What Money Is and How It Is Created

How was money created and turned into a form of trade? Someone had to come up with it, but who?

This is because it is assumed that everyone knows what it is. Money is one of the most familiar things in the world. Despite this, many people fail to accurately explain what money is or how it works. Ideals such as the creation, measurement, and growth of money are abstract concepts to many.

The understanding of money is quite different to many people due to its multifaceted nature. The general understanding though is that it is the means by which we would get our needs and wants.

Money is:

  • A unit of account. It provides the base for prices.
  • A store of value. It can be saved for later use.
  • Medium of exchange. People can use it to buy and sell from each other.

Before money came into existence as a medium of exchange, people used to barter trade. People would trade their own commodities for other commodities that they lacked.

However, it proved to be a difficult affair due to the lack of divisibility and transferability. Some goods were not easily divisible. For example, animals. For example, when you have a goat, and you need mangoes, the first task is to get someone who would be willing to trade mangoes for a goat.

Getting such a person was a difficult task in itself. Let’s say you get the person. Another problem arises in determining how many mangoes would be equal to a whole goat. And again when the situation required you to divide the goat, it would be a messy affair. Thus, barter trade was inefficient in nature.

This brought the need to devise a new form of exchange. Hence, money or currency came into place. In the early years, commodities such as dried corn, precious metals, cowrie shells, peppercorns, barley or beaver pelts served as currency.

The Value of Money

The value of the money was determined by the alternative uses it would have. Precious metals though proved to be convenient in both the three aspects of being a reliable medium that can be used for exchange, a relatively stable unit of account and lastly a durable store of value.

This is because they were durable, were easily divisible and had limited supply. This made them attractive as money than all other goods. People used to carry the actual metal around for purposes of exchange.

But as time went by people saw it convenient to deposit the gold bars in banks and then transact using notes that claimed ownership of the silver or gold deposits. Thus anyone could go to the bank and get the gold or silver that was backed by the note.

As time went by, the link between the note and the metal was broken paving way for fiat money.

Fiat money is basically valueless. It adds value only when a nation or country assigns value to it. Thus, the value assigned to it is based on people’s perception and their faith.

Money is measured in three ways:

  • M1

This includes all physical denominations of currency and coins. This measurement is the narrowest.

  • M2

This category is much broader. It adds all monies in the M1 category to time bound deposits, money market funds (non-institutional) and savings deposits. Money in this category is easily transferred into cash.

  • M3

This is the broadest category. It adds all money in the M2 category and adds it to institutional money market funds. It also adds larger time deposits and generally all large liquid assets.

Money is created in the economy through the actions of the central bank. If the economy needs more money, the central bank can decide to print it. However, this contributes minimally to the overall money supply.

Another instance is through buying government fixed income securities. This will put money into the public space. In order to reduce the supply, the central bank sells the securities.