The definitions that different people use for money are somewhat arbitrary. Economists classify money into different categories, or measures. These measures are: M-1, M-2, M-3, and L.

The distinction between these measures can be somewhat unclear. However, a simple definition of money looks something like this:

Money: anything that is widely accepted as payment in exchange for goods and services.


Barter economy

In order to understand the functions that money serve, consider a barter economy, which is the alternative to a society with money. A barter economy depends on what is called a coincidence of wants. This means that if you want something that someone else has to offer - in order to get it, you must give that person something that they want. Usually, that person is not going to want whatever it is that you have to offer. You will have to find a third person, and probably involve many more people, before you can find an equilibrium where everybody involved will get something that they want in exchange for something that they have to offer.

If you want or have something that is perishable or decreases in value over time, finding someone to trade with becomes a very urgent process. This entire process is very cumbersome and time-consuming. People would end up spending so much of their time just making exchanges that they would have little time left to actually be producing something. It is very difficult to imagine a barter economy with any kind of economic growth, let alone any advances in technology.

Involving many people in the many transactions that would be required so that everybody gets what they want can involve thousands of different goods and services. This would require some sort of exchange rate between all of the goods and services in order to know what the relative values are. It would be very difficult for anybody to keep track of all of the different exchange rates for all of the different combinations of goods and services that can be traded for each other.

In addition, you have to consider the source of the goods or services that you have to offer. You could work for someone, and use whatever they pay you. But they won't likely pay you in whatever it is that you want. They would have to have everything that each and every employee wants in order to do that. And they won't pay you with what you want at exactly the same time that you want it. You would want to spread your earnings out between pay days - even save some to increase your wealth and make larger purchases in the future.

Functions of money

Economists have identified three functions that money serves to distinguish a money economy from a barter economy:

Medium of exchange: Money serves as a means of payment. It eliminates the necessity of a coincidence of wants.

Unit of account: This is a standard of value, or a common denominator, to measure the material worth of all goods and services available in the economy against each other. This gives people a general idea of the relative values of the items that they frequently purchase. This keeps people from having to know the exchange rates between thousands, or potentially millions, of goods and services.

Store of value: Money allows people to store purchasing power. This is necessary because the time that income is received will not always coincide with the time that people will want to use the money to finance expenditures.

As noted above, money is divided into different categories, or measures.

Measures of money:


A few notes concerning money

The distinctions made with these various measures can be somewhat arbitrary. They are mostly based on the relative liquidity of the different classifications of money. Liquidity means the relative ease with which something can be converted to cash.

Many people think of money in terms of only currency and coins. Currency and coins issued by the government are considered legal tender, meaning that no seller can legally refuse to accept currency and coins as payment for goods and services.

Currency (paper money) at one point in time could be legally exchanged for a specific amount of a commodity such as gold or silver. This was called the gold standard (or the silver standard). Coins were made of these commodities, and were called commodity money. Coins had a value based on the material that they were composed of, separate from the face value of the coins. If the value of the gold or silver that the coins were made of exceeded the face value of the coins, people would tend to hoard them. This would reduce the amount of money in circulation. It would necessarily reduce economic activity. This tendency to hoard commodity money is called Gresham's Law. Supply and demand forces, including hoarding, would tend to keep the values of the commodity in line with the face value of the coins. Inflation would be low, but economic growth could be limited.

Currency and coins no longer have value based on commodity prices. The value of cash money is based on the faith that people put in it. This is closely related to the stability of the government. Money that is not backed by commodities is called fiduciary, or fiat, money. One advantage of using fiduciary money is that it is much less expensive for the government to issue it. The government does not have to use or pledge valuable resources such as gold and silver. One disadvantage often cited regarding fiduciary money is that the government may tend to issue too much of it, causing inflation.

M-1 is called transaction money. It includes forms of money that are generally used to finance transactions. By far the largest form of money is demand deposits (checking accounts) rather than currency and coins. Currency and coins held at financial institutions (such as banks) and by the government are not part of the money supply. Only currency and coins held by the public (in circulation) are counted as money.

M-1 is the most widely-used measure of money, especially by those who want to emphasize the medium of exchange function of money.