As used in everyday conversation, the word money can mean many things, but to economists it has a very specific meaning. To avoid confusion, we must clarify how economists’ use of the word money differs from conventional usage. Economists define money (also referred to as the money supply) as anything that is generally accepted as payment for goods or services or in the repayment of debts. Currency, consisting of paper bills and coins, clearly fits this definition and is one type of money. When most people talk about money, they’re talking about currency (paper money and coins). If, for example, someone comes up to you and says, “Your money or your life,” you should quickly hand over all of your currency rather than ask, “What exactly do you mean by ‘money’?”.
To define money merely as currency is much too narrow a definition for economists. Because checks are also accepted as payment for purchases, checking account deposits are considered money as well. An even broader definition of money is needed because other items, such as savings deposits, can, in effect, function as money if they can be quickly and easily converted into currency or checking account deposits. As you can see, no single, precise definition of money or the money supply is possible, even for economists.
To complicate matters further, the word money is frequently used synonymously with wealth. When people say, “Joe is rich—he has an awful lot of money”, they probably mean that Joe not only has a lot of currency and a high balance in his checking account, but also has stocks, bonds, four cars, three houses, and a yacht. Thus, while ‘currency’ is too narrow a definition of money, this other popular usage is much too broad. Economists make a distinction between money in the form of currency, demand deposits, and other items that are used to make purchases, and wealth, the total collection of pieces of property that serve to store value. Wealth includes not only money but also other assets such as bonds, common stock, art, land, furniture, cars, and houses.
People also use the word money to describe what economists call income, as in the sentence “Sheila would be a wonderful catch; she has a good job and earns a lot of money”. Income is a flow of earnings per unit of time. Money, by contrast, is a stock: it is a certain amount at a given point in time. If someone tells you that he has an income of $1,000, you cannot tell whether he earns a lot or a little without knowing whether this $1,000 is earned per year, per month, or even per day. But if someone tells you that she has $1,000 in her pocket, you know exactly how much this is. Keep in mind that the money refers to anything that is generally accepted as payment for goods and services or in the repayment of debts, and is distinct from income and wealth.
Whether money is shells or rocks or gold or paper, it has three primary functions in any economy: as a medium of exchange, as a unit of account, and as a store of value. Of the three functions, its function as a medium of exchange is what distinguishes money from other assets such as stocks, bonds, and houses.
In almost all market transactions in our economy, money in the form of currency or checks is a medium of exchange; it is used to pay for goods and services. The use of money as a medium of exchange promotes economic efficiency by minimizing the time spent in exchanging goods and services. To see why, let’s look at a barter economy, one without money, in which goods and services are exchanged directly for other goods and services.
Take the case of Ellen the Economics Professor, who can do just one thing well: give brilliant economics lectures. In a barter economy, if Ellen wants to eat, she must find a farmer who not only produces the food she likes but also wants to learn economics. As you might expect, this search will be difficult and time-consuming, and Ellen might spend more time looking for such an economics-hungry farmer than she will teaching. It is even possible that she will have to quit lecturing and go into farming herself. Even so, she may still starve to death. The time spent trying to exchange goods or services is called a transaction cost. In a barter economy, transaction costs are high because people have to satisfy a “double coincidence of wants”—they have to find someone who has a good or service they want and who also wants the good or service they have to offer. Let’s see what happens if we introduce money into Ellen the Economics Professor’s world. Ellen can teach anyone who is willing to pay money to hear her lecture. She can then go to any farmer (or his representative at the supermarket) and buy the food she needs with the money she has been paid. The problem of the double coincidence of wants is avoided, and Ellen saves a lot of time, which she may spend doing what she does best: teaching.
As this example shows, money promotes economic efficiency by eliminating much of the time spent exchanging goods and services. It also promotes efficiency by allowing people to specialize in what they do best. Money is therefore essential in an economy: it is a lubricant that allows the economy to run more smoothly by lowering transaction costs, thereby encouraging specialization and division of labor. The need for money is so strong that almost every society beyond the most primitive invents it. For a commodity to function effectively as money, it has to meet several criteria:
- It must be easily standardized, making it simple to ascertain its value;
- It must be widely accepted;
- It must be divisible, so that it is easy to ‘make change’;
- It must be easy to carry;
- It must not deteriorate quickly.
Objects that have satisfied these criteria have taken many unusual forms throughout human history, ranging from wampum (strings of beads) used by Native Americans, to tobacco and whiskey, used by the early American colonists, to cigarettes, used in prisoner-of-war camps during World War II. The diverse forms of money that have been developed over the years are as much a testament to the inventiveness of the human race as are the developments of tools and language.