Money in the modern economy (published in 2014)

 The nature of modern money, in the larger context of the modern economy, is defined by its role as a universally trusted financial claim, fundamentally operating as a special kind of IOU. Money is essential to the workings of a modern economy.

The sources emphasize three key aspects regarding the nature of modern money: its conceptual foundation as an IOU, its distinction from historical forms, and its composition based on which sector issues the debt.

I. The Conceptual Nature of Modern Money

Money in the modern economy is understood as a financial asset.

IOU and Trust: Money solves the problems inherent in complex webs of individual IOUs (promises to repay someone at a later date), which become unwieldy and rely on everyone trusting everyone else. Money is a social institution that resolves this lack of trust by being a special kind of IOU that everyone in the economy trusts. Because it is universally trusted, people are willing to accept it in exchange for goods and services.

Financial Asset vs. Liability: As a financial asset, money represents a claim on someone else in the economy. Crucially, one person's financial asset (money) is always someone else’s financial liability (debt). If all financial assets and liabilities were pooled together for the entire economy, they would cancel out, leaving only the non-financial assets (such as land or houses).

Distinction from Commodity Money: Historically, money was often commodity money—goods or assets valuable in their own right, like gold or iron, which served monetary functions. In contrast, money in the modern economy is a financial asset. Specifically, modern currency (banknotes and coin) is fiat money, meaning it is not convertible to any other asset (such as gold or other commodities).

II. Composition and Creation of Modern Money

The economy is divided into three main groups: the central bank, commercial banks, and consumers (households and companies). There are three main types of money circulating, each representing an IOU between these sectors.

Type of Money	Issuer (Debtor)	Holder (Creditor/Asset)	Proportion/Function
Bank Deposits	Commercial Banks	Consumers	Majority of money (97% of money held by the public in the UK as of December 2013). Created when banks make loans.
Currency (Fiat)	Central Bank (e.g., Bank of England)	Consumers or Commercial Banks	Small proportion of money held by the public. Primarily banknotes, which are fiat money.
Central Bank Reserves	Central Bank (e.g., Bank of England)	Commercial Banks	Used as an electronic medium of exchange for commercial banks to transact with each other.

Bank Deposits (Broad Money): Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves. These deposits are an IOU from commercial banks to consumers. When a bank issues a loan, it simply credits the customer's account with a higher deposit balance, instantly creating new money. Bank deposits are typically held electronically and are widely used as the medium of exchange. Broad money is defined as currency held by the private sector plus bank deposits.

Currency (Fiat Money): Currency, consisting mostly of banknotes, is an IOU from the central bank. The banknotes are a "promise to pay" the holder and are shown as a liability on the central bank's balance sheet and an asset on the holder's balance sheet. Since it is fiat money, the debt can only be repaid in more fiat money. The state plays a role in underpinning the use of currency by accepting it for tax payments and deeming it "legal tender". The usefulness of currency is maintained because the central bank aims to safeguard its value through a low and stable rate of inflation.

Central Bank Reserves (Base Money): Central bank reserves are a different type of IOU from the central bank, held exclusively by commercial banks. These reserves are electronic records that allow banks to conduct large-volume transactions with each other, acting as a medium of exchange for commercial banks, similar to how current accounts work for consumers. Base money (or central bank money) comprises currency plus central bank reserves.

III. The Role of Money in the Exchange Economy

The move toward an exchange economy, away from a subsistence economy where people only consume what they produce, requires money. Money traditionally fulfills three important roles:

1. Medium of Exchange: Money is something people hold specifically to swap for something else. This has often been viewed as its most important function by economists.
2. Store of Value: Money is expected to retain its value in a reasonably predictable way over time.
3. Unit of Account: Money is the item used to price goods and services (e.g., on menus or contracts).

These functions are interconnected: an asset that is a poor store of value (like currency during hyperinflation) is less useful as a medium of exchange. Likewise, it is generally efficient for the medium of exchange to also be the unit of account.

The stability of modern money is maintained by ensuring that it retains its value. For instance, abandoning the gold standard in 1931 allowed the UK to better manage the economy, enabling the government to adjust the amount of money available to match demand, which is not possible when the money supply is linked to a commodity. Today, the Bank of England manages this stability through an inflation target.

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The modern money system can be seen as a set of nested IOUs. Currency and deposits (broad money) serve the general public, while reserves (base money) serve the banks, all ultimately resting on the fundamental societal agreement—the trust—that these specific IOUs will be honored and accepted in exchange. The sheer quantity of money today being bank-created deposits, rather than central bank-issued currency, highlights that commercial bank debt, universally trusted, forms the vast majority of money in the modern economy.

Money in the modern economy is defined as a special kind of IOU (a financial asset), and the sources identify three main types of money currently circulating: currency, bank deposits, and central bank reserves. Each type represents a specific IOU, or financial liability, issued by one sector of the economy to another.

The economy is generally split into three main groups: the central bank (like the Bank of England), commercial banks (like high street banks), and consumers (households and companies). The three types of money function as IOUs between these groups.

