What is Money?
The History Of Money: Currency Wars
Money has played a very important role in every war since its creation. Ancient kings played with the percentages of precious metals in their coins to create more money to raise armies, feudal lords tried to undermine each other's treasuries and counterfeiters have run rampant throughout history. The most famous currency war, however, took place between the British Empire and its colony in America.
Currency Wars
In the 17th century, England was determined to keep control of both the American colonies and the natural resources they controlled. To do this, the English limited the money supply and made it illegal for the colonies to mint coins of their own. Instead, the colonies were forced to trade using English bills of exchange that could only be redeemed for English goods. Colonists were paid for their goods with these same bills, effectively cutting them off from trading with other countries.
In response, the colonies regressed back into a barter system using ammunition, tobacco, nails, pelts and anything else that could be traded. Colonists also gathered whatever foreign currencies they could, the most popular being the large, silver Spanish dollars. These were called pieces of eight because, when you had to make change, you pulled out your knife and hacked it into eight bits. From this, we have the expression of, "two bits", meaning a quarter of a dollar.
Massachusetts Money
Massachusetts was the first colony to defy the British. In 1652, the state minted its own silver coins, including the pine-tree and oak-tree shillings. It circumvented the British law stating that only the monarch of the British empire could issue coins by dating all their coins 1652 - a period when there was no monarch. In 1690, Massachusetts issued the first paper money as well, calling it bills of credit.
Tensions between America and Britain continued to mount until the Revolutionary War broke out in 1775. The colonial leaders declared independence and created a new currency called "continentals" to finance their side of the war. Unfortunately, each government printed as much as it needed without backing it to any standard or asset, so the continentals experienced rapid inflation and became utter worthlessness. This discouraged the government from using paper money for almost a century.
Aftermath of the Revolution
The chaos from the war left the monetary system in America a complete wreck. Most of the currencies in the newly formed United States of America were useless. The problem wasn't resolved until 13 years later in 1788, when Congress was granted constitutional powers to coin money and regulate its value. Congress established a national monetary system and created the dollar as the main unit of money. There was also a bimetallic standard, meaning that both silver and gold could be valued in dollars and used as money.
It took 50 years to get all the foreign coins and competing state currencies out of circulation, but by the early 1800s, the U.S. was ready to try the paper money experiment again. Bank notes had been in circulation all the while, but because banks issued more notes than they had coin to cover, these notes often traded at less than face value.
In the 1860s, the U.S. created more than $400 million in legal tender to finance the Civil War. These were called greenbacks simply because the backs were printed in green. The government backed this currency and stated that it could be used to pay back public and private debts. The value did, however, fluctuate according to the North's success or failure at certain stages in the war. Confederate dollars, also issued during the 1800s, followed the fate of the confederacy and were worthless by the end of the war.
Aftermath of the Civil War
Following its victory, the U.S. government got the National Bank Act through congress (February 1863). This act established a monetary system whereby national banks issued notes backed by U.S. government bonds. The government then choked out notes from state banks by taxation. The U.S. Treasury then worked to get greenbacks out of circulation so that the national bank notes would become the only currency.
During this period of rebuilding, there was a lot of debate over the bimetallic standard. Some were for using silver to back the dollar, others were for gold. The situation was resolved in 1900 when the Gold Standard Act was passed. This meant that, in theory, you could take your money to Fort Knox and exchange it for the corresponding value in gold. Another innovation brought the Federal Reserve into being in 1913. The Federal Reserve was given the power to steer the economy by controlling money supply and interest rates on loans.
Gold No More
In 1971, the U.S. dollar moved off the gold standard. The significance of moving away from the standard is that it became possible to create more money than there was gold to back it. Money's value was now decided purely by its purchasing power as dictated by inflation. There is no shortage of people who believe this is going to cause the end - with the dollar going the way of its forefather, the continental. There is a danger of losing the value of the dollar, but now it is backed by the health of the American economy. If the economy takes a nosedive, the value of the U.S. dollar will drop both domestically through inflation, and internationally through currency rates. Fortunately, the implosion of the U.S. economy would plunge the world into a financial dark age, so many other countries and entities are working tirelessly to ensure that never happens.
