Lesson preview · Money Basics
What Is Money?
~10 min · Free to read
Imagine you raise chickens and want a haircut. The barber wants shoes, not eggs. So you find a shoemaker who happens to want eggs, swap eggs for shoes, then hand the shoes to the barber. That double hunt — both sides wanting exactly what the other has — is what trade looks like without money. It is slow, and most days it simply fails.
Money fixes that. You sell the eggs for cash and hand the barber the cash. The barber will take it because everyone takes it. So money is not really a thing — it is a job, or rather three jobs that one object happens to do well. Name those jobs and you understand what money is.
Key Term
The three functions of money
Anything counts as money if it does these three jobs:
- Medium of exchange — the thing you swap for goods instead of bartering. You hand over cash and walk away with bread; nobody has to want eggs.
- Unit of account — a common yardstick for prices. Bread costs 2, a haircut costs 15, a bike costs 300. One scale lets you compare anything to anything.
- Store of value — it holds its buying power over time. Earn money today, spend it next month, and it still buys roughly the same amount. Eggs would have rotted.
Most things fail at least one test. A house stores value but you cannot spend a doorknob at the shop. Cash passes all three, which is why it is money.
Key Term
Commodity money vs fiat money
Money comes in two kinds, split by where its value comes from:
- Commodity money has intrinsic value — it is worth something on its own, apart from being money. Gold and silver coins are the classic case: melt the coin and the metal still has uses and buyers.
- Fiat money has no intrinsic value. A paper note is worth a few cents of paper. It works only because the government decrees it as legal money (“fiat” means “let it be done”) and because people trust that others will keep accepting it. Every major currency today is fiat.
The leap is psychological. A dollar bill is just paper, yet it works as long as the chain of trust holds — you take it because you are confident the next person will too.
Key Term
The money measures — M0, M1, M2 as nested baskets
How much money exists? It depends on how widely you cast the net, so economists use nested measures — each one contains the one before it, plus more.
- M0 — physical currency: the cash (notes and coins) in people’s wallets and tills.
- M1 — M0 plus checking deposits (also called demand deposits): money in accounts you can spend instantly with a card or cheque.
- M2 — M1 plus savings deposits and retail money-market funds: money that is yours but slightly less ready to spend.
Picture three bowls inside each other. M0 sits inside M1, which sits inside M2. As you widen the measure you add money that is a little harder to spend on the spot. The smallest bowl, physical cash, turns out to be only a sliver of the largest.
Tip
So what?
Most of the money supply is not cash in wallets — it is deposits sitting in bank accounts. Physical cash is the smallest basket by far.
Worked Example
An economy has 100 units of physical cash, 400 units in checking (demand) deposits, and 500 units in savings deposits plus retail money-market funds. (1) Find M0. (2) Find M1. (3) Find M2. (4) What share of M2 is physical cash?
Trap · Common Misconception
"The money supply is mostly cash"
It feels obvious that money means the notes in your wallet. But cash is the smallest basket. In our example, physical cash (M0) is 100 units while broad money (M2) is 1000 — cash is just 10%. The other 90% lives as checking and savings deposits: numbers in bank accounts, never printed. When you pay by card, no cash moves at all; a bank simply lowers one balance and raises another. That is why “how much money exists” is mostly a question about bank deposits, not the printing press — and why the next lesson asks how banks create that deposit money.
Check yourself · no marks
A paper banknote costs almost nothing to print and has no use once it stops being legal money. So why does a 20-unit note buy 20 units of goods? What kind of money is it?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
Which list correctly names the three functions of money?
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