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What money really is

A lot of people get confused between the concepts of money and wealth. Think of wealth as the total sum of assets you have, cash in your pockets, the balance in your current account, any savings account, any bonds or shares you own, the value of your house if you own one etc. Money is basically the portion of your wealth that you can use instantly for transactions, ie paying for stuff. If you go to a coffee shop you pay for the coffee with cash from your pockets – that is money. If you go to a clothes shop and buy some jeans on your debit card then it is drawing on the balance in your current account – that is money. You can’t offer somebody a tiny fraction worth share of the value in your house in exchange for the coffee or jeans, they won’t accept it. This is the concept of liquidity. Money is liquid – you can use it for transactions, your house or money tied up in a long term savings account etc is illiquid, you can’t use it for transactions, you would need to sell it somehow to convert the value into money. Hence when you hear about a business or bank having liquidity problems, it doesn’t mean it has gone bust, it means it has an impending bill like salary payments or a tax bill or an invoice from a supplier etc, and doesn’t have enough liquid assets to pay the bill, even if it has enough value in its illiquid assets to cover the cost.

Basically money serves three functions
1 – A store of value (but not a very good one). If you want to hold back on spending today and spend in the future instead you can just hold on to some of your wealth as money and then use it when you are ready. The reason it is not a very good store of value is because inflation erodes the value of it. If you just withdraw all your wealth as cash and keep it under your bed, even if it doesn’t get stolen, over time inflation will make it worth less than it was when you withdrew it. A similar case would be leaving all your wealth in your current account. It’s convenient because you can use it when you want to but you won’t get paid much interest on your current account, you’ll be lucky to break even with inflation. If you want to earn interest on your wealth by deferring spending today in favour of spending in the future, you usually have to tie it up in some form of illiquid asset like a savings account.

2 – A unit of account. Money is basically convenient for society to use as it allows us a unit for quoting prices. If you hear that a concert ticket is worth twenty packets of biscuits it is hard to get a feel for how much it really is, but if you hear that a concert ticket costs £16 and a packet of biscuits costs 80p then you can understand it much better because you are used to dealing in prices denoted in the currency you are familiar with. This is really how money has developed to facilitate exchange between goods, it is just a matter of convenience. That’s why you don’t need the money itself to be worth anything. We used fiat money which means the money itself has no intrinsic value, it is just a unit of account. Sometimes you will hear people (non-economists) grumbling that “our money isn’t backed by anything” and saying we should go back to the gold standard etc, but the problem with using commodity money where the money itself is worth something, is that you need to be able to produce enough of that to be able to keep pace with the growth of other goods and services in the economy, otherwise you will just get deflation. With fiat money, as the economy grows, you can print more money in proportion to facilitate the transaction of those goods. If you were reliant on mining gold as your currency, and the amount of goods being produced in the economy was faster than the amount of gold you could mine, then you would end up not having enough money in circulation to facilitate the extra transactions that would otherwise have taken place due to the extra goods being produced. So the economy would go into recession, and it would be a rather pointless recession because it was caused only by a shortage of the means to carry out the necessary transactions (ie money).

3 – A medium of exchange. It allows us to make ‘indirect’ transactions between goods, ie if you sell your labour in your job to your employer, your employer pays you a salary, and you can then use that salary to buy a car. You don’t have to sell your labour to the car dealer. The money allows people to exchange their labour or goods that they sell, for things they want to buy.

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Categories: Macro, Money
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