Money in the Future
Although the paper bills we carry around now have high-tech watermarks and security threads, the future of money is moving toward cards and chips. One day, a chip in your wallet may register purchases just by waving it over a product you want to walk out with - no clerk, no smile, no "hi my name is" badge. Internet currencies, such as the Paypal system, are also contenders for the next generation of money as the world becomes more interconnected. Many nations are still worried about cash they can't track or tax, but an internet economy is as inevitable as a free-trading America was. Money has changed a lot since the days of shells and skins, but its main function hasn't changed at all. Regardless of what form it takes, money offers us a medium of exchange for goods and services and allows the economy to grow as transactions can be completed at greater speeds.
What Is Money?
Everyone uses money. We all want it, work for it and think about it. If you don't know what money is, you are not like most humans. However, the task of defining what money is, where it comes from and what it's worth belongs to those who dedicate themselves to the discipline of economics. While the creation and growth of money seems somewhat intangible, money is the way we get the things we need and want. Here we look at the multifaceted characteristics of money.
What is Money?
Before the development of a medium of exchange, people would barter to obtain the goods and services they needed. This is basically how it worked: two individuals each possessing a commodity the other wanted or needed would enter into an agreement to trade their goods.
This early form of barter, however, does not provide the transferability and divisibility that makes trading efficient. For instance, if you have cows but need bananas, you must find someone who not only has bananas but also the desire for meat. What if you find someone who has the need for meat but no bananas and can only offer you bunnies? To get your meat, he or she must find someone who has bananas and wants bunnies ...
The lack of transferability of bartering for goods, as you can see, is tiring, confusing and inefficient. But that is not where the problems end: even if you find someone with whom to trade meat for bananas, you may not think a bunch of them is worth a whole cow. You would then have to devise a way to divide your cow (a messy business) and determine how many bananas you are willing to take for certain parts of your cow.
To solve these problems came commodity money, which is a kind of currency based on the value of an underlying commodity. Colonialists, for example, used beaver pelts and dried corn as currency for transactions. These kinds of commodities were chosen for a number of reasons. They were widely desired and therefore valuable, but they were also durable, portable and easily stored.
Another example of commodity money is the U.S. currency before 1971, which was backed by gold. Foreign governments were able to take their U.S. currency and exchange it for gold with the U.S. Federal Reserve. If we think about this relationship between money and gold, we can gain some insight into how money gains its value: like the beaver pelts and dried corn, gold is valuable purely because people want it.
It is not necessarily useful - after all, you can't eat it, and it won't keep you warm at night, but the majority of people think it is beautiful, and they know others think it is beautiful. Gold is something you can safely believe is valuable. Before 1971, gold therefore served as a physical token of what is valuable based on people's perception.
Impressions Create Everything
The second type of money is fiat money, which does away with the need to represent a physical commodity and takes on its worth the same way gold did: by means of people's perception and faith. Fiat money was introduced because gold is a scarce resource and economies growing quickly couldn't always mine enough gold to back their money requirement. For a booming economy, the need for gold to give money value is extremely inefficient, especially when, as we already established, value is really created through people's perception.
Fiat money, then becomes the token of people's apprehension of worth - the basis for why money is created. An economy that is growing is apparently doing a good job of producing other things that are valuable to itself and to other economies. Generally, the stronger the economy, the stronger its money will be perceived (and sought after) and vice versa. But, remember, this perception, although abstract, must somehow be backed by how well the economy can produce concrete things and services that people want.
That is why simply printing new money will not create wealth for a country. Money is created by a kind of a perpetual interaction between concrete things, our intangible desire for them, and our abstract faith in what has value: money is valuable because we want it, but we want it only because it can get us a desired product or service.
