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Sunday, April 20, 2014

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Intersections: Winter 2005

What Is Money?

If you ask your students, “What is money?” they are likely to tell you that money is the paper currency and coin they carry in their pockets. However, money is more broadly defined than just paper currency and coin. In fact, economists have come up with a number of different definitions of money in analyzing the U.S. economy. These definitions vary depending on the purpose for which the concept of money is being used.

Money has been around since ancient times. It developed because barter, the swapping of goods and services for other goods and services, is difficult. The difficulty lies in the fact that barter requires a coincidence of wants between any two parties interested in making a trade. If Mary wants to buy a chicken and has a cantaloupe to sell and Bill wants a cantaloupe and has a chicken to sell, a coincidence of wants exists between them, and a successful trade can be arranged as long as the parties agree that a chicken is worth a cantaloupe. However, in reality, it is more likely that Mary wants a chicken and has a cantaloupe to sell, but Bill wants a knife and has a chicken to sell. In this situation, a coincidence of wants does not exist between them, and either Mary or Bill will have to carry out a trade with one or more other individuals in order to get what they want. With more individuals and more goods, the process of searching for acceptable trades and the likely need to make multiple trades before obtaining the desired goods makes barter even less efficient.

Throughout history societies have used many different things as money, including stones, shells, elephant-tail bristles, gold and silver coins, furs, salt, whales’ teeth, and pieces of paper. Today, money includes paper currency, coins, bank deposits on which checks can be written, and, at times, other types of deposits that can be easily converted into cash (such as savings deposits or certificates of deposit).

Money has three functions. As a medium of exchange, money can be used for buying and selling goods and services, thereby allowing society to avoid the difficulties associated with barter. When you present cash or use a check or a debit card at the grocery store, you are using money in its function as a medium of exchange.

As a unit of account, money can be used to judge the relative value of different goods and services. Money lets consumers and producers make rational decisions about buying and selling goods and services. When you check the price of a good or service and compare it with the price of another good or service as part of your purchasing decision, money is being used in its unit of account function.

As a store of value, money can be used to transfer purchasing power from one period to another. When you get paid by direct deposit into your checking account and do not spend the money for two weeks, you are employing money’s store of value function.

To function efficiently, money should possess a number of characteristics. Money should be divisible. In our economy Federal Reserve notes in denominations of $1, $2, $5, $10, $20, $50, $100, along with pennies, nickels, dimes, quarters, half-dollars, and one-dollar coins, allow money to be divided from large amounts into small amounts. However, for much of the nation’s early history, shortages of coin meant that dividing large denominations into small denominations was difficult. If money is not divisible, it’s hard to carry out transactions that require the seller to provide change. Therefore, money that is not divisible does not act as a very good medium of exchange.

Money should be relatively scarce. As long as money is relatively scarce, it will act as a good store of value. History provides numerous examples of money that lost value because it was no longer scarce. In colonial Virginia, tobacco was used as money until planters grew so much tobacco that it was no longer scarce. Then tobacco had little or no value as money. Likewise, during the American Revolution, the Continental Congress printed so much paper currency that this paper money became worthless and the phrase “not worth a Continental” became a common term.

Money should be durable. Throughout history, agricultural products have been used as money in different parts of the world. However, perishable agricultural commodities often spoil if held for a long period, resulting in a breakdown in their usefulness as a store of value. Federal Reserve notes are printed on paper that is one-fourth linen and three-fourths cotton to ensure that even if it mistakenly goes through the wash in the pocket of your jeans, it will not be destroyed.

Despite the remarkable durability of our nation’s paper currency, repeated handling does wear out these bills. Therefore, each week, the Federal Reserve Banks shred millions of dollars in worn-out currency and replace it with new Federal Reserve notes to ensure that our nation’s paper currency remains in good condition.

Money should be portable. During the colonial period, livestock and other agricultural commodities were at times used as money. But significant transportation costs associated with bringing livestock and bulk products to market made it difficult to use them as mediums of exchange.

Money should be distinguishable. It needs to be easily recognizable and difficult to fake or counterfeit. From the early colonial money designed and printed by Benjamin Franklin to today’s “Safer, Smarter, More Secure” 2004 series Federal Reserve notes, continual efforts have been made to add features to paper currency that will help protect it from counterfeiters. Security features, such as today’s security thread, color-shifting ink, and the watermark, make it easy for the general public to distinguish genuine Federal Reserve notes from counterfeit bills.

Money should be desirable. If people are unwilling to accept a certain form of money, it ceases to be an effective medium of exchange. Throughout time, when economies have experienced very high levels of inflation, people became reluctant to accept that country’s currency and often desired other countries’ currencies or gold or some form of commodity money. This flight from the local currency occurred because high levels of inflation diminished the usefulness of money as a store of value and unit of account. During the colonial period, when commodities such as livestock and tobacco were used as money, people were often unwilling to accept those commodity monies because storage and transportation costs made them less desirable.

Along with the economic concepts of scarcity, opportunity cost, and choice, the characteristics and functions of money represent some of the most fundamental concepts in economics. A good understanding of the characteristics and functions of money can serve as a strong underpinning for lessons about personal finance. The Federal Reserve System works every day to ensure that money in the United States—whether paper currency, coin, or checkable deposits—efficiently and effectively serves as a medium of exchange, a unit of account, and a store of value.

—Andrew T. Hill, Ph.D.

Applicable Academic Standards

Voluntary National Content Standards in Economics: Standard 11
Students will understand that money makes it easier to trade, borrow, save, invest, and compare the value of goods and services.
Delaware Social Studies Curriculum Framework: Economics Standard 2
New Jersey Core Curriculum Content Standards for the Social Studies: Standard 6.5
Pennsylvania Academic Standards for Economics: Standards 6.2.3, 6.2.6

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