What is money?
Have you ever wondered what money is or what types of money there are?
What makes the difference between a piece of paper of a certain size and shape and another piece of paper of identical size and shape but printed by the Bank of England and with £20 on it?
On the face of it, the answer is very simple:
A central bank prints the second piece of paper. The paper quotes the phrase “I promise to pay the bearer on demand the sum of twenty pounds”. This means you’re confident you can use this piece of paper to buy stuff (in the United Kingdom anyway).
However, I suspect that you’ll want to be able to use it to buy the same stuff a year from now too? It’d be pretty annoying if that £20 pound note is put away for a year and during that time it loses all its value. It’d be worthless!
Using money makes life easier.
And it does so in another way too.
It lets us compare different things.
If I’m looking for a new watch, I may research two different models. One may be an old, second-hand, and very basic model, costing £20. The other, a brand new model with new technology, and more features, and priced at £200.
If both watches are priced in the same units of money, I can work out if I think the newer watch is worth 10 times the value to me. If it is, I may buy it. But, if it’s not, I’ll think it’s expensive and avoid it.
So, whatever the type of money is, it has three functions, or roles:
- It must be acceptable by anyone you may want to buy from, or sell to, as a medium of exchange – a way to swap goods;
- Its future value must be predictable to a certain extent. In other words, it must keep its store of value; and
- It has to let us compare almost anything as a unit of account.
Money is far more than simply cash. In economics, money is a medium of exchange – a way to swap things. And nowadays, with the technology we have available to us, we use four main forms of it, each with their own benefits.
(You’ll note that I haven’t included digital currencies in this list. Find out why by reading the secret post about Bitcoin, in my free resource library, by filling in the form at the bottom of this post.)
1. The first type of money? Commodity Money
Commodity money is where an item itself is used for money. When I was at school, we often used sticker cards for commodity currencies.
“I’ll give you my Garbage Pail Kids Buggy Betty card for your packet of Salt n Vinegar Disco crisps…? “
Then, Garbage Pail cards were banned, they became even more valuable! You could get loads more sweets, crisps, hairbands – you name it – if you could smuggle one in and swap one!
Commodity money is a little like a barter system but one where the commodity itself is more widely used.
Fortunately, Garbage Pail Kids cards were a national currency with school children in the 1980s, so you weren’t confined to swapping with friends at one single school.
Bartering works fine in small communities with not much to swap, and between people who know each other. And commodity money, such as tea, tobacco, salt, or shells, is still used today but usually in developing nations like Burundi or Tanzania. Indeed, in US prisons, I read recently that tinned mackerel fillets are used as currency!
But, what a pain.
It’s costly if your tobacco gets wet or your shells get damaged.
Commodities often need to be looked after and stored properly.
Gold is a type of commodity money and the cost involved with buying it, storing it, and transporting it can be high.
You also have the inconvenience of finding someone who wants to swap goods with you, and at the same time – a double coincidence of wants. This means commodity money is not easily transferable; it’s likely what would happen in a world without any type of money.
If your currency is large – like a donkey – how do you swap it for smaller things, like a bag of rice? You’d have to buy a lot of rice because donkeys are not divisible! (Alive anyway…)
Having a monetary currency solves these problems. You can sell your stuff for cash, in small amounts if needs be, whenever you want to. You can then change the right amount of money for anything else you may want to buy.
2. Fiat Money
Fiat money is what we think of as cash – notes and metal coins.
Actually, in themselves, these things are almost worthless, especially the paper notes. What gives our cash its value is the Government’s backing. If the Government says a note or a coin is legal tender, the entire country knows we can use it for exchange,
And this is where the phrase “I promise to pay the bearer…” comes in.
Unlike commodity money, fiat money is easy to measure, transport and store.
A long time ago, our banknotes used to promise to pay the bearer in gold. But now, there is far more money than there is gold – and certainly in the UK.
So, our entire monetary system is based on the trust we have that a note or coin is worth what it says on the front.
The system only works if we believe in the value of the fiat money, and will accept it as payment.
Fiat money has no value of its own
The funny thing is, that fiat money has no value of its own, unlike commodity money. And it doesn’t pay any interest. We use it, purely, for convenience.
The value of money is effectively how much we can buy with it. Keeping track of this is quite a difficult job when we consider how many new goods and services come along every day.
Government statisticians keep a list – a ‘basket of goods’ – to do exactly this. It reflects what items households are buying and it gets checked regularly and compared with previous time periods.
In 2014, DVD recorders and gardeners fees were taken out of this basket and replaced with the costs of live films streamed over the internet and fruit snacking pots to match what we are buying.
But, this is how the value of money is measured.
How does the Government keep our trust in its money’s value?
This is the job of the Central Bank – the Bank of England in the UK or the Federal Reserve in the US.
Central banks try to ensure that the amount of money in the economy is stable, more or less. For example, in the US, the amount of money in the economy has stayed around 2/3 of Gross Domestic Product (GDP). In other words, total money is around 2/3 the size of the US economy. And the share of bank deposits is around 90%.
