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Empowering your money

What is money? Types, functions, and how it works

At a glance:

  • What is money?

  • The characteristics and functions of money

  • Money, its substitutes, and the future

  • Summary of money

A lot of things are said about what money can and cannot buy. Philosophers and theologians have speculated about its role in human life. We will leave those questions to them and instead focus on what it is and what it does as an economic resource.

As an educated investor, you should recognize the importance and significance of money in our economy. After all, it is what you will be investing with.

What is money?

Seashells, tobacco leaves, gold, silver, diamonds, cattle and even beads all have something in common: they have all been used as money. In a modern world like ours, it is difficult to conceive that these items bought goods and services.

Yet they served to fill the basic functions of money. Most fundamentally, something becomes money when it is used as a medium of exchange. That is, it is universally accepted in exchange for goods and services. In addition, money serves as a store of value in that it would have present and future purchasing power: the ability to buy goods and services.

Finally, money serves as a measure of value. This allows us to compare the worth of dissimilar items. For example, if someone was making $10 an hour and was planning to purchase a computer for $800, he or she would quickly figure out that it would take 80 hours of their labor to purchase the machine.

How money began

In some parts of the world today, persons continue to trade goods, animals, and crops for other goods and services; this is known as barter.

In the ancient Middle East, persons stored grain in community warehouses and used receipts written on clay tablets or other "orders of withdrawal" to purchase other goods and services (not unlike modern checks). Coins formed from precious metals made their appearance in 700 BC, but the first printed money didn't appear until around 800 AD.

The advantage of coins over weighted amounts of precious metal was that counting was easier than weighing – and the advantage of paper over metal is that paper weighs less than metal, and is thus easier to transport.

However, using coins or paper in trade and commerce required a great deal of trust because their value was not immediately measurable.

Why paper currency started

Trust was placed in precious metals used as money. Precious metals such as gold and silver used in trade and commerce are referred to as specie. Because gold and silver each have value in their own rights due to their rarity, desirability, and other properties, they were a natural choice to use as money. Gold and silver could easily be molded into bricks or coins that could easily be stored or transported as needed.

However, due to the weight of these metals, transporting large sums became problematic, so lighter currency was invented to represent the specie. Currency backed by precious metals such as gold or silver is said to be on the gold standard or silver standard, respectively.

You may see old United States paper money with the inscription "gold certificate" or "silver certificate" in museums or numismatic (coin and currency) collections. These paper dollars were exchangeable for specific amounts of gold or silver bars or coins.

Paper currency wasn't always a thing. (Photo: FEDERICO PARRA/AFP via Getty Images)
Paper currency wasn't always a thing. (Photo: FEDERICO PARRA/AFP via Getty Images)

However, most money today is not backed by anything more substantial than the good faith and credit of the government issuing the currency and its banking system. Currency that is not backed by specie is called fiat money. In fact, money has become a commodity in its own right, too, with currencies of different countries being traded around the world.

What all seem to agree upon is that "money" is some medium of exchange used in trade and commerce. The debate centers on money's form, importance, and powers. Some financial counselors even specialize in helping persons get in touch with their feelings about money, as money has a power all its own that affects people dramatically.

Whereas money was once sought for what it could purchase, today money seems to be sought for itself.

The characteristics and functions of money

Money replaced barter in trade and commerce because of its convenience.

Determining worth

An interesting characteristic of money is that it does not have to be worth the value of wealth that it transfers. For example, if one wanted to trade a goat for flour, one could agree upon how much flour a goat was worth. All one had to do was to agree upon the food value of each (fair value) so that an appropriate amount of flour equaled a goat (of some size, age, sex, etc).

If one used money instead, the values would have to be converted into "monetary units." Let's say that a goat was worth 100 gold-krinkles (we made this up). We might buy 50 lbs. of flour with 100 gold-krinkles. But the gold-krinkles do not have any food value. In fact, if the gold-krinkles were made of paper instead of real gold, they wouldn't have any real value at all—they would just be paper.

But because the paper gold-krinkles are "money," we ascribe a certain value to them, which we revere. We trust that the money has value due to legal proclamation, making the money legal tender. In some cultures, refusing legal tender in trade and commerce was a capital offense.

Money makes trade convenient

In addition to not having to lug a sack of flour around, we find that money makes trade and commerce more convenient, because it will not spoil as the flour might or grow old and die, as might a goat. Money holds its value over time. A dollar minted in 1950 is still a dollar today. A penny minted in 1936 equals a penny minted this year.

Moreover, if you had a goat but needed only a cup of flour, how would you divide the goat? Money can be divided into smaller units to make smaller purchases. While it is not convenient to divide the goat for a cup of flour, money can be divided into smaller units that maintain their monetary value with no harm to living things.

Coins were sometimes cut into pieces (bits) when smaller denominations of money were needed for smaller purchases, which led to terms such as "two bits" and "halfpenny."