How is it Measured?
Sure, money is the $10 bill you lent to your friend the other day and don't expect back anytime soon. But exactly how much money is out there and what forms does it take? Economists and investors ask this question everyday to see whether there is inflation or deflation. To make money more discernible for measurement purposes, they have separated it into three categories:
M1 – This category of money includes all physical denominations of coins and currency, demand deposits, which are checking accounts and NOW accounts, and travelers' checks. This category of money is the narrowest of the three and can be better visualized as the money used to make payments.
M2 – With broader criteria, this category adds all the money found in M1 to all time-related deposits, savings deposits, and non-institutional money-market funds. This category represents money that can be readily transferred into cash.
M3 – The broadest class of money, M3 combines all money found in the M2 definition and adds to it all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.
By adding these three categories together, we arrive at a country's money supply, or total amount of money within an economy.
How Money is Created
Now that we've discussed why and how money, a representation of perceived value, is created in the economy, we need to touch on how the central bank (the Federal Reserve in the U.S.) can manipulate the money supply.
Among other things, a central bank has the ability to influence the level of a country's money supply. Let's look at a simplified example of how this is done. If it wants to increase the amount of money in circulation, the central bank can, of course, simply print it, but as we learned, the physical bills are only a small part of the money supply.
Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market. When the central bank buys these government securities, it puts money in the hands of the public. How does a central bank such as the Federal Reserve pay for this? As strange as it sounds, they simply create the money out of thin air and transfer it to those people selling the securities! To shrink the money supply, the central bank does the opposite and sells government securities. The money with which the buyer pays the central bank is essentially taken out of circulation. Keep in mind that we are generalizing in this example to keep things simple.
Conclusion
Remember, as long as people have faith in the currency, a central bank can issue more of it. But if the Fed issues too much money, the value will go down, as with anything that has a higher supply than demand. So even though technically it can create money "out of thin air," the central bank cannot simply print money as it wants.
Money has played a very important role in every war since its creation. Ancient kings played with the percentages of precious metals in their coins to create more money to raise armies, feudal lords tried to undermine each other's treasuries and counterfeiters have run rampant throughout history. The most famous currency war, however, took place between the British Empire and its colony in America.
Currency Wars
In the 17th century, England was determined to keep control of both the American colonies and the natural resources they controlled. To do this, the English limited the money supply and made it illegal for the colonies to mint coins of their own. Instead, the colonies were forced to trade using English bills of exchange that could only be redeemed for English goods. Colonists were paid for their goods with these same bills, effectively cutting them off from trading with other countries.
In response, the colonies regressed back into a barter system using ammunition, tobacco, nails, pelts and anything else that could be traded. Colonists also gathered whatever foreign currencies they could, the most popular being the large, silver Spanish dollars. These were called pieces of eight because, when you had to make change, you pulled out your knife and hacked it into eight bits. From this, we have the expression of, "two bits", meaning a quarter of a dollar.
Massachusetts Money
Massachusetts was the first colony to defy the British. In 1652, the state minted its own silver coins, including the pine-tree and oak-tree shillings. It circumvented the British law stating that only the monarch of the British empire could issue coins by dating all their coins 1652 - a period when there was no monarch. In 1690, Massachusetts issued the first paper money as well, calling it bills of credit.
Tensions between America and Britain continued to mount until the Revolutionary War broke out in 1775. The colonial leaders declared independence and created a new currency called "continentals" to finance their side of the war. Unfortunately, each government printed as much as it needed without backing it to any standard or asset, so the continentals experienced rapid inflation and became utter worthlessness. This discouraged the government from using paper money for almost a century.
Aftermath of the Revolution
The chaos from the war left the monetary system in America a complete wreck. Most of the currencies in the newly formed United States of America were useless. The problem wasn't resolved until 13 years later in 1788, when Congress was granted constitutional powers to coin money and regulate its value. Congress established a national monetary system and created the dollar as the main unit of money. There was also a bimetallic standard, meaning that both silver and gold could be valued in dollars and used as money.
