Money, any medium of exchange that is widely accepted in payment for
goods and services and in settlement of debts. Money also serves as a
standard of value for measuring the relative worth of different goods
and services. The number of units of money required to buy a commodity
is the price of the commodity. The monetary unit chosen as a measure
of value need not, however, be used widely, or even at all, as a
medium of exchange. During the colonial period in America, for
example, Spanish currency was an important medium of exchange, while
the British pound served as the standard of value.
Money of the World Most nations have their own system of money and
print their own currency. Made of paper, these pieces of currency have
very little intrinsic value. As fiat money, however, the paper bills
represent a specific monetary value decreed by the government and
accepted by the people. The bills pictured here are examples of fiat
money from all over the world. George Chan/Photo Researchers, Inc.
II MONEY AND THE ECONOMY
Circular Flow of the Economy This illustration presents a simplified
version of how money circulates in the U.S. economy. Although it does
not take into account several major factors, such as the role of
government in the economy, the diagram shows the basic money
transactions that make the economy work.© Microsoft Corporation. All
Rights Reserved.
The functions of money as a medium of exchange and a measure of value
greatly facilitate the exchange of goods and services and the
specialization of production. Without the use of money, trade would be
reduced to barter, or the direct exchange of one commodity for
another; this was the means used by primitive peoples, and barter is
still practiced in some parts of the world. In a barter economy, a
person having something to trade must find another who wants it and
has something acceptable to offer in exchange. In a money economy, the
owner of a commodity may sell it for money, which is acceptable in
payment for goods, thus avoiding the time and effort that would be
required to find someone who could make an acceptable trade. Money may
thus be regarded as a keystone of modern economic life.
Sidebar
SIDEBAR
The Origin of Money
The earliest known use of money occurred in Mesopotamia around 2500
bc. Replacing the barter system, in which one good was exchanged for
another, the use of money brought about an explosion in the variety of
goods available. In a barter economy a barley farmer, for example,
could only acquire those goods that people were willing to trade for
barley. With money, people could easily purchase exactly what they
wanted or needed. This Discover Magazine article by author Heather
Pringle explores the early history of money.
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A Types of Money
Early Forms of Money Before paper and coins were introduced as
permanent forms of money, people used a variety of other objects to
serve as money for trading goods. Examples of early forms of money, as
shown here, include rice (China), dogs' teeth (Papua New Guinea),
small tools (China), quartz pebbles (Ghana), gambling counters (Hong
Kong), cowrie shells (India), metal disks (Tibet), and limestone disks
(Yap Island).Dorling Kindersley
The most important types of money are commodity money, credit money,
and fiat money. The value of commodity money is about equal to the
value of the material contained in it. The principal materials used
for this type of money have been gold, silver, and copper. In ancient
time, various articles made of these metals, as well as of iron and
bronze, were used as money, while among primitive peoples such
commodities as shells, beads, elephant tusks, furs, skins, and
livestock served as mediums of exchange. The gold coins that
circulated in the United States before 1933 were examples of commodity
money. Credit money is paper backed by promises by the issuer, whether
a government or a bank, to pay an equivalent value in the standard
monetary metal. Paper money that is not redeemable in any other type
of money and the value of which is fixed merely by government edict is
known as fiat money. In the past, fiat money generally consisted of
repudiated credit money, such as the U.S. note known as the greenback,
which was issued during the American Civil War. Most minor coins in
circulation are also a form of fiat money, because the value of the
material of which they are made is usually less than their value as
money.
interactivity
Compound Interest
Both the fiat and credit forms of money are generally made acceptable
through a government decree that all creditors must take the money in
settlement of debts; the money is then referred to as legal tender. If
the supply of paper money is not excessive in relation to the needs of
trade and industry and the people feel confident that this situation
will continue, the currency is likely to be generally acceptable and
to be relatively stable in value. If, however, such currency is issued
in excessively large volume in order to finance government needs,
confidence is destroyed and it rapidly loses value. Such depreciation
of the currency is often followed by formal devaluation, or ...
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settlement of debts; the money is then referred to as legal tender. If
the supply of paper money is not excessive in relation to the needs of
trade and industry and the people feel confident that this situation
will continue, the currency is likely to be generally acceptable and
to be relatively stable in value. If, however, such currency is issued
in excessively large volume in order to finance government needs,
confidence is destroyed and it rapidly loses value. Such depreciation
of the currency is often followed by formal devaluation, or reduction
of the official value of the currency, by governmental decree.
