Money serves three basic functions: as a unit of account, a medium of exchange, and a store of value. A unit of account is used to denominate the prices of goods and services, creating a concrete way to express value. A medium of exchange can be used in financial transactions, including buying goods and services. A store of value is a way to maintain the purchasing power of one’s earnings or wealth over time.
Fiat Money
Money has no singular definition, it is popularly associated with currency banknotes and coins—in other words, cash. When central bankers, economists, and financial market participants talk about money, they have a much broader concept in mind. Monetary aggregates that are useful for evaluating the stance and outcomes of monetary policy, including the extent to which the creation of money supports real economic activity and affects inflation, can be classified into two categories as outside money and inside money.
Outside Money
The first category, outside money, corresponds to the popular conception. This is money issued by a central bank or other entity authorized by the government or central bank. This is called outside money because it is created outside the private sector. Such money is also referred to as fiat money because it is created by an official authority and is usually not backed by anything other than faith in the central bank or the government that stands behind it.
Fiat money comes with one major risk. If a profligate government spends more than it takes in through tax revenues, it can (through the national central bank) simply issue more currency to pay for its expenditures on various goods and services. This would cause the prices of an economy’s output to rise quickly—high inflation—and erode the purchasing power of money. The government can of course then print even more money to get the goods and services it wants, but trying to outrun inflation in this manner can quickly end in hyperinflation and economic collapse.
This loss of confidence in outside money can damage an economy because people and businesses might then lack a reliable and trustworthy medium of exchange. To avoid this problem, outside money can be explicitly backed by assets or commodities such as gold and silver. In other words, if the central bank ties its hands and limits its own ability to print money wantonly, confidence in the currency can be maintained. This was the case during the gold standard period when the central banks could issue currency only if they had enough gold in their vaults to back such currency. This approach was meant to instill monetary discipline—the central bank could not, in this setup, issue currency at will or on the government’s command.
Backing fiat money with gold or another currency has come to be seen as constraining for central banks that might need to adjust the money supply on short notice to support their economies and financial systems. Most countries have therefore abandoned any form of such backing. There are a few exceptions. A handful of economies still maintain currency board arrangements under which their domestic currencies are fully backed by a foreign one. For instance, Hong Kong has a currency board, with its central bank issuing Hong Kong dollars that are backed one for one with US dollars. Bulgaria has a currency board as well, with the issuance of the Bulgarian lev fully backed by euros. Setting a few such exceptions aside, though, unbacked fiat money has become the norm in modern economies.
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Inside Money
Money is created not just by a nation’s central bank but by the private sector as well. When a commercial bank approves a loan to a household or a business and then credits that amount to the borrower’s account, it has created money in the form of a bank deposit. That money circulates within the banking system as the money is used to purchase goods and services, passing through various accounts at multiple other institutions. Thus, inside money is created by entities within the private sector and circulates among private businesses and households. It is, in effect, an asset representing or backed by any form of private credit, and it circulates as a medium of exchange.
Measures of Money
Measures of the overall amount of money in an economy, referred to as monetary aggregates, serve as both indicators and determinants of economic activity and inflation. Too little money creation, including limited credit creation by commercial banks, can dampen economic activity. Too much money creation can result in rising inflation.
Monetary aggregates typically include both outside and inside money—money issued by the central bank as well as bank deposits. Bank deposits come in various forms. They can range from money market accounts and demand deposits, which allow depositors to take money out at will, to longer-term fixed deposits, in which the money is locked in for longer periods (in some cases the deposit can be taken out before the maturity date by paying a penalty).
No template for reporting such data on monetary aggregates is followed consistently by all countries. In general, M0 characterizes currency in circulation (banknotes and coins). Certain types of bank deposits share some of the characteristics of cash—they are easily accessible and can be used to make payments. A measure of money that encompasses such deposits is M1. M1 typically includes M0, demand deposits, and checking deposits.
A broader monetary aggregate, M2, is popular in academic and policy circles because it includes central bank money and various short-term deposits, and most countries by and large define it similarly. Not surprisingly, M2 is sometimes referred to simply as broad money.
Money in the World
“The whole of the global economy is based on supplying the cravings of two percent of the world’s population.” -Bill Bryson
How much money is there in the world, and which countries account for the majority of this money? It is an interesting exercise to compare the shares of various countries in global money totals and to contrast those with their shares in global GDP.
The above figure shows the global distribution of currency (banknotes and coins in circulation) or, equivalently, M0. The United States accounts for 24 percent of the global total of $8.4 trillion, about the same as its share of global GDP in 2020. The eurozone accounts for 20 percent, although its share of global GDP is only 15 percent, and China accounts for 15 percent, roughly in line with its 16 percent share of global GDP.
A sizable fraction of the currency issued by major advanced economies, particularly US dollars, and euros, is held outside their borders. Recent estimates suggest, for instance, that more than half of all US currency is held abroad. In any event, US dollars, euros, Chinese renminbi, and Japanese yen together constitute nearly three-quarters of the global supply of currency. (Excerpt is from ‘The Future of Money’ by Eswar S. Prasad)