It took 50 years to get all the foreign coins and competing state currencies out of circulation, but by the early 1800s, the U.S. was ready to try the paper money experiment again. Bank notes had been in circulation all the while, but because banks issued more notes than they had coin to cover, these notes often traded at less than face value.
In the 1860s, the U.S. created more than $400 million in legal tender to finance the Civil War. These were called greenbacks simply because the backs were printed in green. The government backed this currency and stated that it could be used to pay back public and private debts. The value did, however, fluctuate according to the North's success or failure at certain stages in the war. Confederate dollars, also issued during the 1800s, followed the fate of the confederacy and were worthless by the end of the war.
Aftermath of the Civil War
Following its victory, the U.S. government got the National Bank Act through congress (February 1863). This act established a monetary system whereby national banks issued notes backed by U.S. government bonds. The government then choked out notes from state banks by taxation. The U.S. Treasury then worked to get greenbacks out of circulation so that the national bank notes would become the only currency.
During this period of rebuilding, there was a lot of debate over the bimetallic standard. Some were for using silver to back the dollar, others were for gold. The situation was resolved in 1900 when the Gold Standard Act was passed. This meant that, in theory, you could take your money to Fort Knox and exchange it for the corresponding value in gold. Another innovation brought the Federal Reserve into being in 1913. The Federal Reserve was given the power to steer the economy by controlling money supply and interest rates on loans.
Gold No More
In 1971, the U.S. dollar moved off the gold standard. The significance of moving away from the standard is that it became possible to create more money than there was gold to back it. Money's value was now decided purely by its purchasing power as dictated by inflation. There is no shortage of people who believe this is going to cause the end - with the dollar going the way of its forefather, the continental. There is a danger of losing the value of the dollar, but now it is backed by the health of the American economy. If the economy takes a nosedive, the value of the U.S. dollar will drop both domestically through inflation, and internationally through currency rates. Fortunately, the implosion of the U.S. economy would plunge the world into a financial dark age, so many other countries and entities are working tirelessly to ensure that never happens.
Money in the Future
Although the paper bills we carry around now have high-tech watermarks and security threads, the future of money is moving toward cards and chips. One day, a chip in your wallet may register purchases just by waving it over a product you want to walk out with - no clerk, no smile, no "hi my name is" badge. Internet currencies, such as the Paypal system, are also contenders for the next generation of money as the world becomes more interconnected. Many nations are still worried about cash they can't track or tax, but an internet economy is as inevitable as a free-trading America was. Money has changed a lot since the days of shells and skins, but its main function hasn't changed at all. Regardless of what form it takes, money offers us a medium of exchange for goods and services and allows the economy to grow as transactions can be completed at greater speeds.
What Is Money?
Everyone uses money. We all want it, work for it and think about it. If you don't know what money is, you are not like most humans. However, the task of defining what money is, where it comes from and what it's worth belongs to those who dedicate themselves to the discipline of economics. While the creation and growth of money seems somewhat intangible, money is the way we get the things we need and want. Here we look at the multifaceted characteristics of money.
What is Money?
Before the development of a medium of exchange, people would barter to obtain the goods and services they needed. This is basically how it worked: two individuals each possessing a commodity the other wanted or needed would enter into an agreement to trade their goods.
This early form of barter, however, does not provide the transferability and divisibility that makes trading efficient. For instance, if you have cows but need bananas, you must find someone who not only has bananas but also the desire for meat. What if you find someone who has the need for meat but no bananas and can only offer you bunnies? To get your meat, he or she must find someone who has bananas and wants bunnies ...
The lack of transferability of bartering for goods, as you can see, is tiring, confusing and inefficient. But that is not where the problems end: even if you find someone with whom to trade meat for bananas, you may not think a bunch of them is worth a whole cow. You would then have to devise a way to divide your cow (a messy business) and determine how many bananas you are willing to take for certain parts of your cow.