B Monetary Standards
Foreign Exchange Rates in U.S. Dollars The foreign exchange rate
indicates the value of any given currency relative to another. The
exchange rates can change drastically from day to day depending upon
the state of a country's economy and various other factors. Many
newspapers provide current information about exchange rates.©
Microsoft Corporation. All Rights Reserved.
The basic money of a country, into which other forms of money may be
converted and which determines the value of other kinds of money, is
called the money of redemption or standard money. The monetary
standard of a nation refers to the type of standard money used in the
monetary system. Modern standards have been either commodity
standards, in which either gold or silver has been chiefly used as
standard money, or fiat standards, consisting of inconvertible
currency paper units. The principal types of gold standard are the
gold-coin standard, the standard in the United States until 1933; the
gold-bullion standard consisting of a specified quantity of gold; and
the gold-exchange standard, under which the currency is convertible
into the currency of some other country on the gold standard. The
gold-bullion standard was used in Great Britain from 1925 to 1931,
while a number of Latin American countries have used the
dollar-exchange standard. Silver standards have been used in modern
times chiefly in the Orient. Also, a bimetallic standard (see
Bimetallism) has been used in some countries, under which either gold
or silver coins were the standard currency. Such systems were rarely
successful, largely because of Gresham's law, which describes the
tendency for cheaper money to drive more valuable money out of
circulation.
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Most monetary systems of the world at the present time are fiat
systems; they do not allow free convertibility of the currency into a
metallic standard, and money is given value by government fiat or
edict rather than by its nominal gold or silver content. Modern
systems are also described as managed currencies, because the value of
the currency units depends to a considerable extent on government
management and policies. Internally, the monetary system of the United
States contains many elements of managed currency; although gold
coinage is no longer permitted, gold may be owned, traded, or used for
industrial purposes. It is a recurrent problem whether the value of
inconvertible-credit currency can be maintained at a fairly stable
level for extended periods of time.
C Economic Importance
Credit, or the use of a promise to pay in the future, is an invaluable
supplement to money today. Most of the business transactions in the
United States use credit instruments rather than currency. Bank
deposits are commonly included in the monetary structure of a country;
the term money supply denotes currency in circulation plus bank
deposits.
The real value of money is determined by its purchasing power, which
in turn depends on the level of commodity prices. According to the
quantity theory of money, prices are determined largely or entirely by
the volume of money outstanding. Experience has shown, however, that
equally important in determining the price level are the speed of
turnover of money and the volume of production of goods and services.
The volume and speed of turnover of bank deposits are also
significant. See National Income.
III THE MONETARY SYSTEM OF THE UNITED STATES
In the American colonies, coins of almost every European country
circulated, with the Spanish dollar predominating. Because of the
scarcity of coins, the colonists also used various primitive mediums
of exchange, such as bullets, tobacco, and animal skins; many of the
colonies issued paper money that circulated at varying rates of
discount. The first unified currency consisted of the notes issued by
the Continental Congress to finance the American Revolution. These
notes were originally declared redeemable in gold or silver coins, but
redemption was found impossible after the Revolution because of the
excess of printed notes over metal reserves. Thus, the notes
depreciated and became nearly worthless.
A Early Monetary Regulations
In 1792 Congress passed the first coinage act, adopting a bimetallic
standard under which both gold and silver coins were to be minted. The
gold dollar contained 24.75 grains of pure gold and the silver dollar
15 times as much silver, making the legal mint ratio 15 to 1 (see
Dollar). At this ratio gold was undervalued at the mint, as compared
with its value as bullion, and very little gold was presented for
coinage. Silver dollars also were largely withdrawn from circulation,
because they could be exported to the West Indies and exchanged at
face value for slightly heavier Spanish dollars, which were then
melted down and taken to the mint for coinage into American dollars at
a profit. Until 1834, when Congress adopted a mint ratio of 16 to 1 by
reducing the weight of the gold dollar, the metallic currency was
limited mainly to a meager supply of small silver and copper coins.
The first Bank of the United States, which was chartered by Congress
in 1791 for 20 years, and the second Bank of the United States, which
existed from 1816 to 1836, issued bank notes that maintained a fairly
stable value. Many state-chartered banks also issued notes that,
because of the lax state banking laws, often greatly depreciated in
value. After the closing of the second Bank of the United States, most
of the paper currency consisted of notes of state-chartered banks and
circulated only in a limited area.
