What is Money?
The Evolution of Money

In this article we will be talking about the two theories which explain what money is. The first is the convention theory which looks at the evolution of money.  In other words we will follow the larger stops money has made while "growing up", going from exchanging different items to turning into the electronic money we can use today. The second theory is the functional theory, which defines what functions something must have to become money.

Convention theory
At our very first stop we find ourselves in the times of the caveman. Somewhere in those ancient ages people started to find that they can exchange something that is theirs for something that is someone else's. If someone was a fisherman, he could exchange fish for pots, which he could use to store his food in. The problem with exchange is that it can only take place where needs meet. If no one wants fish, no one will give the pots to the fisherman. In this case he either gets no pots, or has to make numerous exchanges to get them.

Quite early on though commodity money started to become widespread. This money was accepted by everybody to be of high value (and usually one of the community's main products). It had to be of stable value, divisible and easy to handle. Cloth, sheep, cows, even salt was used in some places.

The next stop is coinage. This is just like commodity money, but the commodity is the metal that the money is made of. Their metal content was always the same (well, legally anyway) so it could be used to exchange in a uniform way. Only a small step from here is precious metal based money. This was first made by Kroiszosz in the VIIth century, of course his money was gold-based (Red gold, or sequins). Red gold was main payment method for about 2500 years! You were actually, in practice able to pay with gold coins until about 1910, and it stayed the basis for the international monetary systems.

During this time another type of money was evolving, called representative money. This is the money we use today. The actual material of the money is not valuable, it has a market value. This currency was backed by the government or a bank, who promised to redeem the representative money for a given weight of precious material, such as silver or gold.

Another type of money is fiat money (yes, like the car). This is representative money, which is not backed by the government. It is given value by decree. This has been used by many governments in crisis, or in wars. In 1971 the US switched to fiat money, which was some problem for Western countries whose currencies were fixed to the dollar.

The modern state of money, which is actually not easy to distinguish from other types, is credit money. Credit money is best explained through an example. If you have one dollar and put it in a bank, you no longer actually hold the money in your hand but it is still yours. The bank can give your $1 to someone else, who needs it who then spends it in a shop. The shopkeeper then puts that money back into the bank. Now your can use your $1 and so can the shopkeeper, while his $1 is actually from your $1. This means that $1 is used by more people simultaneously, which looks like there is extra money. This is what is called credit money. These were the basic forms of money. Many of these money types, especially the later ones evolved and existed beside each other.

Today money is no longer gold based, because increasing demand cannot be fulfilled by gold. Credit money is the most widespread, but now electronic money is being revolutionized and may take over quickly. This is not exactly credit money because it is not (or will not be) backed up by real money. It is sort of a mix between credit money and fiat money.

Functional theory
Let's look at some of the functions that money has to have:

  • Exchange and payment. It has to be universal, you have to be able to use it to pay for anything you want.

  • Value-keeping. The money has to be stable, it has to have a constant value to ensure trade keeps on going. No one would want you to pay with money that might be worthless tomorrow.

  • Setting function. It has to have this abstract function, you have to be able to know what something is worth in a certain currency because then you can define what goods are worth compared to each other.

If something has these functions it can be considered to be money, although today you cannot just find something and say it is money, so this theory requires a bit of common sense.


Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.