By the beginning of the 20th century almost all countries had adopted the gold standard, backing their legal tender notes with fixed amounts of gold. The U. In the U. After this many countries de-pegged their currencies from the U. According to proponents of modern money theory , fiat money is also backed by taxes.
By imposing taxes, states create demand for the currency they issue. In Money and the Mechanism of Exchange , William Stanley Jevons famously analyzed money in terms of four functions: a medium of exchange , a common measure of value or unit of account , a standard of value or standard of deferred payment , and a store of value.
By , Jevons's four functions of money were summarized in the couplet :. This couplet would later become widely popular in macroeconomics textbooks. There have been many historical disputes regarding the combination of money's functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all.
One of these arguments is that the role of money as a medium of exchange is in conflict with its role as a store of value : its role as a store of value requires holding it without spending, whereas its role as a medium of exchange requires it to circulate. The term "financial capital" is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender.
When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the " coincidence of wants " problem. Money's most important usage is as a method for comparing the values of dissimilar objects. A unit of account in economics  is a standard numerical monetary unit of measurement of the market value of goods, services, and other transactions.
Also known as a "measure" or "standard" of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt. Money acts as a standard measure and common denomination of trade. It is thus a basis for quoting and bargaining of prices. It is necessary for developing efficient accounting systems.
While standard of deferred payment is distinguished by some texts,  particularly older ones, other texts subsume this under other functions. When debts are denominated in money, the real value of debts may change due to inflation and deflation , and for sovereign and international debts via debasement and devaluation. To act as a store of value , a money must be able to be reliably saved, stored, and retrieved — and be predictably usable as a medium of exchange when it is retrieved.
The value of the money must also remain stable over time. Some have argued that inflation, by reducing the value of money, diminishes the ability of the money to function as a store of value. To fulfill its various functions, money must have certain properties: .
In economics, money is any financial instrument that can fulfill the functions of money detailed above. These financial instruments together are collectively referred to as the money supply of an economy. In other words, the money supply is the number of financial instruments within a specific economy available for purchasing goods or services.
Since the money supply consists of various financial instruments usually currency, demand deposits and various other types of deposits , the amount of money in an economy is measured by adding together these financial instruments creating a monetary aggregate. Modern monetary theory distinguishes among different ways to measure the stock of money or money supply, reflected in different types of monetary aggregates, using a categorization system that focuses on the liquidity of the financial instrument used as money.
The most commonly used monetary aggregates or types of money are conventionally designated M1, M2 and M3. M1 includes only the most liquid financial instruments, and M3 relatively illiquid instruments. The precise definition of M1, M2 etc. Another measure of money, M0, is also used; unlike the other measures, it does not represent actual purchasing power by firms and households in the economy.
It is measured as currency plus deposits of banks and other institutions at the central bank. M0 is also the only money that can satisfy the reserve requirements of commercial banks. Legal tender , or narrow money M0 is the cash money created by a Central Bank by minting coins and printing banknotes. Currently, bank money is created as electronic money. Contrary to some popular misconceptions, banks do not act simply as intermediaries, lending out deposits that savers place with them, and do not depend on central bank money M0 to create new loans and deposits.
Money is the most liquid asset because it is universally recognised and accepted as the common currency. In this way, money gives consumers the freedom to trade goods and services easily without having to barter. Liquid financial instruments are easily tradable and have low transaction costs. There should be no or minimal spread between the prices to buy and sell the instrument being used as money. Many items have been used as commodity money such as naturally scarce precious metals , conch shells , barley , beads etc.
Commodity money value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity. These items were sometimes used in a metric of perceived value in conjunction to one another, in various commodity valuation or price system economies. Use of commodity money is similar to barter, but a commodity money provides a simple and automatic unit of account for the commodity which is being used as money. Although some gold coins such as the Krugerrand are considered legal tender , there is no record of their face value on either side of the coin.
The rationale for this is that emphasis is laid on their direct link to the prevailing value of their fine gold content. In , the British economist William Stanley Jevons described the money used at the time as " representative money ". Representative money is money that consists of token coins , paper money or other physical tokens such as certificates, that can be reliably exchanged for a fixed quantity of a commodity such as gold or silver.
