What Is Money?

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Money is an important feature of virtually every economy. Without money, members of a society must rely on the barter system in order to trade goods and services. Unfortunately, the barter system has an important downside in that it requires a double coincidence of wants. In other words, the two parties engaged in a trade must both want what the other is offering. This feature makes the barter system highly inefficient.

For example, a plumber looking to feed his family would have to search out a farmer who needs plumbing work done on his house or farm. If such a farmer were not available, the plumber would have to figure out how to trade his services for something that the farmer wanted so that the farmer would be willing to sell food to the plumber. Luckily, money largely solves this problem.

What Is Money?

In order to understand much of macroeconomics, it's crucial to have a clear definition of what money is. In general, people tend to use the term "money" as a synonym for "wealth" (e.g. "Warren Buffett has a lot of money"), but economists are quick to clarify that the two terms are not, in fact, synonymous.

In economics, the term money is used specifically to refer to currency, which is, in most cases, not an individual's only source of wealth or assets. In most economies, this currency is in the form of paper bills and metal coins that the government has created, but technically anything can serve as money as long as it possesses three important properties.

The Properties and Functions of Money

  • The item serves as a medium of exchange. In order for an item to be considered money, it must be widely accepted as payment for goods and services. In this way, money creates efficiency because it eliminates uncertainty regarding what is going to be accepted as payment by various businesses.
  • The item serves as a unit of account. In order for an item to be considered money, it must be the unit that prices, bank balances, etc. are reported in. Having a consistent unit of account creates efficiency since it would be pretty confusing to have the price of bread quoted as a number of fish, the price of fish quoted in terms of t-shirts, and so on.
  • The item serves as a store of value. In order for an item to be considered money, it has to (to a reasonable degree) hold its purchasing power over time. This feature of money adds to efficiency because it gives producers and consumers flexibility in the timing of purchases and sales, eliminating the need to immediately trade one's income for goods and services.

As these properties suggest, money was introduced to societies as a means of making economic transactions simpler and more efficient, and it mostly succeeds in that regard. In some situations, items other than officially designated currency have been used as money in various economies.

For example, it used to be somewhat common in countries with unstable governments (and also in prisons) to use cigarettes as money, even though there was no official decree that cigarettes served that function.

Instead, they became widely accepted as payment for goods and services and prices began to be quoted in number of cigarettes rather than in official currency. Because cigarettes have a reasonably long shelf life, they do in fact serve the three functions of money.

One important distinction between items that are officially designated as money by a government and items that become money by convention or popular decree is that governments will often pass laws stating what citizens can and cannot do with money. For example, it is illegal in the United States to do anything to money that makes the money unable to be further used as money. In contrast, there are no laws against burning cigarettes, aside from those banning smoking in public places of course.