Money is an important facet of our daily lives. We use money to conduct transactions for just about everything – haircuts, bananas, trips abroad, fertilizer, shares of public companies, and much more can all be purchased with money. In fact, money is usually the only realistic way to acquire something. It’s very difficult to get goods or services in a modern economy without it.

The values of money

Particularly philosophical readers may wonder why money is important at all. After all, most money is simply a piece of paper, a small bit of metal, or a number on a computer screen. We could easily decide that something else – say, seashells – was really money, and ignore the silly bits of colored paper. Or, we could do away with the paper and the seashells entirely, and just trade real goods with one another. So why do people use money?

The immediate answer is that money has value and is useful because people believe it has value. We all recognize that money is a valid and useful way to pay for goods and services, which makes it worthwhile to have. Going further, there are three main helpful qualities that make money useful for us.

First, money is a medium of exchange. This means that any person is able to exchange money for any good or service, because everyone recognizes that money has value. For example, a barber does not need to provide a haircut to a butcher in order to buy some raw beef (which would be bartering). Instead, the barber can receive money from any of their customers, and use that money to purchase the beef they want from the butcher. This purpose of money serves as a massive boon of convenience for all individuals. It allows trade to happen between individuals even when one person is not providing a good or service for the other.

Second, money is also a store of value. The value of money (usually) can be relied upon because it does not rapidly decay and is not easily destroyed. For example, ice cream would be a poor store of value because it would only last for a few minutes before melting away.

In contrast, paper or coin money is normally, but not always, a good store of value. In cases of hyperinflation, money makes a poor store of value because runaway inflation erodes its worth faster than people can spend it, leading to economic hardship. See the linked articles, particularly hyperinflation, for examples of how improperly managed currencies can become poor store of value.

The third useful property of money is that it is a unit of account. It is the same everywhere (that uses the same currency, at least). When someone walks into a store and sees a menu of prices, it’s very clear how much each item is worth and how much each will cost to purchase. Without a consistently defined system of money, judging how much things cost might be very confusing.

Of course, even with these three useful characteristics, money itself does not create productivity or grow the economy. Having more money doesn’t necessarily mean the economy is growing or doing better.

For example, consider a bicycle. Suppose the bike costs £15. It’s pink, and it is a good quality bicycle. Then, suppose that all prices in the economy double, so the pink bicycle now costs £30.

Although the price has changed, in this case the actual number value is meaningless – the bicycle is still the same, good quality, pink bicycle. Its true usefulness has not changed, even though the price doubled. Having more bits of paper and coin to pay for a bicycle doesn’t make the bicycle worth more; it just increases the otherwise arbitrary number value we assign to it in monetary terms.

Of course, in this case, the value of the bicycle didn’t change because all other prices doubled as well. But if the price rises or falls for just one good but not others, the relative values will change.

How the money supply is measured: M1 and M2

Defining money more formally will help us to analyze it further. Money is an asset that individuals can use to trade for goods and services that they desire. As an asset, it is very liquid – liquidity measures how easily an asset can be converted into cash. Highly liquid assets can thus easily be traded for goods and services.

When you say “money”, most people think of cash. But cash isn’t the only form of money. Economists generally track money using two different categories. These “monetary aggregates” are called M1 and M2, and they contain different forms of assets at varying levels of liquidity. In other words, M1 and M2 are two different measures of the money supply.

M1 is the most liquid measurement of the money supply; it is composed of assets that can very quickly be used to make purchases. This includes cash, of course. It also includes liquid assets like debit cards linked to your bank account, traveler’s checks, and other checkable deposits. Essentially, all of the money in M1 consists of assets that could be used as payment very quickly – within hours or even seconds. Thus, M1 is the most direct sense of the amount of money or currency in circulation.

M2 consists of assets that are relatively liquid, but less liquid than M1. These assets can still be used to pay for things in the short term, though. M2 includes money deposited into assets such as savings accounts, money market accounts, and certificates of deposit. Generally, the assets can’t be used to pay for something directly. But, these assets can quickly be converted into M1. For example, you don’t hand over your savings account to buy a new car. But you can withdraw several thousand dollars from that savings account (turning it into cash, part of M1) to pay for the new car relatively quickly.

M1 and M2 help economists analyze the health of the economy in a number of ways. For example, if there’s too much money in circulation, the economy is at risk of high inflation. By carefully analyzing the supply of money in the economy, central banks can implement different monetary policy strategies that are best for the economic situation. The Monetary Policy article details the various considerations that central banks must make when examining the economy, and is worth a read.

Further details on M1 and M2

Readers may wonder how M1 and M2 are controlled. After all, the government prints money, and the central bank conducts monetary policy. Therefore, one may expect that the money supply is directly controlled by one or both of these institutions. This is not the case, however.

In some countries, the government controls the printing of money directly; in others, the central bank – which in many countries is not a government institution – determines how much money is printed, even if the government does the printing. The central bank is also usually responsible for conducting monetary policy; it may conduct strategies like “open market operations” to influence the money supply. But even the central bank does not completely control the supply of money.

This is because the money supply is also influenced by the actions of banks. Banks can choose to hold excess money as reserves with the central bank, which effectively removes that money from circulation. Reserves can’t be used for transactions until the bank takes it out again. This lowers the money supply.

The central bank does, however, directly control the monetary base. This consists of the total amount of cash in circulation plus the total amount of reserves that banks hold with the central bank.

Further Reading

Even though M1 and M2 are useful definitions for the money supply, different countries may define the aggregates differently. For example, some countries may consider certain savings accounts to be part of M1 while others would place it in M2. There is no strict rule. In actuality, most countries have very similar definitions for M1, but varying definitions for M2.

For more information about the precise differences in how countries track money supply, this linked page from the US Federal Reserve will prove instructive. Although out of date, the page clearly shows how countries can measure monetary aggregates differently around the world.

Good to Know

Money being used in most economies today is known as “fiat money”. This means that the value of the money stems entirely from its officially recognized role as currency. Fiat money is controlled by a central bank, and this bank has tools to help stabilize the currency (and potentially exchange rates) to avoid currency crises.

In the past, though, countries have relied on commodity money – such as gold and silver – that are considered to have value in themselves. Some countries have also relied on money backed by commodities. Using this system of money gives their currency value by promising that a certain amount of a commodity – usually a precious metal like gold – was represented by that paper money. Theoretically, people could trade in their paper notes for a certain amount of that commodity if they so wished.

Commodity money and money that is tied to the value of commodities face issues that fiat money does not. For this reason, fiat money is generally considered superior.

For instance, countries that tied their currency to a commodity needed to hoard that commodity in order to have a stable money supply. Moreover, commodities like gold exist in limited quantities, which imposes very real limits on how much money can be in circulation. And, the fluctuating value of the commodities themselves could pose problems.

But commodity money hasn’t entirely disappeared from our economies. Digital or cryptocurrencies represent a recent, new form of commodity money that many investors have eagerly participated in (Bitcoin, for example). These currencies tout additional benefits such as speed, security, global reach, and decentralization that older commodity monies did not have. However, they may still face some challenges that older commodity currencies did, too; for example, the supply of many cryptocurrencies is fixed, similar to how the supply of gold is fixed, and no central bank is able to control the value of a cryptocurrency.