15 Oct, 2020
What is money?
This informal CPD article on What is money? was provided by Gianluigi Narciso, IIMR research intern at The Institute of International Monetary Research, an educational charity that promotes research into how developments in banking and finance affect the wider economy.
Money is considered by many one of the most important and successful institutions that has ever been created in human history. We use money every day almost but we rarely wonder what it really is and what are the mechanisms behind it; this brief article will explore the most important features of money.
Money can be any item which is collectively accepted and recognized as the preferred medium of exchange able to serve four purposes:
1. as a means of payment for goods and services and settle debts;
2. as a unit account, which offers a shared standard to measure the value of things and transactions;
3. as a store of value, that is, as an asset that holds value over time;
4. and as a result of the above, a standard of deferred payment, as it can be used as a means to transfer agents’ purchase power through time.
Money is usually divided into two categories: money that has intrinsic value as well as exchange value, and money that does not have intrinsic value but only exchange value. The first category refers to those monetary systems in the past that used to forge gold, silver or other precious metals’ coins. The value of a coin, and thus its purchasing power, was mainly given by the value of the physical metal in it. And we say ‘mainly’ because the currency normally had a face value (its exchange value) higher than its intrinsic value (i.e. the so-called ‘seignoriage’ or the profit from the issue of money). On the contrary, modern ‘paper money’ is not accepted for its intrinsic value but because it is backed by something else. During the Classical Gold Standard era (1870s – 1913), central bank notes were redeemable into gold at demand, therefore holding a bank note was equivalent to holding a promise of payment in gold. However, once the Gold Standard was fully abandoned in 1971 and replaced by a system where the amount of money is not tied anymore to the amount of gold held by the central bank, it is only accepted on the basis of trust. This system is nowadays called ‘fiat money’; one in which notes and coins are backed by the government itself and its ability to honour its financial obligations. This system frees the hands of central banks to decide how much money it wants to have in the economy, and therefore grants more power to intervene in the economy.
Since fiat money is not a scarce resource and central banks create the majority of money electronically (see further details in the IIMR’s previous news articles on the CPD website), central banks – and thus governments by extension – can never run out of it. They can print as much money as they deem necessary in any given circumstance. Only one limitation to the “printing press” exists: inflation.
Nonetheless, even though central banks remain the only institution that can issue currency, in modern economies characterised by fractional reserve banking systems, 90% to 95% of money is in fact created by commercial banks every time when they decide to extend a loan to a client and create a new deposit.
Understanding money is essential, not only when undertaking economic research of any kind at an academic level, but also to simply be more informed and aware citizens and be able to monitor the performance of central banks and governments.
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