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Money, Money, Money

MONEY can be anything that is generally and universally accepted for the payment of goods, services, or debts. It consists of coins, paper money or currency, and checks that are convertible into currency and coin on demand. These three items expedite the production and trade of goods and services, and they liquidate debt. If it were not for money, all goods and services would have to be traded directly for other goods and services, a system known as barter. Good money consists of a material that is durable, easily stored, lacking in bulk, and light in weight. Metallic coins and paper are ideal for these purposes.

Money is created by a government and also by private institutions under its direct control. The Constitution of the United States grants Congress the "power to coin money and regulate the value thereof." Congress has delegated this money power to the U. S. Treasury, the Federal Reserve System, and through it to the system of privately owned commercial banks.

Some but not all money is also legal tender – that is, money that by law must be acceptd as payment of debt. Currency and coins are legal tender because they are created directly by a government and by governmental decree must be accepted. Checks, which are created by commercial banks, are money but are not legal tender.

Money and credit both affect prices. Because money finances virtually all economic activity, the total money supply will have a powerful effect on the price of goods and services. If the quantity of money doubles, then, all else remaining equal, the price level will tend to double.

An important characteristic of money is the Rapidity with which it circulates or changes hands. This is referred to as the Velocity of Money. If, for example, a dollar changes hands ten times per year, the velocity of money is ten. An increase in either the quantity of money or its velocity will cause prices to rise (inflation). Or one may rise and the other fall, tending to negate any impact on prices. The overall price level, then, is determined by the quantity of money times its velocity of circulation.

Money can also be defined functionally — that is, by noting the four functions it performs:

- medium of exchange;
- measure or standard of value;
- store of value; and
- standard of deferred payment. (Read more about money functions...)

Coins and currency in the hands of the public, together with all checking accounts, are the only items that perform all four of the functions of money. However, numerous other things perform some of the functions of money but not all four. In recent years a small but growing number of economists have broadened their definition of money to include some of these other items, which are really "near money" or money substitutes. This has resulted in several definitions of the money supply, labeled M1, M2, and M3.

The debate over how to define the money supply really has to do with whether or not savings deposits should be included in it. M1 stands for the traditional definition of the money supply and consists of:

M3 c (broad money – informal name) it is the symbol for the amount of money in circulation given by M3 + foreign currency bank deposits.

Money and Value

There are two theories concerning why money has value. The older is called "The Commodity Theory of Money". The other concerns "Fiat Money".

Commodity Money

The commodity theory holds that money has value only because it is made up of some commodity — or at least is backed by that commodity — that has intrinsic value that is conveyed to money. Historically the commodities chosen to convey value to money were always gold and silver. The commodity theory in its pure form would require that coins contain enough gold or silver so that, if melted down into bullion, they would retain their face value. A pure commodity theory also would require that paper money be convertible into gold or silver at its face value. A less rigorous interpretation of the commodity theory would permit a lesser amount of gold or silver in coins and would not require convertibility of paper money but only that it be backed by gold or silver. The commodity theory is no longer valid.

Fiat Money

Fiat money consists of coins with little or no precious metal in them, and of currency that is not convertible and usually not backed by gold or silver. Issued by a government, it may be called money by government decree. All coin and currency in the United States and virtually all in the world is fiat money.

Fiat money has value because it provides utility and is kept relatively scarce by the government issuing it. If the government issues too much money — that is, if it inflates greatly — the value of money falls, and if the process goes far enough and fast enough, money could become worthless. In the final analysis, then, the value of money is a function of the confidence in the government issuing it and the extent to which it is issued.

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