The value of representative money stands in direct and fixed relation to the commodity that backs it, while not itself being composed of that commodity. Fiat money or fiat currency is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity such as gold. Instead, it has value only by government order fiat. Usually, the government declares the fiat currency typically notes and coins from a central bank, such as the Federal Reserve System in the U. Some bullion coins such as the Australian Gold Nugget and American Eagle are legal tender, however, they trade based on the market price of the metal content as a commodity , rather than their legal tender face value which is usually only a small fraction of their bullion value.
Fiat money, if physically represented in the form of currency paper or coins can be accidentally damaged or destroyed. However, fiat money has an advantage over representative or commodity money, in that the same laws that created the money can also define rules for its replacement in case of damage or destruction.
For example, the U. These factors led to the shift of the store of value being the metal itself: at first silver, then both silver and gold, and at one point there was bronze as well. Now we have copper coins and other non-precious metals as coins.
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Metals were mined, weighed, and stamped into coins. This was to assure the individual taking the coin that he was getting a certain known weight of precious metal. Coins could be counterfeited, but they also created a new unit of account , which helped lead to banking. Archimedes' principle provided the next link: coins could now be easily tested for their fine weight of metal, and thus the value of a coin could be determined, even if it had been shaved, debased or otherwise tampered with see Numismatics.
In most major economies using coinage, copper, silver and gold formed three tiers of coins. Gold coins were used for large purchases, payment of the military and backing of state activities. Silver coins were used for midsized transactions, and as a unit of account for taxes, dues, contracts and fealty, while copper coins represented the coinage of common transaction. This system had been used in ancient India since the time of the Mahajanapadas. In Europe, this system worked through the medieval period because there was virtually no new gold, silver or copper introduced through mining or conquest.
In premodern China , the need for credit and for circulating a medium that was less of a burden than exchanging thousands of copper coins led to the introduction of paper money , commonly known today as "banknote"s. This economic phenomenon was a slow and gradual process that took place from the late Tang dynasty — into the Song dynasty — It began as a means for merchants to exchange heavy coinage for receipts of deposit issued as promissory notes from shops of wholesalers, notes that were valid for temporary use in a small regional territory.
In the 10th century, the Song dynasty government began circulating these notes amongst the traders in their monopolized salt industry. The Song government granted several shops the sole right to issue banknotes, and in the early 12th century the government finally took over these shops to produce state-issued currency. Yet the banknotes issued were still regionally valid and temporary; it was not until the mid 13th century that a standard and uniform government issue of paper money was made into an acceptable nationwide currency.
The already widespread methods of woodblock printing and then Pi Sheng 's movable type printing by the 11th century was the impetus for the massive production of paper money in premodern China. At around the same time in the medieval Islamic world , a vigorous monetary economy was created during the 7th—12th centuries on the basis of the expanding levels of circulation of a stable high-value currency the dinar.
Innovations introduced by Muslim economists, traders and merchants include the earliest uses of credit ,  cheques , promissory notes ,  savings accounts , transactional accounts , loaning, trusts , exchange rates , the transfer of credit and debt ,  and banking institutions for loans and deposits. In Europe, paper money was first introduced in Sweden in Sweden was rich in copper, thus, because of copper's low value, extraordinarily big coins often weighing several kilograms had to be made.
The advantages of paper currency were numerous: it reduced transport of gold and silver, and thus lowered the risks; it made loaning gold or silver at interest easier, since the specie gold or silver never left the possession of the lender until someone else redeemed the note; and it allowed for a division of currency into credit and specie backed forms.
It enabled the sale of stock in joint stock companies , and the redemption of those shares in paper. However, these advantages held within them disadvantages. First, since a note has no intrinsic value, there was nothing to stop issuing authorities from printing more of it than they had specie to back it with. Second, because it increased the money supply, it increased inflationary pressures, a fact observed by David Hume in the 18th century. The result is that paper money would often lead to an inflationary bubble, which could collapse if people began demanding hard money, causing the demand for paper notes to fall to zero.
The printing of paper money was also associated with wars, and financing of wars, and therefore regarded as part of maintaining a standing army. For these reasons, paper currency was held in suspicion and hostility in Europe and America. It was also addictive, since the speculative profits of trade and capital creation were quite large.
