Money makes the world go around.

Economies rely on the exchange of money

for products and services. Economists define money, where it comes from, and
what it's worth. Here are the multifaceted characteristics of money.

KEY TAKEAWAYS

 Money is a medium of exchange; it allows people to obtain what they need

to live.
 Bartering was one way that people exchanged goods for other goods
before money was created.
 Like gold and other precious metals, money has worth because for most
people it represents something valuable.
 Fiat money is government-issued currency that is not backed by a physical
commodity but by the stability of the issuing government.
Medium of Exchange
Before the development of a medium of exchange—that is, money—people
would barter to obtain the goods and services they needed. Two individuals,
each possessing some goods the other wanted, would enter into an agreement
to trade.

Early forms of bartering, however, do not provide the transferability and divisibility
that makes trading efficient. For instance, if someone has cows but needs
bananas, they must find someone who not only has bananas but also the desire
for meat. What if that individual finds someone who has the need for meat but no
bananas and can only offer potatoes? To get meat, that person must find
someone who has bananas and wants potatoes, and so on.

The lack of transferability of bartering for goods is tiring, confusing, and

inefficient. But that is not where the problems end; even if the person finds
someone with whom to trade meat for bananas, they may not consider a bunch
of bananas to be worth a whole cow. Such a trade requires coming to an
agreement and devising a way to determine how many bananas are worth
certain parts of the cow.

Commodity money solved these problems. Commodity money is a type of good

that functions as currency. In the 17th and early 18th centuries, for example,
American colonists used beaver pelts and dried corn in transactions. Possessing
generally accepted values, these commodities were used to buy and sell other
things. The commodities used for trade had certain characteristics: they were
widely desired and, therefore, valuable, but they were also durable, portable, and
easily stored.
Another, more advanced example of commodity money is a precious metal such
as gold. For centuries, gold was used to back paper currency—up until the
1970s. In the case of the U.S. dollar, for example, this meant that foreign
governments were able to take their dollars and exchange them at a specified
rate for gold with the U.S. Federal Reserve. What's interesting is that, unlike the
beaver pelts and dried corn (which can be used for clothing and food,
respectively), gold is precious purely because people want it. It is not necessarily
useful—you can't eat gold, 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. So, gold is
something that has worth. Gold, therefore, serves as a physical token of wealth
based on people's perceptions.

This relationship between money and gold provides insight into how money gains
its value—as a representation of something valuable.

Impressions Create Everything

The second type of money is fiat money, which does not require backing by a
physical commodity. Instead, the value of fiat currencies is set by supply and
demand and people's faith in its worth. Fiat money developed because gold was
a scarce resource, and rapidly growing economies growing couldn't always mine
enough to back their currency supply requirements. For a booming economy, the
need for gold to give money value is extremely inefficient, especially when its
value is really created by people's perceptions.

Fiat money becomes the token of people's perception of worth, the basis for why
money is created. An economy that is growing is apparently succeeding in
producing other things that are valuable to itself and other economies. The
stronger the economy, the stronger its money will be perceived (and sought after)
and vice versa. However, people's perceptions must be supported by an
economy that can produce the products and services that people want.

For example, in 1971, the U.S. dollar was taken off the gold standard—the dollar
was no longer redeemable in gold, and the price of gold was no longer fixed to
any dollar amount. This meant that it was now possible to create more paper
money than there was gold to back it; the health of the U.S. economy backed the
dollar's value. If the economy stalls, the value of the U.S. dollar will drop both
domestically through inflation and internationally through currency exchange
rates. 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.

Today, the value of money (not just the dollar, but most currencies) is decided
purely by its purchasing power, as dictated by inflation. 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 real, tangible things, our 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 Money Measured?

But exactly how much money is out there, and what forms does it take?
Economists and investors ask this question to determine whether there is
inflation or deflation. Money is separated into three categories so that it is more
discernible for measurement purposes:

 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 is essentially the money used to buy things and make
payments (see the "active money" section below).
 M2 – With broader criteria, this category adds all the money found in M1 to
all time-related deposits, savings accounts 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 the total amount of money within an economy.

Active Money
The M1 category includes what's known as active money—the total value of
coins and paper currency in circulation. The amount of active money fluctuates
seasonally, monthly, weekly, and daily. In the United States, Federal Reserve
Banks distribute new currency for the U.S. Treasury Department. Banks lend
money out to customers, which becomes active money once it is actively
circulated.

The variable demand for cash equates to a constantly fluctuating active money
total. For example, people typically cash paychecks or withdraw from ATMs over
the weekend, so there is more active cash on a Monday than on a Friday. The
public demand for cash declines at certain times—following the December
holiday season, for example.

How Money Is Created

We have discussed why and how money, a representation of perceived value, is
created in the economy, but another important factor concerning money and the
economy is how a country's central bank (the central bank in the United States is
the Federal Reserve or the Fed) can influence and manipulate the money supply.

If the Fed wants to increase the amount of money in circulation, perhaps to boost
economic activity, the central bank can, of course, print it. However, 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 into the marketplace, and effectively
into the hands of the public. How does a central bank such as the Fed pay for
this? As strange as it sounds, the central bank simply creates the money and
transfers it to those selling the securities. Alternatively, the Fed can lower interest
rates allowing banks to extend low-cost loans or credit—a phenomenon known
as cheap money—and encouraging businesses and individuals to borrow and
spend.

To shrink the money supply, perhaps to reduce inflation, 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.