After 1834, silver was undervalued at the mint; its market value was
constantly higher than its coin value. As a result, gold gradually
replaced silver in the monetary stock, especially after the discovery
of gold in California in 1849. To relieve the famine in small coins,
Congress, in 1853, reduced the weight of the half-dollars, quarters,
and dimes by 7 percent. Because the new subsidiary coins were worth
more as money than as bullion, it was possible to keep them in
circulation. As a result of a revision of the coinage laws in 1873 the
silver dollar was omitted from the list of coins authorized to be
minted. Although the coinage of silver dollars was resumed in 1878,
the metallic gold dollar remained the monetary standard of value in
the U.S.; thus, bimetallism was legally discontinued and the gold
standard adopted. Actually, silver dollars had been an insignificant
part of the currency since early in the century.
During the Civil War the governments in both the North and the South
financed their needs through the issue of fiat money. The notes issued
by the Confederate treasury and the southern states became entirely
worthless after the war. The U.S. notes (greenbacks) and other paper
money issued by the federal government also depreciated rapidly,
especially after the suspension of payment in specie (redemption of
paper money with coins, usually of gold or silver) in 1861, and gold
and silver coins were driven out of circulation. In 1863, the National
Banking Act authorized the establishment of national banks that could
issue bank notes backed by government bonds. A 10 percent tax levied
on state bank notes in 1865 forced state banks to discontinue issuing
them, thus giving the national banks a monopoly of bank-note issue.
The state banks, however, remained an important element in the banking
system.
After the elimination of the silver dollar in 1873, the greatly
expanded production of silver in the West caused the value of silver
to fall sharply and led to agitation by the silver interests for
restoration of the free coinage of the silver dollar. In this effort
they were joined by political groups who favored the free coinage of
silver as a means of improving general economic conditions. This
agitation led to the passage of the Bland-Allison Act in 1878 and the
Sherman Act in 1890, under which the Treasury was directed to purchase
larger amounts of silver for coinage. The former law also created the
silver certificate, which remained an important part of U.S. currency
until it was retired in 1968. The Sherman Act, which introduced into
the stream of currency an enormous quantity of overvalued silver and
caused a drastic decline in the gold reserve of the Treasury, helped
to bring on the panic of 1893 and was repealed by Congress in that
year. Even so, silver was the main issue in the 1896 presidential
campaign, when William Jennings Bryan called for free coinage of
silver at a ratio of 16 to 1. The silver forces were defeated, and in
1900 the Gold Standard Act affirmed the gold dollar as the standard
unit of value.
B Federal Reserve System
The next important change in the currency system was introduced by the
Federal Reserve Act of 1913, which authorized the establishment of 12
regional Federal Reserve banks, with power to issue two types of
currency (see Federal Reserve System). The first, and most important,
was the Federal Reserve note, which is issued under conditions
consistent with economic stability and the needs of trade and
industry. As member banks require more currency, they can obtain it
from the Federal Reserve banks by drawing on their deposits or
borrowing or rediscounting commercial paper if their deposit balances
with the Federal Reserve banks are insufficient. The second type of
Federal Reserve currency, the Federal Reserve Bank note, was
originally intended to replace the national bank notes, but never
became a permanent part of the currency because the Federal Reserve
notes proved adequate. The national bank notes were retired in 1935,
but greenbacks are still part of U.S. paper currency.
C The Great Depression
The economic depression and the epidemic of bank failures in the early
1930s led to sweeping reforms in the nation's monetary structure.
Executive proclamations issued by President Franklin D. Roosevelt in
March and April 1933, prohibited gold exports except under government
license, and called in all gold and gold certificates from general
circulation, thus ending the gold standard. Under the Gold Reserve Act
of January 30, 1934, the country returned to a modified gold standard
with a devalued dollar. The act gave the president authority to lower
the weight of the gold dollar to between 50 and 60 percent of its
former gold content. The following day the president issued a
proclamation reducing the gold content of the dollar to 59 percent of
that established by the Gold Standard Act of 1900, or from 23.22 to
13.71 grains of fine gold.
The years 1933 and 1934 were also marked by important legislation
regarding silver. Under the Thomas Amendment to the Emergency Farm
Relief Act of May 12, 1933 (commonly known as the Inflation Act), the
president was given the power to restore unlimited coinage of silver
under a bimetallic system. The Silver Purchase Act, which was signed
by the president on June 19, 1934, authorized the nationalization of
silver and declared it to be the policy of the U.S. to have the silver
holdings of the Treasury ultimately make up a maximum of one quarter
of the value of the nation's combined monetary gold and silver stocks.
On August 9, 1934, the president issued an executive order requiring
that all silver in the U.S., with the exception of certain categories
such as silver coins, fabricated silver, and silver owned by foreign
governments, be delivered to the mints to be coined or held as bullion
for later coinage. Under the Silver Purchase Act and subsequent
legislation the Treasury purchased large quantities of silver abroad
and from domestic producers, which tended to raise the price of the
metal and curtail the monetary use of silver abroad, especially in
China and India.
