Approaches to Money: Introduction

- Article photo, courtesy of CEPR
In general, people often think of money as currency notes, coins, or bank deposits. However, in economics, the term "money" encompasses a broader range of concepts, defined differently by various economists.
Despite its central role in the economy, there is no universally accepted definition of money. As economist Walters remarked, “Throughout history to the present day, there is no agreement on the most fundamental of questions—what is money?” This lack of consensus has made defining money a topic of debate.
At its core, money can be understood as any commodity or asset that is generally accepted as a medium of exchange and a measure of value. Historically, various commodities have fulfilled these functions, evolving over time from livestock to the modern credit card.
The Challenges of Defining Money
Defining money is complicated by the increasing number of money substitutes, including assets that can be easily converted into spendable forms of money. While currency and bank deposits remain the most liquid assets, other forms of money have emerged.
Adding to the complexity is the divergence between conceptual definitions (theoretical) and empirical definitions (practical). Over time, the concept of money has shifted from a clearly measurable quantity to one that is more abstract and difficult to quantify.
The Four Approaches to Defining Money
Economist H.G. Johnson classified the various approaches to defining money into four categories:
- The Conventional Approach
- The Chicago Approach
- The Central Bank Approach
- The Gurley-Shaw Approach
The Conventional Approach
The conventional approach is the oldest and most widely accepted definition of money. It emphasizes the two fundamental functions of money: acting as a medium of exchange and a measure of value. As Stanley Withers famously put it, “Money is what money does.”
Historically, various commodities such as cattle, grains, shells, metals, and even cigarettes served as money in different parts of the world. These are known as commodity money. However, commodity money had significant limitations, such as:
- Lack of uniformity
- Variability in size and weight
- Lack of durability
- Poor portability
- Instability in value
- Indivisibility
Due to these issues, societies gradually transitioned to more efficient forms of money, including metallic coins, paper currency, and demand deposits (which are accessed through checks). These forms of money, as per the conventional approach, constitute the total supply of money.
The Chicago Approach
The Chicago approach, pioneered by Milton Friedman and the Chicago School, extends the conventional definition of money to include time deposits in banks. The Chicago School argues that time deposits should be included in the money supply because:
- There is a high correlation between the money supply (including time deposits) and Gross National Product (GNP), indicating its importance in the economy.
- Time deposits, although not immediately available for transactions, are close substitutes for demand deposits and become available after a short time.
Moreover, time deposits are often loaned out by banks, allowing them to re-enter the economy and function as a medium of exchange. For these reasons, the Chicago School advocates including time deposits in the money supply.
The Gurley-Shaw Approach
The Gurley-Shaw approach, developed by economists John G. Gurley and Edward S. Shaw, goes further than the Chicago approach. It recognizes that not only demand deposits and time deposits, but also financial claims against non-banking intermediaries, should be included in the money supply.
Gurley and Shaw argue that various financial instruments, such as savings accounts and shares in savings and loan associations, function as liquid stores of value. However, while the Gurley-Shaw approach is theoretically sound, it is difficult to empirically determine the degree of substitutability between different financial instruments.
The Central Bank Approach
Central banks, such as the Federal Reserve or the European Central Bank, take a broader view of money. Their goal is to regulate credit flows and implement monetary policies that meet the needs of the economy.
According to this approach, money includes not only currency and demand deposits but also assets that are highly liquid—those that can be converted into cash easily. This approach is attributed to the Radcliffe Committee, which emphasized the similarity between currency and other forms of purchasing power. In practice, central banks use different measures of money supply (referred to as M1, M2, M3, and M4), depending on their policy objectives.
Commodity Money
Commodity money refers to items with intrinsic value that were widely accepted as mediums of exchange. These were items that could be traded for other goods and services. Historically, various commodities such as cattle, grains, metals, and shells were used as money because they held value within the community. Common forms of commodity money included:
- Cattle (cows, oxen)
- Grains (wheat, barley)
- Precious Metals (gold, silver)
- Cowry Shells (widely used in Africa and parts of Asia)
While commodity money was useful, it had limitations such as lack of uniformity, durability, and portability.