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Major nations established mints to print money and mint coins, and branches of their treasury to collect taxes and hold gold and silver stock. At this time both silver and gold were considered legal tender , and accepted by governments for taxes. However, the instability in the ratio between the two grew over the course of the 19th century, with the increase both in supply of these metals, particularly silver, and of trade. This is called bimetallism and the attempt to create a bimetallic standard where both gold and silver backed currency remained in circulation occupied the efforts of inflationists.
Governments at this point could use currency as an instrument of policy, printing paper currency such as the United States greenback , to pay for military expenditures. They could also set the terms at which they would redeem notes for specie, by limiting the amount of purchase, or the minimum amount that could be redeemed. By , most of the industrializing nations were on some form of gold standard, with paper notes and silver coins constituting the circulating medium. Private banks and governments across the world followed Gresham's law : keeping gold and silver paid, but paying out in notes.
This did not happen all around the world at the same time, but occurred sporadically, generally in times of war or financial crisis, beginning in the early part of the 20th century and continuing across the world until the late 20th century, when the regime of floating fiat currencies came into force. One of the last countries to break away from the gold standard was the United States in No country anywhere in the world today has an enforceable gold standard or silver standard currency system.
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Commercial bank money or demand deposits are claims against financial institutions that can be used for the purchase of goods and services. A demand deposit account is an account from which funds can be withdrawn at any time by check or cash withdrawal without giving the bank or financial institution any prior notice.
Banks have the legal obligation to return funds held in demand deposits immediately upon demand or 'at call'.
Demand deposit withdrawals can be performed in person, via checks or bank drafts, using automatic teller machines ATMs , or through online banking. Commercial bank money is created through fractional-reserve banking , the banking practice where banks keep only a fraction of their deposits in reserve as cash and other highly liquid assets and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand. The process of fractional-reserve banking has a cumulative effect of money creation by commercial banks, as it expands the money supply cash and demand deposits beyond what it would otherwise be.
Because of the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple greater than 1 of the amount of base money created by the country's central bank. That multiple called the money multiplier is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators. The money supply of a country is usually held to be the total amount of currency in circulation plus the total value of checking and savings deposits in the commercial banks in the country.
In modern economies, relatively little of the money supply is in physical currency. For example, in December in the U. The development of computer technology in the second part of the twentieth century allowed money to be represented digitally. By , in the United States all money transferred between its central bank and commercial banks was in electronic form. By the s most money existed as digital currency in bank databases. Non-national digital currencies were developed in the early s.
In particular, Flooz and Beenz had gained momentum before the Dot-com bubble. When gold and silver are used as money, the money supply can grow only if the supply of these metals is increased by mining. This rate of increase will accelerate during periods of gold rushes and discoveries, such as when Columbus discovered the New World and brought back gold and silver to Spain, or when gold was discovered in California in This causes inflation, as the value of gold goes down. However, if the rate of gold mining cannot keep up with the growth of the economy, gold becomes relatively more valuable, and prices denominated in gold will drop, causing deflation.
Deflation was the more typical situation for over a century when gold and paper money backed by gold were used as money in the 18th and 19th centuries. Modern day monetary systems are based on fiat money and are no longer tied to the value of gold. The control of the amount of money in the economy is known as monetary policy. Monetary policy is the process by which a government, central bank, or monetary authority manages the money supply to achieve specific goals.
Usually the goal of monetary policy is to accommodate economic growth in an environment of stable prices. For example, it is clearly stated in the Federal Reserve Act that the Board of Governors and the Federal Open Market Committee should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. A failed monetary policy can have significant detrimental effects on an economy and the society that depends on it. These include hyperinflation , stagflation , recession , high unemployment, shortages of imported goods, inability to export goods, and even total monetary collapse and the adoption of a much less efficient barter economy.
This happened in Russia, for instance, after the fall of the Soviet Union. Governments and central banks have taken both regulatory and free market approaches to monetary policy. Some of the tools used to control the money supply include:. In the US, the Federal Reserve is responsible for controlling the money supply, while in the Euro area the respective institution is the European Central Bank.
For many years much of monetary policy was influenced by an economic theory known as monetarism. Monetarism is an economic theory which argues that management of the money supply should be the primary means of regulating economic activity. US Politics.
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