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ECONOMY ECONOMICS

Table of Contents
Medium of Exchange
What Is Money? Definition,
Impressions Create
Everything
History, Types, and
How Is Money Measured? Creation
Active Money
By THE INVESTOPEDIA TEAM Updated November 30, 2022
How Money Is Created Reviewed by CAITLIN CLARKE
Fact checked by JIWON MA
The History of American
Money

The Bottom Line

Money is any item or medium of exchange that is accepted by people for

the payment of goods and services, as well as the repayment of loans.
Money makes the world go 'round. Economies rely on money to facilitate
transactions and to power financial growth. Typically, it is economists who
define money, where it comes from, and what it's worth. Here are the
multifaceted characteristics of money.

KEY TAKEAWAYS
Money is a medium of exchange; it allows people and businesses
to obtain what they need to live and thrive.
 Bartering was one way that people exchanged goods for other
INVESTING SIMULATOR
goods BANKING
before PERSONAL
money was created.FINANCE NEWS REVIEWS ACADEMY TRADE

Like gold and other precious metals, money has worth because
for most people it represents something valuable.
Fiat money is government-issued currency that is not backed by a
physical commodity but by the stability of the issuing government.
Above all, money is a unit of account - a socially accepted
standard unit with which things are priced.

Medium of Exchange
Before the development of a medium of exchange—that is, money—
people would barter to obtain the goods and services they needed. Two
individuals, each possessing some goods the other wanted, would enter
into an agreement to trade.

Early forms of bartering, however, do not provide the transferability and

divisibility that makes trading efficient. For instance, if someone has cows
but needs bananas, they must find someone who not only has bananas
but also the desire for meat. What if that individual finds someone who
has the need for meat but no bananas and can only offer potatoes? To get
meat, that person must find someone who has bananas and wants
potatoes, and so on.

The lack of transferability of bartering for goods is tiring, confusing, and

inefficient. But that is not where the problems end; even if the person finds
someone with whom to trade meat for bananas, they may not consider a
bunch of bananas to be worth a whole cow. Such a trade requires coming
to an agreement and devising a way to determine how many bananas are
worth certain parts of the cow.

Commodity money solved these problems. Commodity money is a type of

good that functions as currency. In the 17th and early 18th centuries, for
example, American colonists used beaver pelts and dried corn in
transactions. 1 Possessing generally accepted values, these commodities
were used to buy and sell other things. The commodities used for trade
had certain characteristics: they were widely desired and, therefore,
valuable, but they were also durable, portable, and easily stored.

Another, more advanced example of commodity money is a precious

metal such as gold. For centuries, gold was used to back paper currency
—up until the 1970s. 2 In the case of the U.S. dollar, for example, this
meant that foreign governments were able to take their dollars and
exchange them at a specified rate for gold with the U.S. Federal Reserve.
What's interesting is that, unlike the beaver pelts and dried corn (which
can be used for clothing and food, respectively), gold is precious purely
because people want it. It is not necessarily useful—you can't eat gold,
and it won't keep you warm at night, but the majority of people think it is
 beautiful, and they know others think it is beautiful. So, gold is something
INVESTING SIMULATOR BANKING
that has worth. PERSONAL
Gold, therefore, serves FINANCE
as a physicalNEWS
token REVIEWS
of wealth ACADEMY TRADE
based on people's perceptions.

This relationship between money and gold provides insight into how
money gains its value—as a representation of something valuable.

Impressions Create Everything

The second type of money is fiat money, which does not require backing
by a physical commodity. Instead, the value of fiat currencies is set by
supply and demand and people's faith in its worth. Fiat money developed
because gold was a scarce resource, and rapidly growing economies
growing couldn't always mine enough to back their currency supply
requirements. 3 4 For a booming economy, the need for gold to give money
value is extremely inefficient, especially when its value is really created by
people's perceptions.

Fiat money becomes the token of people's perception of worth, the basis
for why money is created. An economy that is growing is apparently
succeeding in producing other things that are valuable to itself and other
economies. The stronger the economy, the stronger its money will be
perceived (and sought after) and vice versa. However, people's
perceptions must be supported by an economy that can produce the
products and services that people want.