Metallic Coins
The next stage in the evolution of money saw the introduction of metallic coins, first believed to be minted in Lydia (modern-day Turkey) around 7th century BC. Metals like gold, silver, and copper were chosen due to their durability, divisibility, and ease of transport. Coins had intrinsic value, based on the metal content, and served as an improvement over commodity money because they were standardized in size, weight, and value. Governments later took control of minting coins, giving them legal status and establishing state-backed monetary systems.
Paper Money
Paper money was introduced as a further improvement over metal coins. It is believed that the Chinese were the first to use paper currency during the Tang Dynasty (7th century AD). Unlike coins, paper money had no intrinsic value; instead, it represented a promise to pay a certain amount of metal or goods. Paper currency quickly became widely accepted, especially with government backing, and was easier to carry in large amounts. Over time, it became the dominant form of money worldwide.
Bank Deposits and Cheques
With the rise of banking systems, money continued to evolve into forms that didn’t require physical handling. Bank deposits and cheques emerged as representations of money, enabling people to store wealth securely and transfer funds without needing to exchange physical coins or paper money. Cheque systems became a bridge between physical money and more abstract forms of payment, laying the foundation for modern electronic payments.
Credit Cards and Electronic Money
The 20th century saw the rise of credit cards, enabling people to make purchases with credit rather than physical cash. This era also marked the rise of electronic money in the form of bank transfers and digital payments. Credit cards worked by extending short-term loans, which users could pay off at the end of the month or accumulate interest on.
The Digital Age: Cryptocurrencies, Tokens, and Altcoins
The advent of the internet and advancements in cryptography gave birth to a new era of money—digital currencies. Cryptocurrencies such as Bitcoin, introduced in 2009, revolutionized the concept of money by introducing decentralized, peer-to-peer payment systems free from government control. These digital currencies leveraged blockchain technology to ensure security, transparency, and immutability in transactions.
Tokens
In addition to cryptocurrencies, the concept of tokens emerged. Tokens are digital assets created on blockchain platforms that represent ownership or utility within specific ecosystems. They can represent anything from real estate, commodities, or rights to services within decentralized applications (dApps). For example, utility tokens are used within a specific platform, while security tokens represent investment in assets.
Tokens differ from traditional money because they often have specific use cases beyond just being a medium of exchange. They can also serve as governance tools, enabling holders to vote on changes within blockchain platforms.
Altcoins
As cryptocurrencies gained popularity, new versions called altcoins (alternative coins) emerged. Altcoins are alternatives to Bitcoin, each with unique features or functions. Some altcoins, like Ethereum, introduced the concept of smart contracts, programmable contracts that execute automatically when certain conditions are met. Other altcoins, like Litecoin and Ripple (XRP), focused on improving transaction speed and scalability.
Key examples of altcoins:
- Ethereum (ETH): Introduced smart contracts, enabling decentralized applications (dApps) and decentralized finance (DeFi) platforms.
- Ripple (XRP): Focused on real-time global payments with fast transaction speeds.
- Litecoin (LTC): Designed as a "lighter" version of Bitcoin with faster transaction times.
Central Bank Digital Currencies (CBDCs)
The most recent development in the evolution of money is the emergence of Central Bank Digital Currencies (CBDCs). Governments and central banks worldwide are exploring CBDCs as digital forms of their national currencies. Unlike decentralized cryptocurrencies, CBDCs are fully controlled by the issuing government, providing the benefits of digital money (such as faster transactions and lower costs) while maintaining state control over monetary policy.
Conclusion
From barter systems to blockchain, money has evolved in response to changing economic systems, technological advancements, and societal needs. Today, digital currencies like tokens and altcoins represent the cutting edge of financial innovation, offering new ways to store, exchange, and transfer value. The evolution of money continues to shape how we interact in the global economy, with blockchain technology likely to play a pivotal role in the future of financial systems.
Let's examine each approach.
The Evolution of Money: From Commodities to Tokens and Altcoins
Money has undergone a remarkable evolution throughout history, adapting to the changing needs of societies and economies. Starting from the most primitive forms of commodity money, it has evolved into complex digital representations such as tokens and altcoins. Below is an outline of the evolution of money, from its earliest forms to modern-day digital currencies.