Stacks of twenty dollar bills pass through on machine at the Bureau of Engraving and Printing. (Photo: Mark Wilson/Getty Images)
Stacks of twenty dollar bills pass through on machine at the Bureau of Engraving and Printing. (Photo: Mark Wilson/Getty Images)

Inflation changes the value of money

Currency represents money because its use as money is protected by law (legal tender), it can be conveniently divided into smaller units of exchange, and it is durable (it keeps its value over time). This is not to say that the value of money doesn't change in what it can purchase.

We are well aware of the effects of inflation on money. Inflation erodes the value of money and can destroy public trust in its use. In some countries, the national currency is so mistrusted that local citizens would rather use foreign currency or specie than their own currency.

This is why it is important for a government to have a sound economic policy that takes measures to curb inflation and stabilize its currency.

Money is used to accumulate things. The real "value" in money is not in itself, but in how much it can buy. Yet, today, there are those who accumulate money for its own sake.

Money, its substitutes, and the future

Historically, currency, as well as investment certificates of deposit (CDs) and other assets easily converted to "cash," have been considered to be substitutes for money, which traditionally was deemed specie (gold, silver, gems, etc.).

Today we see a panoply of new substitutes that may eventually replace money. Today, oddly enough, barter may also substitute for money.

Is cash going extinct?

We are rapidly becoming a cashless society with increased use of credit cards, debit cards, electronic transfers, cryptocurrencies, and other substitutes for money. One can currently make purchases using "smart card" technology that allows instantaneous financial transactions at gasoline stations, highway tollbooths, and amusement parks.

We rely less and less upon currency for our daily financial transactions. Even paper checks, which allow one to have funds drawn from one's bank, are losing popularity as a cash substitute. But is "magic plastic" really money, and what is the future of money?

Why credit and debit cards are so popular

Credit cards are very popular because they provide an instant loan of money to make purchases. Loans are limited by the user's available credit line. You don't need money in the bank to use a credit card. If the user repays the loan within a specified time (usually referred to as "the grace period"), the owner will not be charged any interest or fees for the use of the money.

However, merchants pay fees to the credit card issuers for the convenience of letting customers use them instead of currency. Merchants pass these fees along to their customers through increased costs of goods and services. Should the credit card user fail to repay all of the borrowed money within the grace period, the issuer charges the user interest and possibly fees for use of their money.

While debit cards look like credit cards, they work much differently. Debit cards are linked to a user's checking, savings, or other deposit account. The user must have a cash balance in his or her account to cover the amount to be paid by using the debit card.

Unless the debit card is utilized on one's own bank to make a withdrawal of cash, the user's bank charges the cardholder for the convenience of using the card. The merchant, too, is charged a nominal fee for the convenience of allowing customers to use cards instead of currency.

This Sunday, Aug. 11, 2019, photo shows a Capital One credit card in New Orleans. (AP Photo/Jenny Kane)
This Sunday, Aug. 11, 2019, photo shows a Capital One credit card in New Orleans. (AP Photo/Jenny Kane)

Electronic means of using money

Many banks allow customers to pay bills online through electronic transfers. Customers who use personal accounting software such as Quicken and Microsoft Money, or who make online purchases, may be able to have purchases paid directly with transfers from their bank to the merchant's bank.

One can even arrange with utilities and other monthly providers to have payments made automatically by electronic transfer. Electronic transfers are very convenient, but convenience comes with a price, and fees may apply.

Smart-card technology now makes it possible to store a lot of information about a person—including cash balances – directly onto a plastic card using electronic memory media that can be read and written to. This allows the user to store electronic cash on the card that can be debited when it is used to make purchases.

Is all of this really money?

But is any of this money? The jury is still out as the debate goes on. Surely, none of these methods of payment qualifies as legal tender, and merchants can use their discretion in deciding whether to accept payment in anything other than government-issued currency.

While purveyors of "magic plastic" take extra measures to protect themselves and users from fraud, it is much easier to fall victim to counterfeiting schemes with them than with real money. However, as encryption technology evolves, who is to say that the government will not sanction another type of currency as legal tender?

Summary of money

From the dawn of man, persons have needed to trade with one another in order to survive. At first, transactions were simple barter where one thing was traded for another. But as society became more complex, a more convenient means of exchange was needed to complete more financial transactions. At first, weighted amounts of precious metals or gems were used. These were the first forms of money.

As time went on, money evolved, as a more convenient means of exchange was needed. To function as money, a medium needed to be durable, hold its value, and be recognized as money. Currency including coins and paper eventually replaced the gold, silver, and other precious specie as money. Governments soon stepped in to regulate money, making their own currency the legal tender for trade and commerce.

In the electronic age, we see a further evolution in how we do trade and commerce. Today, most transactions are conducted without paper or coins. Is this new medium money?

Certainly, the concept of money remains, and electronic transactions are a bookkeeping representation of money, often denoted by the extant units of currency.

What will money be in the future? We still do not know, but it is fun to speculate.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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