates to help measure the economy’s money supply:

• M0 (the monetary base). This category refers to all of the circulating currency, including paper and coins, as well as the bank reserves held by the central bank.

• M1. All of M0 plus traveler’s checks and demand deposits, which are bank deposits that can be withdrawn without notice. Common examples of demand deposits are checking and savings accounts.

• M2. All of M1 plus demand deposits and money market shares, which is when money from investors is combined to invest safely, typically in short-term government bonds or high-grade corporate debt.

Tracking monetary aggregates like these three measurements offers insight into economic activity, growth, and the risk of inflation.