How Does Something Qualify as Money and Types of Money

What would the world look like without money? For one thing, if you were a carpenter who needed a boat ride to the Canary Islands, you would have to find a boat owner who needed a new coffee table in order to achieve your goal. This could be extremely inconvenient and take up lots of your time and energy if, indeed, such a boat owner even existed near your location.

It’s so much easier to know that almost all boat owners are interested in receiving payment in national currencies like US dollars, South African rands, or French francs. This way you’re saved the distress of the bargaining process, which could eat up even more of your time, (especially since it’s not clear at all how much carpentry would be equivalent to that particular boat ride). The whole of the American economy, by contrast, agrees that US dollars are valuable things, which smooths out the processes of buying or selling whatever you need to buy or sell, no matter where in the USA you happen to be.

But are all kinds of money like US dollars, South African rands and French francs, or are there other kinds of money out there? And, if there are other kinds of money, how do we know that they indeed qualify as money? This question is important because it determines whether or not new types of money – say, digital kinds – could emerge in the future and take the places of our dollars, rands, and francs. Let’s talk about the stuff that makes the world go round.

Types of Money

Commodity Money

The original economic transactions were done through bartering. This requires, as we have mentioned, that both parties involved come to an agreement that the values of the items being exchanged are equivalent. The next step came when people took items like gold or silver that societies have valued for hundreds of years and gauged the value of goods or services in terms of those commodities. When we standardized the sizes of our gold coins, we could, then, use them to buy and sell quite effectively. Take note that this kind of money doesn’t appeal to some overarching body like the US government in order to prove that it’s valuable. Rather, it’s viewed as self-evident that gold is valuable and will remain so into the foreseeable future, and this is what allowed purchases to be made without the need to barter.

Representative Money

Understandably, it proved inconvenient for people to carry large bags of gold coins around with them. They are heavy, bulky, and easily stolen. The next idea was to substitute the coins with tokens that could be redeemed for a certain amount of gold or silver. This way, our money still had the inherent value of gold to back up, ultimately, but we were saved the back problems that come with lugging around heavy loads throughout the day. And then, “Over time people grew to trust the paper certificates as much as the gold”, explains the St. Louis Fed, and this brings us to fiat money.

Fiat Money

Examples of this kind of money, also called fiduciary money, are our familiar dollars, rands, and francs. Your ten-dollar note cannot actually be redeemed for a nugget of gold held in a vault in the Federal Reserve, so don’t try to do that. By this point, our money gets its value without relying on any “essentially” valuable commodity like precious metal. The US government declares that dollars should be accepted as a medium of exchange at any retail point within the country. This encourages people to accept them when doing their own financial transactions, but it also makes it illegal for a grocery store to reject dollars at its cashpoints in favour of, say, bead strings or pigs. As Bloomberg’s Matt Levine puts it, “The US has a government and an army and an income tax and a debt stock and a trade balance, which help preserve the value of the dollar”. But is the government stamp of approval all that’s needed to promote pieces of green paper to the status of money? And if so, wouldn’t that imply that cheese wedges would function equally as well, if only the authorities gave them the thumbs up?

Qualities of Money

Money should be divisible, and cheese wedges can be neatly divided into sections, so they check out well on that score. Money should be portable, which can also, technically, be said of cheese wedges. However, beyond this point, we start to run into trouble. For your boat owner to accept cheese wedges in exchange for a ride, he would want to know that the power of a cheese wedge to purchase his own needs will remain fairly stable as the days and weeks roll by. In other words, he would want to be sure that these objects are good stores of value. Whereas the power of a ten-dollar bill to buy a carton of milk will remain reasonably stable from week to week, and even month to month, the same cannot be said about cheese wedges. Another problem with cheese wedges is that they tend to rot, sooner or later, which is undesirable for obvious reasons. Money needs to be durable.

And then there’s the quality of scarcity. The scarcity of US dollars is ensured by the fact that only the US Federal Reserve is allowed to issue them. This official body chooses when and how much of this currency to issue, based on their own calculations and objectives. By contrast, if goats or soybeans were declared to be money, there would be no way of controlling the money supply. People would likely farm these commodities in enormous volumes, which would increase the money supply without limit, and this would eat away at the buying power of the goats or soybeans.

Beyond this, money has to be widely acceptable as payment. Most merchants and service providers in our times are not open to accepting soybeans or goats in exchange for their goods and services, which effectively rules them out as money. “We accept money because we believe others in turn will accept it too”, explains author Jason Goodwin. “It works because it works.”

Digital Currency

When we evaluate a digital currency like bitcoin, it’s unclear whether or not it falls into the same category as recognized forms of money. Bitcoin lacks the perks of government backing enjoyed by the US dollar and relies on “a broad voluntary market consensus based almost entirely on itself”, in Matt Levine’s words. On the other hand, there is a large number of people in the world who agree bitcoin should hold value, which does make it money-like.

As a means of payment, though, bitcoin has yet to earn widespread acceptance. Some people do actually pay for things with bitcoin but, in most cases, it’s treated more like an asset one buys in the hopes it will appreciate in value, like Apple shares. And in terms of being a store of value, digital currency falls short again. The purchasing power of a single bitcoin, in fact, fluctuates enormously from week to week, and sometimes even minute to minute. Until such a time that the price of bitcoin starts hovering around a certain close range of values, it can’t really be considered money. Finally, and as an extension of the above, bitcoin is not regarded as a unit of account, as US dollars are. This means that people don’t tend to measure the values of things in bitcoins, as they do in dollars. To say that it would cost about eight bitcoins to build a new bridge just wouldn’t be helpful to people, at least at this point in time.

A CBDC (central bank digital currency) would, however, have the potential to qualify as money. This is because the unit of account would be the relevant country’s national currency, which could be exchanged at parity with the digital version. It would be widely accepted too, since it’s only a new form of the same old currency, and since the government would stand behind it too. And, of course, it would function as an effective store of value since it would fall under the government’s purview. Not many nations have yet issued CBDCs, but most of them are thinking about it.

Wrapping Things Up

Through looking at the various types of money that have existed, we have come to a better understanding of what money needs to be able to do, and also of the benefits we enjoy every day from our own fiduciary money. We’ve built a foundation for understanding which sorts of currency might potentially make the grade in times ahead, with the notable example of CBDCs. And in the future – who knows? – it’s possible that a totally new form of money will emerge on the scene. As long as it can make the world go round like dollars and francs can, there’s no reason why it shouldn’t join the club.