Theories of Money

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Introduction

Uses of money

• medium of exchange. Money is fungible, i.e., one unit can be substituted for another unit (as in making change), and it is also exchangeable for other items in buying and selling. Money is used for final settlement of accounts when transactions do not take place through direct exchange of goods.

• unit of account. Money is the unit of account used to price other items in relation to each other.

• store of value. Money is used to store wealth financially for future use. What distinguishes money from other stores of value such as real property is superior liquidity.

• standard for deferred payment. Money is used in extending credit. Here money is used for final settlement of debt, which extinguishes the loan obligation.

Types of money

State money is a liability of the state that is accepted by the state in discharge of liabilities to the state (primarily taxes). In this sense, state money is a tax credit as an asset of nongovernment. Since no concomittant liability for this asset is created in nongovernment, state money is a net financial asset of nongovernment.

Commodity money is the use of a commodity as a medium of exchange, usually a commodity high in demand. Metallism designates commodity-based money that has a given quantity of a precious metal which when stamped circulates as a means of payment and medium of exchange. Often its supply is monopolized in some manner by government. Commodity money consists of coins whose value is determined by the quantity of precious metal they contain.

Fiat money is a liability of the state with no promise to convert it into anything other than itself (as in making change).

Bank money is liabilities of a private bank that are accepted as means of payment or media of exchange; this is primarily deposits on which cheques can be drawn, although in the past it consisted primarily of bank notes. Some bank money is convertible without much delay and with little loss of value to fiat money and/or commodity money. Today, conversion is always done at par with fiat money. In the past bank money often circulated without convertibility. Just as the state agrees to accept fiat money at its pay offices, banks accept bank money in payment to retire liabilities to the banking system. Since loans creates deposits, bank money nets to zero.

Credit money is money that is created by extending a creditary relationship between creditor and debtor, usually involving the debtor paying interest to the creditor who assumes risk of default. Bank money is one form of credit money, but all credit extension creates "money" in a broad sense. Since all credit money is created with corresponding assets and liabilities in nongovernment, credit money created in nongovernment nets to zero.

Monetary Systems

Convertible fixed rate system

Money is convertible into something other than itself, e.g., a quantity of precious metal like gold or silver, at a fixed rated, usually a fixed weight of metal for an elementary unit of account, e.g., one ounce of gold for one US dollar. The relationship among currencies is anchored by the convertibility rate as an external standard.

Nonconvertible flexible (floating) rate system

Money is only convertible into itself (as in making change), and different currencies float in the foreign exchange market. Since there is no external standard, currencies fluctuate relative to each other in the foreign exchange market.

Monetary Theory