In this lesson, you'll learn what money is and its four basic functions. You'll also take a look at how it benefits society and explore the different types of money.
What is Money?
Go with me to the town of Ceelo, where Margie the cake baker is busy baking cupcakes in her own kitchen today, while Mike the mechanic works on her minivan in the driveway.
In the town of Ceelo, we often hear people using terms like money and wealth interchangeably. When people talk about Margie the cake baker and what a nice house she has, they often say, 'Margie has a lot of money.' However, there's an important distinction between money and wealth. Although wealth could mean stocks, bonds, real estate, or gold, money is something far simpler. In economics, money is anything that is widely accepted in exchange for goods and services.
A World Without Money
What would the world be like without money? An economy can operate without money. In fact, most economies have operated without it at some point in history. But you wouldn't want to try this for long, as it would become quite frustrating. Here's how that would play out.
Suppose there are only two people in the entire economy - Mike the mechanic and Margie the cake baker. Instead of using money, they could trade products or services. Mike could trade an oil change - that he sells for $20 normally - for two of Margie's chocolate cakes - which she sells for $10 normally. This seems pretty simple in an economy with only two people. However, the more people you have and the more types of goods you have, the more complicated your economy gets and the more costly it becomes to satisfy everyone's needs and wants. A world without money becomes problematic.
For example, if you produce wheat, but you want cows, then you'll have to find somebody who raises cattle who also wants wheat. When two parties to an exchange value the good they would receive as much as the good they would give away, economists call this a coincidence of wants. Suppose you're a mason who lays bricks, and you need some oil. Not sunflower oil or extra virgin olive oil - I'm talking about light, sweet, crude oil - black gold, Texas Tea. Where can a mason find an oil refiner who happens to need a brick wall? This may cost you a great deal of time and effort, and as you try to locate the right person to exchange goods and services with, this could be a long time.
The Benefits of Money
As you can see, money offers consumers and businesses some very basic and practical benefits. Money was invented as an alternative to bartering. The major benefit of money is that it increases the efficiency of an economy by reducing transactions costs. When people can use money instead of bartering, this leads to more specialization and better division of labor within the economy.
In an economy with money, Margie and Mike can specialize in what they do best instead of what they can use to exchange with other people. Margie can bake cakes instead of being a farmer, and Mike can repair cars, which he's really good at, instead of raising cattle.
Why does this really matter? Because an economy with more specialization and division of labor trades more often, produces more, and enjoys greater economic output.
Three Types of Money
There are three types of money recognized by economists - commodity money, representative money, and finally, fiat money (and I'm not talking about the car). Let's take a closer look at each one of these and find out where they began.
Money that's in the form of a commodity with intrinsic value is considered commodity money. 'Intrinsic value' means it has value outside of its use as money. For example, gold has been used as commodity money for thousands of years. Suppose Margie decided to pay Mike with a gold bar that she inherited from her European grandfather - this would be an example of commodity money being exchanged.
Gold is valuable for a host of reasons, not just because it looks pretty cool. But, believe it or not, if you walk through the streets of any major city in America and you ask people randomly, many of them will still tell you they think our money is connected to gold. Of course it's not. It has absolutely no connection to it whatsoever. But if we used gold coins to buy things, that would be an example of commodity money.
Representative money is not money itself, but something that represents money. It is exchangeable for a commodity. During colonial days in America, tobacco was a valuable commodity. Somebody could pay for the goods and services that they needed using tobacco, and it would be accepted just like money was.
Tobacco became such a big deal during this time that people would store their tobacco in a warehouse and receive a receipt showing that they owned a certain amount of tobacco in the warehouse. Sounds kind of like a bank, doesn't it? A tobacco warehouse receipt quickly became representative money because this receipt was backed by tobacco sitting in a warehouse.
Suppose Mike and Margie lived in colonial days, and, of course, Mike was just as attracted to Margie's cakes as he is right now. When Mike wants to pay for a chocolate cake in colonial days, then he would use a tobacco receipt. Representative money is treated just as if it was real money, even though it's not. In today's economy, a check from a checkbook - that's an example of representative money because it represents money but it's not the money itself.
So far, we've talked about two types of money, both of which are based on something of real value. There's a third type of money that's most common. It's called fiat money. Fiat money is money with absolutely no intrinsic value that is just used as money. Fiat money only has value because the government says it's valuable. A fiat is simply an order or decree given by a government.
Basically, fiat money is money because the government says it is, not because it's actually worth anything. In fact, most of the paper currency - including the Federal Reserve Notes issued by the central bank of the United States - isn't worth the paper it's printed on, in spite of the fact that it's used and accepted virtually everywhere in the world. Amazing, isn't it?
Suppose Mike the mechanic worked for five weeks straight on Margie's minivan. During this long project, each Friday at three o'clock, when Mike would expect to be paid for all of his hard work during the week, he would go inside Margie's house. Although he dreamed of getting Margie's cakes, she would instead write on a piece of scratch paper '$120.' Obviously this is ridiculous because Mike couldn't take a piece of paper that says '$120' and go and buy groceries with it at the grocery store. This piece of paper doesn't represent anything of tangible value, like gold, for example - so it's not commodity money. However, if the government made a decree that it was worth something, then it would be. Such is our money today - the government says it's worth something, therefore people believe it and they act on it. This is what fiat money is.
Okay, it's time to review. In macroeconomics, money is anything that is widely accepted in exchange for goods and services. Money was first used as an alternative to bartering in order to lower the cost of transactions.
The major benefit of money is that it increases the efficiency of an economy by reducing transactions costs. When people can use money instead of bartering, this leads to more specialization and better division of labor. An economy with more specialization and division of labor trades more often, produces more, and enjoys greater economic output.
There are three types of money recognized by economists - commodity money, representative money, and also fiat money.
- Money that's in the form of a commodity with intrinsic value is considered commodity money.
- Representative money is not money itself, but something that represents money. It is exchangeable for money.
- Fiat money is money with absolutely no intrinsic value that's used as money only because the government says it's valuable.
When you've completed the lesson, it should be easy for you to:
- Define money as it is used in macroeconomics
- Describe economic benefits of using money
- Identify the three types of money: commodity money, fiat money, and representative money