D Recent Developments
sidebar
SIDEBAR
Crisis in Gold
During much of the 20th century, countries around the world used the
gold standard, which tied the value of currencies to the value of
gold. The 1944 Bretton Woods Conference established a modified gold
standard under which the exchange rates of most currencies were fixed
against the gold-based United States dollar. Although the system
inspired economic confidence, by the late 1960s the United States
became unable to maintain the system and gradually abandoned the
Bretton Woods agreement during the 1970s. This 1968 Collier's Year
Book article by economist Eliot Janeway explores the history of the
gold standard and the Bretton Woods agreement.
open sidebar
Near the end of World War II most of the Allied nations joined
together in a conference held at Bretton Woods, New Hampshire, to set
up a new international monetary system, replacing the international
gold standard that had collapsed during the Great Depression. The
conference also provided for the establishment of the International
Monetary Fund (IMF). The U.S. dollar played a key role in the new
system, becoming, in effect, the world's currency. This was true,
first, because all IMF members defined the value of their own
currencies in terms of the dollar and, second, because the U.S. agreed
to convert all dollars held by foreign governments into gold on demand
and at the exchange rate agreed on when the IMF was established.
Officially, this meant that the world was on a "gold exchange
standard" since governments could change their currencies into gold
via the U.S. dollar.
So long as the United States had most of the world's gold supply, as
was true after World War II, this system worked fairly well. When the
quantity of dollars held by foreign governments began to exceed U.S.
gold holdings by large amounts, however, the system started to falter.
By the early 1970s foreign government holdings of U.S. dollars were
over five times greater than the U.S. gold stock. In August 1971
President Richard M. Nixon suspended gold payments of U.S. dollars.
This closing of the "gold window" effectively ended all ties between
the U.S. dollar and either gold or silver. Since then the United
States has had a fully managed currency system, one with no metallic
base whatsoever. U.S. citizens are free to own, buy, and sell gold,
but its price is determined in the same way as any other freely traded
commodity--on the basis of supply and demand. Gold no longer serves as
a medium of exchange. Federal Reserve notes are overwhelmingly the
dominant form of currency in circulation today.
Two important developments took place in the U.S. monetary system in
1980. The Federal Reserve redefined its measures of the money supply,
setting up four categories of money, known as M1, M2, M3, and L. The
differences between these categories are technical, but essentially
they reflect the extent to which various kinds of financial and
monetary instruments serve as money under diverse circumstances and
for different purposes. M1 is the best-known measure of money,
consisting of currency and demand deposits. As of December 1990 it
totaled $523 billion.
In March 1980 the Depository Institutions Deregulation and Monetary
Control Act was passed. It expanded the range of monetary instruments
used by the financial community, gradually eliminated the ceiling on
interest rates that savings and loan institutions are allowed to pay
depositors, and made all banks subject to the reserve requirements of
the Federal Reserve System by 1989.
U.S. monetary policy is carried out through commercial banks and the
Federal Reserve System. Monetary policy involves action to influence
the economy's performance--its output and employment level as well as
the inflation rate--by controlling the money supply and the rate of
interest. The Federal Reserve specifically initiates and carries out
monetary policy. It is relatively easy for the Fed to increase the
reserves of commercial banks, thus making possible an expansion of the
money supply if businesses and individuals are willing to borrow.
Still, there is no assurance that borrowing will take place, even when
credit terms have eased and loans are readily available. However, the
experience of the 1970s and 1980s shows that when the Fed "tightens
up," making credit more costly and loans less plentiful, the economy
is affected rapidly, falling into recession with rising unemployment.
This happened in 1969, 1974, and 1980-1981. In the late 1970s the
Federal Reserve began to "target" the money supply; that is, the Fed
tried to establish a stable rate of growth for the money supply. This
tactic was abandoned in mid-1982, and the Federal Reserve went back to
the practice of targeting interest rates as the primary control
variable.
Recent experience with policy and legislation shows that the U.S.
monetary system is still evolving. Historically, the nation has gone
from a wholly metallic system, when coins were the primary money in
circulation, to a managed system, in which, aside from the currency in
people's pockets, most of the money consists of entries in the books
of banks. At the close of 1990 only about 30 percent of the primary
money supply consisted of currency; the remaining 70 percent of total
M1 consisted of demand and other deposits, much of which came into
existence through borrowing. In the continuing evolution, as more
money is exchanged and transferred electronically, the U.S. money
supply will increasingly be represented by entries in computer data
banks
Microsoft® Encarta® Encyclopedia 2002. © 1993-2001 Microsoft
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