Introduction to money
In our discussion thus far we have spoken about income, spending, production with a focus on these things in real terms. In other words relating to physical units of production rather than the monetary value, as with using real GDP instead of nominal GDP. In the real world money is a critical component of transactions. We need to build up some terminology and concepts in preparation for understanding how money and monetary policy impact the economy.
Before our main discussion it is good to highlight a subtle distinction in terminology, between money and currency. Money refers to the actual unit of measurement, say U.S. Dollars, while currency refers to paper notes and physical coins. The terms are often used interchangeably when discussing broader topics such foreign exchange. In such cases currency is used to mean money supply in a specific country or area, like U.S. Dollars for the United States or Euros for the Eurozone.
What makes something money?
Money has four functions it serves.
A medium of exchange enables not just trade between two people, but also further exchanges with others. A single trade may not be complicated, as our loose barter examples above suggest, but not every trade will result in a good that you can trade with someone else for something you want. Anything with wide acceptance for trading can serve as a medium of exchange.
The function of acting as a unit of account has a deep connection to one of our earliest concepts, the need to evaluate trade-offs. Market transactions will offer direct comparisons, perhaps sometimes requiring minor adjustments. Comparing prices of goods, for example, may require a conversion to price per weight or per unit, due to differences in package sizes. Comparisons across countries require adjustments using exchange rates, and fairly comparing across time requires use of a measure of inflation to get things in real terms.
Closely connected to this is the function of serving as a standard of deferred payment, expanding the role of money to include payments in the future as well as payments today. So items such as loans, bonds and other debt instruments are denominated in money. Physical paper money in the United States uses the term “legal tender” which means that it is legally recognized by the government for tax payments.
Finally, money must be a store of value. That does not require that it has the same value, just that it will safely still be worth a somewhat predictable amount. Lots of things may be a store of value, such as collectible items like any variety of tradable cards or historical coins, but these items cannot be commonly used for purchases, other goods are not valued in terms of them and except for rare cases future payments are not based on them.
All four functions are required for something to be considered money. There are things that may be used for transactions such as cryptocurrencies, but then usually fail to meet the store of value requirement. There is an argument that countries with currencies that are not managed well can also suffer from this problem, but when it comes to the official currency of a country we can set that issue aside as long as the other functions are met.
Money and trade
Money enables the exchange of goods and services. A hypothetical world without any money at all needs some other way to enable trading. One possibility is barter, the direct trade of one good for another. This would be highly inefficient because of “the double coincidence of wants.” To make a barter trade with your neighbor, they must have something that you wand and you need to have something that they want.
As an example, if a farmer with chickens wants a new fence, they need to not only find someone with lumber who can build a fence, but also one that wants the eggs that they have. Even assuming you can find the right items to trade, both parties still need to agree on an amount to trade. The trade ratio represents a real price, exactly like the Ricardian trade examples discussed earlier with individuals instead of countries.
This is a common story told by economists as a motivator for monetary development. There is not strong evidence of any early society completely organized around barter. What is more likely are systems of informal credit. This includes things such as transferable IOUs instead formal measures such as legal contracts or intermediaries such as banks.
The time and resources lost in making trades in informal systems are transaction costs. These are especially problematic when trading multiple goods or producing complex goods. Think of goods with many small pieces that are made by different companies, such as a car, a computer or a house.
Money cuts down on transaction costs and makes frequent trades and complex goods easier to accomplish. It also enables the building blocks of our financial system, the ability to save, borrow, invest and develop more complex financial contracts and structures.
Commodity and fiat money
Although we are used to paper money, which we will talk about shortly, historically money has taken many forms. Early examples are primarily commodity money, where the items traded have intrinsic value, value from some alternative use. Most commonly this was precious metals, such as gold and silver, but examples in other countries included copper and shells. At first glance shells may not seem to have intrinsic value, but in societies that used them they had significant social and cultural purposes beyond their use as currency.
By the late 19th century the gold was the primary basis for the international monetary system, with silver having a secondary role. Many countries minted gold and silver coins, providing standardization and reducing the need to weigh out precious metals for transactions. This sometimes included tokens, coins not made from precious metals but exchangeable for them. This would eventually expand to include banknotes, paper money that was initially backed by precious metals and could be exchanged for them at banks.
A major drawback of these developments is that the use of non-precious metals and paper money does encourage counterfeiting, the criminal production of non-official copies for financial gain.
After World War Two, the Bretton Woods system removed the need for the backing by precious metals with the sole exception of U.S. Dollars. In 1971 that was suspended as well, and we moved completely to the modern system where paper notes themselves are all that matters. This is called fiat money, money that has value because everyone else thinks it does and not because you can actually do anything with the notes themselves. A key factor behind the confidence in paper bank notes is that the government must accept these as payment for taxes and other debts owed. A related idea is that a key source of inflation can be a loss of confidence in the government’s willingness and ability to collect tax revenue.
** Modern definitions of money Liquidity has already been discussed as the ease at which a thing can be turned into the medium of exchange, both in terms of time and real transaction costs. This concept is at the heart of how we label different types of money.
As we move forward the most important items are all labelled with capital letters. $C=currency $, $R=reserves $, and . These abbreviations will be particularly useful when we discuss the money multiplier in the next subchapter.
Everything beyond currency in M1 is currently referred to as “transaction deposits” by the Federal Reserve. An important change related to this occurred in 2020, when Regulation D was amended to reduce the limits on savings account withdrawals. That shifted the categorization of savings accounts from M2 to M1. They now count as transaction deposits, since reduced liquidity is no longer a legal requirement. This is an important difference, so be cautious if using older AP resources for review.
In M2, “small” refers to deposits less than $100,000. This may not seem small, but it is for financial actors such as banks and the Fed. As we move forward, when we talk about the money supply you should think of it as M2, the broadest measure of readily available funds.
Importantly, notice what is not counted as money here. There has been no mention of credit cards, or debt of any kind. Also missing are modern creations such as cryptocurrencies. These could be considered speculative assets, at a minimum failing to meet the function of a store of value due to their wild price swings. There is the possibility for this to change over time, and some countries such as El Salvador have attempted to make Bitcoin legal tender. As of mid-2026, even in those countries acceptance and regular use is still not common.