Understanding Money: Forms and Evolution
Money: A Medium of Exchange
Money is anything that constitutes a commonly accepted medium of exchange or payment. The form that money has taken has changed over time. In the earliest exchanges, money wasn’t used; instead, exchange occurred through barter, or the trading of goods.
As exchanges became more complex, the need arose for a good that could be exchanged for any other and serve as a means of payment. This led to the emergence of commodity money. Commodity money must meet certain conditions:
- Durability
- Ease of transport
- Divisibility into smaller parts
- Uniformity (any unit of the good is equal to others)
- Limited supply (to maintain economic value)
Examples of commodity money include gold and silver. However, money continued to evolve, leading to the concept of fiat money. Fiat money is an asset with very low intrinsic value as a commodity, but it maintains its value as a medium of exchange because people have faith that the issuer will be liable for the pieces of paper or coins minted and will ensure that the amount issued is limited.
This new concept of money arose in the Middle Ages with the work of goldsmiths, who stored gold in their safes. They issued paper receipts to depositors, representing the amount of gold stored. Over time, gold holders began paying their debts with these receipts, as it was easier and faster. This was the origin of paper money. This paper money was convertible into gold (full-content paper money), and the value of the certificates was equal to the value of gold. An economy operating this way is said to be governed by the gold standard.
Goldsmiths began issuing paper money for loans exceeding the value of the gold they held, in exchange for interest. This was the beginning of banks. If all depositors had wanted to recover their gold simultaneously, it wouldn’t have been possible. Therefore, this money was nominally called convertible into gold.
Money Supply and Monetary Aggregates
The money supply, or amount of money, is defined as the sum of cash held by the public plus bank deposits. Monetary aggregates are variables that quantify the existing money in an economy, which central banks use for analysis and monetary policy decisions. The Eurosystem primarily considers three aggregates:
- M1: Consists of notes and coins in circulation (currency held by the public) and demand deposits.
- M2: Consists of M1 plus time deposits of up to two years and deposits redeemable at notice of up to three months.
- M3: Consists of M2 plus repurchase agreements, shares in money market funds, and debt securities up to two years issued by monetary financial institutions.
Repurchase agreements (repos) are a product offered by banks to attract funds from the public. A customer provides money to the entity, and the entity, in turn, sells the customer certain securities from its portfolio, agreeing to buy them back at a later date for a higher amount. The price difference represents the interest earned. Repos are a typical operation in the public debt market in Spain.
FIAMM (Investment Funds in Money Market Assets), also known as money market funds or money funds, are a category of mutual funds that, by law, must invest at least 90% of their portfolio in short-term debt (maturity not exceeding 18 months). Fixed income securities represent a share of a claim against the issuer and lead to the payment of certain interests, the value of which is determined at the time of issuance. It also includes those securities that represent loans whose interest may vary according to an indexation formula or other arrangements made at the instant of its market launch.
The value of M3 is the most stable and is therefore used to study the growth of money. Other important related variables include:
- Bank Reserves: The sum of the credit system’s cash and deposits at the Central Bank.
- Monetary Base: Bank reserves plus cash in public hands.