This article asks the all-important question: “What is money?”
As my website is called Money Meets Life, this concept of money must be examined a little.
When I was a child, I was fairly certain that money was the same thing as the cash that I held in my hands. We really take the existence of this strange stuff for granted.
However, as I studied economics and finance more, I started to realise that the concept of money is challenging to pin down. Perhaps it is a concept that needs to evolve through the years, or there is one definition which can express its meaning at every point in time.
The Philosophy of Money
I started my research on this topic, not by consulting a financial or economics dictionary, but by taking a look at the Stanford Encyclopedia of Philosophy’s entry on the topic.
Commodity Theory of Money
Aristotle believed that money primarily served three functions:
- As a medium of exchange
- As a unit of account
- As a store of value
Money is a medium of exchange because it allows people to purchase goods and services. In a barter economy, where goods and services would be exchanged for other goods and services, it would be cumbersome as we would have to lug around goods to make purchases. Money in the form of notes and coins is easy to carry around.
As a unit of account, monetary units make it easy to understand and keep records. A barter economy could have records, but they would be confusing records as the units of exchange would be variable.
Money acts as a store of value because it is physically tough to destroy (or used to be). Coins also used to be made of precious metals which meant that they held some sale value.
Flaws in the Theory
It is clear that especially on the third point, the commodity theory of money is a flawed theory for modern times. Our money is quite different because it clearly does not act as a store of value: it both loses value over time and does not hold any intrinsic value as the notes and coins aren’t worth anything intrinsically.
Returning to this system of having gold and silver coins would also be flawed, as the value of all the goods and services would amount to more than the gold and silver that existed, and would also lead to their being arbitrage opportunities that would emerge from the market price of gold and silver deviating from the money price.
Credit Theory of Money
The credit theory of money posits that notes and coins act as tokens. Their value is socially constructed.
If you look at any banknote, you’ll see that these notes bear the words: ‘I promise to pay the bearer on demand the sum of five/ten/twenty/fifty pounds’.
This was originally because you could exchange bank notes for the equivalent in gold and silver at the bank. Now, however, the words remain on the notes, yet their meaning seems obscure and confusing.
Money can be conceptualised as a system of promises. When someone promises to pay, it involves both a borrower and a lender. Essentially, when we withdraw money from a bank, the bank is committing to provide us with that amount. Similarly, when we purchase goods, we’re pledging to pay the seller.
Banks Lending Money
The majority of the money circulating in our economy is generated through the lending activities of banks. When a bank extends a loan to an individual or business, they record the loan amount as an asset on their balance sheet. This essentially means that the bank has an asset in the form of the loan they’ve provided.
Simultaneously, the borrower gains access to the funds they’ve borrowed, which increases the money supply in circulation.
So, when you receive a loan from a bank, not only does the bank list the loan as an asset, but you also obtain the borrowed funds, thereby contributing to the overall money supply.
Confidence in Currency
What imbues value to this currency?
Essentially, the value of money is sustained by the confidence of the general populace. This is why we frequently refer to money as “currency.”
Currency, by definition, implies not only presentness but also trustworthiness and relevance. Moreover, currency dynamically circulates within the economy, facilitating transactions and economic activity.
Conclusion
In our journey to understand “What is money?” on Money Meets Life, we’ve explored its different aspects. From our childhood view of money as physical cash to its complex role in today’s world, we’ve come a long way.
We learned about Aristotle’s ideas on money, where it serves as a way to exchange, keep track of, and store value. But now, our money doesn’t quite fit that model anymore.
Instead, we’ve discovered the credit theory, where money’s value is based on trust and promises. Banks play a big part in creating money through loans, which keeps our economy going.
Ultimately, money’s value relies on us believing in it—hence why we call it currency. It’s what keeps transactions flowing and our economy moving.
So, while “What is money?” might seem like a simple question, it’s actually quite deep. And as we keep exploring, we’ll keep uncovering more about how money shapes our lives.