To solve these problems came commodity money, which is a kind of currency based on the value of an underlying commodity. Colonialists, for example, used beaver pelts and dried corn as currency for transactions. These kinds of commodities were chosen for a number of reasons. They were widely desired and therefore valuable, but they were also durable, portable and easily stored.
Another example of commodity money is the U.S. currency before 1971, which was backed by gold. Foreign governments were able to take their U.S. currency and exchange it for gold with the U.S. Federal Reserve. If we think about this relationship between money and gold, we can gain some insight into how money gains its value: like the beaver pelts and dried corn, gold is valuable purely because people want it.
It is not necessarily useful - after all, you can't eat it, and it won't keep you warm at night, but the majority of people think it is beautiful, and they know others think it is beautiful. Gold is something you can safely believe is valuable. Before 1971, gold therefore served as a physical token of what is valuable based on people's perception.
Impressions Create Everything
The second type of money is fiat money, which does away with the need to represent a physical commodity and takes on its worth the same way gold did: by means of people's perception and faith. Fiat money was introduced because gold is a scarce resource and economies growing quickly couldn't always mine enough gold to back their money requirement. For a booming economy, the need for gold to give money value is extremely inefficient, especially when, as we already established, value is really created through people's perception.
Fiat money, then becomes the token of people's apprehension of worth - the basis for why money is created. An economy that is growing is apparently doing a good job of producing other things that are valuable to itself and to other economies. Generally, the stronger the economy, the stronger its money will be perceived (and sought after) and vice versa. But, remember, this perception, although abstract, must somehow be backed by how well the economy can produce concrete things and services that people want.
That is why simply printing new money will not create wealth for a country. Money is created by a kind of a perpetual interaction between concrete things, our intangible desire for them, and our abstract faith in what has value: money is valuable because we want it, but we want it only because it can get us a desired product or service.
How is it Measured?
Sure, money is the $10 bill you lent to your friend the other day and don't expect back anytime soon. But exactly how much money is out there and what forms does it take? Economists and investors ask this question everyday to see whether there is inflation or deflation. To make money more discernible for measurement purposes, they have separated it into three categories:
M1 – This category of money includes all physical denominations of coins and currency, demand deposits, which are checking accounts and NOW accounts, and travelers' checks. This category of money is the narrowest of the three and can be better visualized as the money used to make payments.
M2 – With broader criteria, this category adds all the money found in M1 to all time-related deposits, savings deposits, and non-institutional money-market funds. This category represents money that can be readily transferred into cash.
M3 – The broadest class of money, M3 combines all money found in the M2 definition and adds to it all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.
By adding these three categories together, we arrive at a country's money supply, or total amount of money within an economy.
How Money is Created
Now that we've discussed why and how money, a representation of perceived value, is created in the economy, we need to touch on how the central bank (the Federal Reserve in the U.S.) can manipulate the money supply.
Among other things, a central bank has the ability to influence the level of a country's money supply. Let's look at a simplified example of how this is done. If it wants to increase the amount of money in circulation, the central bank can, of course, simply print it, but as we learned, the physical bills are only a small part of the money supply.
Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market. When the central bank buys these government securities, it puts money in the hands of the public. How does a central bank such as the Federal Reserve pay for this? As strange as it sounds, they simply create the money out of thin air and transfer it to those people selling the securities! To shrink the money supply, the central bank does the opposite and sells government securities. The money with which the buyer pays the central bank is essentially taken out of circulation. Keep in mind that we are generalizing in this example to keep things simple.
Conclusion
Remember, as long as people have faith in the currency, a central bank can issue more of it. But if the Fed issues too much money, the value will go down, as with anything that has a higher supply than demand. So even though technically it can create money "out of thin air," the central bank cannot simply print money as it wants.
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