Imagine trying to buy lunch by offering the chef an hour of accounting. You would need to find a chef who happens to want accounting right now. That awkward search is what life without money looks like. Money solves it, and it does three distinct jobs at once.
These are the functions of money. It is a medium of exchange, so you can pay for anything without bartering. It is a store of value, so you can hold wealth today and spend it next month. And it is a unit of account, a common yardstick that lets you compare the price of a car with the price of a coffee. Anything that does all three reliably can serve as money.
Money has taken different forms. Commodity money has value in itself, like gold or salt, which people would want even if it were not money. Fiat money is the kind in your wallet today. It has no intrinsic value, just paper and a promise. It works only because the government declares it legal tender and everyone agrees to accept it.
Because money comes in degrees of usefulness, economists measure it in layers. M0 is physical cash and bank reserves. M1 adds checking deposits you can spend instantly. M2 adds savings accounts and other money that takes a little effort to access. Moving outward, each measure is broader but slightly less liquid.
Here is the part that surprises everyone. Banks do not just store money, they create it. Under fractional-reserve banking, a bank keeps only a small slice of its deposits on hand and lends out the rest. The fraction it must hold is the reserve ratio. Deposit 1,000 dollars and the bank might keep 100 and lend 900. That 900 gets spent, deposited at another bank, and lent out again, minus its own reserve.
This chain multiplies the original deposit into far more money across the banking system. The money multiplier captures the total expansion, and it equals $1/ ext{reserve ratio}$. With a 10 percent reserve ratio, the multiplier is 10, so an initial 1,000 dollars can support up to 10,000 dollars of deposits across the economy.
Money is also bought and sold like anything else. Money demand depends on how much cash people want to hold for spending and safety. Put demand together with the supply set by the central bank, and you get the money market, which is where the short-run interest rate is determined.