In the UK, bank deposits make up around 97% the size of the economy.
Central banks control the amount of money in circulation by using interest rates. The level of these reflect the amount of credit we, as consumers, are asking for to buy stuff. When we ask for a lot, the bank increases interest rates as a brake on our borrowing. But when we start to spend less, and ask for less credit, the bank lowers the rates to try and encourage us to borrow and keep spending.
Its all about supply and demand. But not of money itself – of bank credit.
This means that although individual banks can create money, the Central Bank still controls it. The problem comes when we lose trust in the Central Bank to do this.
3. Fiduciary Money
Quite frankly, cash is a pain for larger transactions. (And sometimes for that coffee!)
Imagine having to buy something large with cash. We’d need huge pockets!
This is where fiduciary money comes in. This is also called representative money. Examples of fiduciary money are cheques or debit cards. Fiduciary money is very similar to fiat money in that it’s worthless in itself. Its value comes from being able to exchange it for something else.
The difference here is that unlike banknotes or coins, fiduciary money is not legal tender. This means we don’t need to accept it like it is cash. But, as for fiat money, it needs to be widely accepted to be able to be exchanged or it’s pretty useless!
Find out why I haven’t included digital currencies as fiduciary money by reading the SECRET post on Bitcoin in my free resource library. Get the password to the library at the bottom of this post.)
Fiduciary money goes back a long time!
Centuries ago, medieval bills of exchange were used. These were letters written by one merchant to another ordering his banker to pay a bill on his behalf. But, unlike cash, this is not a promise to pay – it’s a way telling someone else to on his behalf.
It’s the issuer – the bank – that makes the promise to pay. Fiduciary money is our way of getting it to do so, provided we have made a deposit to the bank! Or it ‘bounces’.
Fiduciary money has the advantage of not being cash but allowing an exchange of goods to happen. In other words, you can go shopping, pay by cheque or debit card, and not need to carry around a whole purse full of cash.
The downside is, fiduciary money needs to be ‘cleared’ by its issuer, meaning it takes longer than paying with cash. The bank needs to check we have the funds already deposited with it to make the agreed payment. Or it’ll refuse. Debit cards and cheques must be cleared, but debit cards, as electronic forms of payment, are cleared so much quicker.
Credit cards are another example of fiduciary money
Although they work slightly differently.
Credit cards represent a promise to pay in the future, so you don’t need to have money deposited with a bank at the time you make the promise. But, you will have to make sure you can pay by the time the balance has to be settled.
With a credit card, we borrow the bank’s money to make the trade and we agree to pay the bank back within a certain time period. It’s a liability, in accounting terms. In other words, credit is an amount of money we owe.
It suits the bank to allow us to borrow the money because the bank charges us for this service – interest – and makes money this way. The more likely the bank thinks we are not to pay it back the funds, the more interest it will charge.
This is why credit cards that almost anyone can access have such high interest rates – the bank wants to cover the risk of defaulting.
4. Commercial Bank Money
Remember earlier we mentioned the demand for bank credit as a way of keeping track of how much money there is?
This is where commercial bank money comes in. Commercial bank money is money created by high street banks to put into our bank accounts.
If we want to buy something, and arrange with our bank to get a loan, the money that appears in your bank account is commercial bank money.
The bank creates the money and we agree to pay it back.
It does this and then charges us interest for its services – payment for its services over a certain period of time.
I think of this by comparing a bank with another business. Apple makes the iPhone and sells it on to its customers for a profit. A high street bank makes money and sells it on to its customers for a profit. The same principle applies
There is one major difference, however, And that’s high street banks are limited by the Central Bank as to how much money they can make. It does this in two ways. Firstly, by using interest rates and mentioned before; and secondly, by setting a limit on how much money a bank can create.
Fractional Reserve Banking
When creating money, banks are able to loan out more money than they hold in customer deposits. In other words, if I put £100 into my bank account, the bank can create an additional £900 and then make a £1000 loan on the back of that. It’s known in the lingo as Fractional Reserve Banking.
Central Banks control this by giving the bank a maximum ratio of loans to deposits that they cannot go over. It’s known as the Capitalisation Ratio, and was one of the consequences of the 2008 financial crisis.
So, a high street bank doesn’t lend money. It creates it and we call this commercial bank money.
Characteristics of all types of money
If you’ve read this far, you’ve probably realised that to be really useful, all modern types of money have certain characteristics. Being durable and long-lasting is really important or you won’t be able to use it to swap for goods. All useful types of money need to be portable and easy to carry around, which is one of the problems with keeping gold. It also has to be possible to divide it down into smaller parts to use as change.
We have to widely accept that certain items are types of money to be able to use it across the country, and for that, we have to trust it will not only keep its value but that it is worth what it says it is. In other words, it mustn’t be easy to fake or copy it; and the Central Bank needs to do a good job in maintaining the trust of us all when it comes to how much our money is really worth.
Economists identify four main types of money – commodity, fiat, fiduciary, and commercial. All are very different but have similar functions.
Have you used all these money types? What do you think about them? Do you think there are more or less types of money?
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