Money exists in all modern economies and it clearly plays a major role in the exchange of goods and services.

Money is any generally accepted medium of exchange which enables a society to trade goods without the need for barter Opens in new window.

In the literature money as also been defined as:

  • Any objects or tokens regarded as a store of value and used a medium of exchange. Included in this category are coins and banknotes collectively identified as a medium of exchange. Money is also more widely referred to any written, printed, or electronic record of ownership of the values represented by coins and notes which is generally accepted as equivalent to or exchangeable for these.
  • Means of payment considered as representing value or purchasing power; the power of purchase or means of exchange represented by coins, banknotes, cheques, etc. Hence: property, possessions, resources, etc., viewed as having exchangeable value or a value expressible in terms of monetary units; liquid assets, funds.

Thus money is anything that circulates among economic agents in the process of exchange and which provides a common unit for expressing the price of goods and services exchanged.

It is important for individuals to know what is acceptable in exchange but this is a matter of national, and sometimes local, practice and might change over time.

People also need to know how easily and speedily, and at what cost, they can convert illiquid assets Opens in new window into money and how likely they are to be able to obtain liquid resources through borrowing. For none of this do people need either a formal definition of money or an appreciation of how much money exists in the economy.

At an individual level, people are seldom prevented from engaging in the exchange of goods because of a lack of money in the sense that we are using it here, although they may be so prevented because of a lack of spending power or by the cost of borrowing against their assets or their expected future income.

It is important to say something about the meaning of ‘exchange’ in the phrase ‘medium of exchange’.

This is particularly because the exchange of products in a modern economy is frequently based not on the transfer of notes and coin or bank deposits but on the promise to pay later.

That is, the purchaser goes into debt, usually being granted credit by the seller or a financial intermediary. Why, then, is not credit a ‘generally accepted medium of exchange’?

Monetary economics Opens in new window accepts the importance of credit but has always sought to distinguish between ‘money’ and ‘credit’. The standard way of doing so has been to define the act of exchange such that it is only completed when the debt incurred by the purchaser is settled and for this to happen there has to be transfer of ‘money’.

The consequent definition of ‘money’ as any asset that is generally acceptable as a medium of exchange and is acceptable in final settlement of debt is a common one but this is radically different from the idea that only money allows exchange to occur.

The debt incurred, for example, in the purchase of a motor car may not be settled for some years but the act of exchange occurs when the purchaser acquires the legal right to make use of the car. The later settlement of the debt is a consequence of the exchange but is not needed to allow it to happen.

Further, many of the broader economic consequences of the exchange follow from the exchange of contracts rather than from any subsequent settlement of the debt—cars purchased with debt enter into sales figures and these influence production and hence employment decisions in following periods.

Some purchasers fail to pay the debt but companies allow in their calculations for a certain level of bad debts Opens in new window. Naturally, there will be a later economic impact if more people than expected do not repay the debt they have taken on, but it remains that the ability to obtain credit permits a high proportion of the exchange in a modern economy.

Things become more complex when we consider the use of credit cards to buy a number of different products. The seller of each product is paid by the transfer of a deposit from the bank issuing the credit card. Exchange occurs when the credit card is accepted.

In this case, the bank determines the ability to enter into exchange by the limit that it allows on each credit card. A purchaser’s debt no longer corresponds directly to any particular good he has bought.

Indeed, the bank to which he is in debt might sell that debt on to another firm or the purchaser might repay the debt by borrowing from another bank or finance company or by re-mortgaging his house.

Yet again, the debt might be passed on to subsequent generations or be extinguished by bankruptcy or death. In such ways, the final settlement of the debt becomes almost totally detached from any particular act of exchange.

We can still accept a logical distinction between money and credit based on the notion that an exchange remains ‘incomplete’ until the debt has been settled and that this, by definition, requires ‘money’ — assets that are legally and/or customarily accepted in settlement of debt.

However, this is to look at matters entirely from the point of view of the creditor. From the point of view of the purchaser, we can think of ‘money’ as ‘spending resources’ – anything that allows him to enter immediately into exchange. This, in turn, is dependent on two things:

  1. currently-held real and financial assets plus the amount that can be borrowed;
  2. the ease and speed with which currently-held assets can be converted into forms accepted by sellers (the degree of liquidity of assets).

#1 gives us a broad definition of wealth, including Milton Friedman’s (1957) idea of ‘human wealth’ — abilities and skills that enable people to borrow against expected future income.

The importance of liquidity Opens in new window means, of course, that, even from the point of view of the purchaser, not all wealth can be used to make immediate purchases — not, at least, without considerable risk of associated loss.

Consequently, even from the purchaser’s point of view, money is only one part of total wealth. However, it is clear that any definition of money from the point of view of the purchaser will be much broader than a definition from the point of view of the seller.

It is also clear that neither approach leads to a precise definition that tells one exactly which assets must be included and which excluded. This is more so in the case of broader definitions of money (taken from the purchaser’s point of view) since purchasers may be more or less willing to suffer some loss in converting assets into a form allowing them finally to settle debt. That is, there is no precise notion of how liquid assets must be before we include them in a broad definition of money.

This uncertainty as to precisely which assets we should include in a definition of money gives us a particular problem concerning the notion of a demand for money. We can say that people have a demand for money because they need it to allow them to purchase goods and services and we can see that the lack of money in this sense acts as a constraint on expenditure and to the extent that it does this it is important in analyzing expenditure in the economy.

However, we have seen that goods and services can be acquired through going into debt or by liquidating other assets. Thus, at the level of the individual economic agent, holdings of ‘narrow money’ do not act as a constraint on expenditure.

People who have assets and/or are able to borrow will almost always be able to obtain funds in the form necessary to undertake expenditure.

From the point of view of exchange, it is difficult to see why they should be particularly concerned with the proportion of their assets that they hold in the form of narrow money.

Yet, even if we exclude credit but widen our definition of money to include relatively liquid assets, we muddy the waters by including assets that people might choose to hold for reasons that have nothing to do with the desire to enter into exchange.