For example, in 1971, the U.S. dollar was taken off the gold standard—the
dollar was no longer redeemable in gold, and the price of gold was no
longer fixed to any dollar amount. 5 This meant that it was now possible to
create more paper money than there was gold to back it; the health of the
U.S. economy backed the dollar's value. If the economy stalls, the value
of the U.S. dollar will drop both domestically through inflation and
internationally through currency exchange rates. The implosion of the U.S.
economy would plunge the world into a financial dark age, so many other
countries and entities are working tirelessly to ensure that never happens.

Today, the value of money (not just the dollar, but most currencies) is
decided purely by its purchasing power, as dictated by inflation. 6 That is
why simply printing new money will not create wealth for a country. Money
is created by a kind of a perpetual interaction between real, tangible
things, our desire for them, and our abstract faith in what has value.
Money is valuable because we want it, but we want it only because it can
get us a desired product or service.

How Is Money Measured?

But exactly how much money is out there, and what forms does it take?
Economists and investors ask this question to determine whether there is
 inflation or deflation. Money is separated into three categories so that it is
INVESTING SIMULATOR BANKING
more discernible PERSONAL
for measurement FINANCE
purposes: NEWS REVIEWS ACADEMY TRADE

M1 – This category of money includes all physical denominations of

coins and currency; demand deposits, which are checking accounts
and NOW accounts; and travelers' checks. This category of money is
the narrowest of the three, and is essentially the money used to buy
things and make payments (see the "active money" section below). 7
M2 – With broader criteria, this category adds all the money found in
M1 to all time-related deposits, savings accounts deposits, and non-
institutional money market funds. This category represents money that
can be readily transferred into cash. 8
M3 – The broadest class of money, M3 combines all money found in
the M2 definition and adds to it all large time deposits, institutional
money market funds, short-term repurchase agreements, along with
other larger liquid assets. 9 M3 indicates a country's money supply or
the total amount of money within an economy.

Active Money
The M1 category includes what's known as active money—the total value
of coins and paper currency in circulation. 7 The amount of active money
fluctuates seasonally, monthly, weekly, and daily. In the United
States, Federal Reserve Banks distribute new currency for the U.S.
Treasury Department. 10 Banks lend money out to customers, which
becomes active money once it is actively circulated.

The variable demand for cash equates to a constantly fluctuating active

money total. For example, people typically cash paychecks or withdraw
from ATMs over the weekend, so there is more active cash on a Monday
than on a Friday. The public demand for cash declines at certain times—
following the December holiday season, for example. 11

How Money Is Created

We have discussed why and how money, a representation of perceived
value, is created in the economy, but another important factor concerning
money and the economy is how a country's central bank (the central bank
in the United States is the Federal Reserve or the Fed) can influence and
manipulate the money supply.

If the Fed wants to increase the amount of money in circulation, perhaps

to boost economic activity, the central bank can, of course, print it.
However, the physical bills are only a small part of the money supply.

Another way for the central bank to increase the money supply is to buy
government fixed-income securities in the market. When the central bank
buys these government securities, it puts money into the marketplace, and
 effectively into the hands of the public. How does a central bank such as
INVESTING SIMULATOR BANKING
the Fed pay for this? As PERSONAL
strange FINANCE
as it sounds, NEWSbankREVIEWS
the central simply ACADEMY TRADE
creates the money and transfers it to those selling the securities. 12
Alternatively, the Fed can lower interest rates allowing banks to extend
low-cost loans or credit—a phenomenon known as cheap money—and
encouraging businesses and individuals to borrow and spend.

To shrink the money supply, perhaps to reduce inflation, the central bank
does the opposite and sells government securities. The money with which
the buyer pays the central bank is essentially taken out of circulation.
Keep in mind that we are generalizing in this example to keep things
simple.

A central bank cannot print money without end. If too much

money is issued, the value of that currency will drop consistent
with the law of supply and demand.

Remember, as long as people have faith in the currency, a central bank

can issue more of it. But if the Fed issues too much money, the value will
go down, as with anything that has a higher supply than demand.
Therefore, the central bank cannot simply print money as it wants.

