What is Money

What is Money & How Does it Work?

In this article, we’ll look at what is Money and how does it work?

Money is a medium of exchange that is used by people to purchase goods and services, as well as to save and invest. It is a store of value and is accepted as payment in various forms, including cash, coins, checks, and digital currencies like Bitcoin.

Let’s dive in to learn more about money, how money works and its characteristics.

What is Money?

Money is a medium of exchange that is used to facilitate transactions between parties. It is important to note that money is not a physical commodity, such as gold or silver, but rather a unit of account that is used to measure the value of goods and services.

Because money is a unit of account, it measures the value of goods and services. It is also a store of value, meaning it can be used to store wealth over time.

Money is not a substitute for goods and services but rather an intermediary that facilitates the exchange of goods and services. It can come in various forms, including cash, coins, checks, and digital currencies like Bitcoin.

People use money to purchase goods and services, transfer wealth, and save and invest.

The History of Money

Before the invention of money, people used to indulge in barter. 

In the barter system, goods and services would be directly exchanged without using money. So, if you had extra wheat, you could exchange it for meat, milk, or any other commodity you wanted. There were two main problems with the barter system: 

1) Double Coincidence of Wants: In the barter system, if you wanted chicken, you had to find someone that didn’t only have chickens but also wanted the wheat you were producing. This conundrum was called the double coincidence of wants. Finding the right person with your needs and the exact product you wanted was quite difficult.

2) Subdivision of Goods: Since bulky products like chicken and cows were indivisible, it was hard to exchange goods and services. If you only wanted one kg chicken, it wasn’t possible to divide it. You had to buy the whole chicken!

To solve these problems, money was invented. Money was a widely accepted method of payment that would allow the easy exchange of goods and services. 

Throughout history, we have seen various forms of money, for example, gold, paper money, cigarettes in post-WWI Germany, and most recently, cryptocurrencies. 

What are the Characteristics of Money?

For something to be accepted as a form of money, it must have all these 6 characteristics:

  1. General Acceptability: Before it can be used as money, people need to trust that it will be generally accepted in the market. In post-WWI Germany, cigarettes were accepted as a form of payment because the Deutschmark had lost general acceptability. Today, the US Dollar is traded in the market because the US government has established acceptability for the currency.
  2. Durability: Money should last a few years without losing its value. If you wanted to store a chicken, you ran the risk of losing it to disease or death.
  3. Portability: Money should not be too bulky. A fundamental problem with gold and silver coins was that you could not carry huge amounts. Due to the proliferation of debit cards, you can carry thousands of dollars in your pocket today without feeling too bulky.
  4. Divisibility: As mentioned above, cows and chickens cannot function as money because they are not divisible. With paper currency, you have small denominations like 50 cents and 1 dollar, making purchasing a cup of coffee or candy easier.
  5. Homogeneity: Currency bills should look exactly the same to be accepted as a means of payment. If each note looks different, people will not be able to differentiate a fake dollar bill from an original one.
  6. Limited Supply: Most importantly, money can lose value if it has a high supply. This is happening in countries like US and UK, where inflation was at record-high levels in 2022.

Types of Money

When we talk about money, we’re actually talking about two different things: fiat money and digital money.

Fiat Money

Fiat money is a currency that is backed by a government or a central bank. Currencies like the U.S. dollar, the Euro, and the British pound are all examples of fiat money. Fiat currency is created as debt by the government or central bank. The government or central bank will print new units of fiat money to replace old units of currency that are being destroyed or used in transactions. This creates more demand for the currency, which drives up its value.

Digital Money

Digital money is also known as virtual currency, digital asset, electronic cash, or e-cash. It is not backed by a physical object like fiat money is, but rather by trust in the system.

What is Digital Money?

Digital money, also known as cryptocurrencies like Bitcoin, has all the above characteristics except stability. Bitcoin is unstable, as it can have sharp bumps and dumps, making it difficult to use as a means of payment. 

Due to this reason, vendors cannot currently accept it as means of payment as Bitcoin tends to fall 20-30% in 2-3 days. However, in countries like Venezuela, where local currencies have lost their value due to hyperinflation, people have started using cryptocurrencies.

What are CBDC? (Central Bank Digital Currencies)

One interesting aspect to look for in the future is Central Bank Digital Currencies (CBDCs). Governments are conducting research and experiments on CBDCs, and we could eventually see them being accepted as digital money. CBDCs are cryptocurrencies living on the blockchain that will be fully backed and endorsed by national governments.

However, there are no guarantees that, in the long run, the problems of inflation and lack of accountability are not found in CBDCs.

FAQs

How Do You Define Money?

Money is any commodity or token that is widely accepted as a medium of exchange for goods and services. Money is also used as a unit of account, a store of value, and a means of payment.

What Are The 4 Types of Money?

The four types of money are commodity, fiat, fiduciary, and commercial bank. Commodity money is a physical good that is used as a medium of exchange, such as gold or silver. Fiat money is a currency that is declared legal tender by a government. Fiduciary money is money that a third party, such as a bank or government back. Commercial bank money is a type of money created by private banks when they issue loans.

What Makes Money a Money?

Money is considered money when it has certain characteristics, such as durability, portability, divisibility, homogeneity, and limited supply. Durability means the money should last a few years without losing value. Portability means that the money should not be too bulky. Divisibility means that the money should be able to be divided into smaller denominations. Homogeneity means that all money should look the same. Limited supply means that there should be a finite amount of money in circulation.

What Are The 3 Definitions of Money?

1. It is any commodity or token that is widely accepted as a medium of exchange for goods and services. 
2. Its also used as a unit of account, a store of value, and a means of payment. 
3. Money is also a set of institutional arrangements that allow for transferring and exchanging goods and services between economic agents.

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