The History of American Money

Currency Wars
In the 17th century, Great Britain was determined to keep control of both
the American colonies and the natural resources they controlled. To do
this, the British limited the money supply and made it illegal for the
colonies to mint coins of their own. Instead, the colonies were forced to
trade using English bills of exchange that could only be redeemed for
English goods. Colonists were paid for their goods with these same bills,
effectively cutting them off from trading with other countries. 13

In response, the colonies regressed to a barter system using ammunition,

tobacco, nails, pelts, and anything else that could be traded. Colonists
also gathered whatever foreign currencies they could, the most popular
being the large, silver Spanish dollars. These were called pieces of eight
because, when you had to make change, you pulled out your knife and
hacked it into eight bits. From this, we have the expression "two bits,"
meaning a quarter of a dollar. 13

Massachusetts Money
Massachusetts was the first colony to defy the mother country. In 1652,
the state minted its own silver coins including the Oak Tree and Pine Tree
shillings. The state circumvented the British law stating that only the
 monarch of the British empire could issue coins by dating all their coins in
INVESTING SIMULATOR
1652, a periodBANKING
when there PERSONAL FINANCE
was no monarch. NEWS
In 1690, REVIEWS
Massachusetts also ACADEMY TRADE
issued the first paper money calling it bills of credit. 13

Tensions between America and Britain continued to mount until the

Revolutionary War broke out in 1775. The colonial leaders declared
independence and created a new currency called Continentals to finance
their side of the war. Unfortunately, each government printed as much
money as it needed without backing it to any standard or asset, so the
Continentals experienced rapid inflation and became worthless. This
experience discouraged the American government from using paper
money for almost a century. 13

Aftermath of the Revolution

The chaos from the Revolutionary War left the new nation's monetary
system a complete wreck. Most of the currencies in the newly formed
United States of America were useless. The problem wasn't resolved until
13 years later in 1788 when Congress was granted constitutional powers
to coin money and regulate its value. Congress established a national
monetary system and created the dollar as the main unit of money. 14
There was also a bimetallic standard, meaning that both silver and gold
could be valued in and used to back paper dollars. 15

It took years to get all the foreign coins and competing for state currencies
out of circulation. Bank notes had been in circulation all the time, but
because banks issued more notes than they had coin to cover, these
notes often traded at less than face value. 16

Eventually, the United States was ready to try paper money again. In the
1860s, the U.S. government created more than $400 million in legal
tender to finance its battle against the Confederacy in the American Civil
War. These were called greenbacks because their backs were printed in
green. The government-backed this currency and stated that it could be
used to pay back both public and private debts. The value did, however,
fluctuate according to the North's success or failure at certain stages in
the war. 17

Confederate dollars, issued by the seceding states during the

1860s, followed the fate of the Confederacy and were
worthless by the end of the war.

Aftermath of the Civil War

In February 1863, the U.S. Congress passed the National Bank Act. This
act established a monetary system whereby national banks issued notes
 backed by U.S. government bonds. The U.S. Treasury then worked to get
INVESTING SIMULATOR
state bank BANKING
notes PERSONAL
out of circulation FINANCE
so that NEWS
the national REVIEWS
bank notes would ACADEMY TRADE
become the only currency. 18

During this period of rebuilding, there was debate over the bimetallic
standard. Some advocated using just silver to back the dollar, others
advocated for gold. The situation was resolved in 1900 when the Gold
Standard Act was passed, which made gold the sole backing for the
dollar. This backing meant that, in theory, you could take your paper
money and exchange it for the corresponding value in gold. In 1913, the
Federal Reserve was created and given the power to steer the economy
by controlling the money supply and interest rates on loans. 19

The Bottom Line

Money has changed substantially since the days of shells and skins, but
its main function hasn't changed at all. Regardless of what form it takes,
money offers us a medium of exchange for goods and services and allows
the economy to grow as transactions can be completed at greater speeds.

ARTICLE SOURCES
INVESTING SIMULATOR BANKING PERSONAL FINANCE NEWS REVIEWS ACADEMY TRADE
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