I. Bank Deposits (The Largest Component)

Bank deposits represent the largest proportion of money held by the public in the modern economy.

1. Definition and Scope: Bank deposits are an IOU from commercial banks to consumers. They are typically held electronically and come in many forms, such as current accounts or savings accounts. As of December 2013, 97% of the money held by the public in the United Kingdom was in the form of deposits with banks, rather than currency.
2. Function and Trust: Consumers prefer holding bank deposits over physical currency because deposits can pay interest and are generally a more convenient medium of exchange and store of value. Deposits are trusted because, for most household depositors, they are guaranteed up to a certain value, ensuring confidence in their convertibility into currency. Consumers use deposits directly as the medium of exchange, such as when paying a shop by debit card.
3. Creation: Unlike currency, bank deposits are mostly created by commercial banks themselves. When a bank issues a new loan to a customer, it simply credits the customer's account with a higher deposit balance, which simultaneously creates new money. The bank's IOU (the deposit) becomes money because it is widely accepted as a medium of exchange.
4. Broad Money: Bank deposits, combined with currency held by the private sector, make up what is known as Broad money.

II. Currency (Fiat Money)

Currency is the physical form of money, consisting of banknotes and coin, but it constitutes a very small amount of the total money held by people and firms in the economy.

1. Definition and Issuer: Currency is an IOU from the central bank, mostly to consumers. Banknotes make up around 94% of the total value of currency (as of December 2013) and are a "promise to pay" the holder a specified sum. These banknotes are recorded as a liability on the central bank's balance sheet and an asset for the holder.
2. Nature (Fiat): Since 1931, Bank of England money has been fiat money. Fiat money is defined as money that is not convertible to any other asset like gold or other commodities. The central bank's debt can only be repaid in more fiat money.
3. Trust and Value: The state generally underpins the use of currency by accepting it for tax payments and by deeming it "legal tender". However, its universal acceptance depends on trust that its value will remain broadly stable over time. The Bank of England achieves this stability by maintaining an inflation target for consumer prices.
4. Creation: The Bank of England issues new banknotes to meet the public's demand, often by swapping new notes for old ones. Commercial banks obtain extra newly issued currency by swapping their central bank reserves for the physical notes.

III. Central Bank Reserves (Base Money)

Central bank reserves are exclusively used by commercial banks for transactions with each other.

1. Definition and Issuer: Reserves are a different type of IOU from the central bank. They are electronic records of the amount owed by the central bank to each commercial bank.
2. Function: Reserves act as a medium of exchange for commercial banks, similar to how current accounts function for households. When one commercial bank needs to make a large payment to another, the Bank of England adjusts their reserve balances accordingly.
3. Relationship to Currency: Commercial banks need reserves to purchase currency from the central bank when meeting depositor demands for withdrawals. The central bank guarantees that reserves can be swapped for currency.
4. Base Money: Central bank reserves, combined with currency (both held by consumers and banks), comprise Base money (or Central bank money). This is important because the central bank uses its position as the sole issuer of base money to implement monetary policy.

In summary, all three types of modern money are special kinds of IOUs that are universally trusted to act as a medium of exchange. The relationship between them shows a hierarchy of debt: bank deposits and currency form Broad money used by the public, while central bank reserves and currency form Base money issued by the central bank, which underpins the system. The fact that bank deposits (commercial bank debt) constitute the vast majority of the money supply means the modern monetary system relies heavily on the public’s confidence in the solvency and liquidity of commercial banks.

The sources define money in the modern economy as a universally trusted financial claim or IOU [1, 3 money in the modern economy as a universally trusted financial claim or IOU. To quantify the amount of this debt circulating, economists and commentators pay close attention to different aggregate measures of money, specifically Broad money and Base money. These measures categorize the three main types of money—currency, bank deposits, and central bank reserves—based on which sector holds them and which sector issued them.

Here is a discussion of the Measures of Money in the context of the modern economy:

I. Broad Money

Broad money is the measure of money most relevant to consumption and spending decisions in the economy.

Composition: Broad money comprises the IOUs held by the private sector of households and companies, referred to as 'consumers'. Specifically, it is made up of:

1. Currency (banknotes and coin) held by the private sector. This is an IOU from the central bank.
2. Bank Deposits (and other similar short-term liabilities of commercial banks) held by consumers. This is an IOU from commercial banks to consumers.

Significance: Broad money is considered a useful concept because it measures the amount of money held by those responsible for spending decisions in the economy (households and companies). Economists and academics pay close attention to the amount of broad money circulating.

Measure Details: The Bank of England's headline measure of broad money is M4ex. This specific measure excludes the deposits of certain financial institutions (known as intermediate other financial corporations or IOFCs) to ensure the measure is more relevant for tracking spending in the economy.

Dominant Component: It is crucial to note that the vast majority of broad money consists of bank deposits. As of December 2013, 97% of the money held by the public in the United Kingdom was in the form of deposits with banks, rather than currency.

II. Base Money (or Central Bank Money)

Base money is the aggregate measure that focuses solely on the liabilities (IOUs) issued by the central bank.

Composition: Base money comprises IOUs from the central bank, specifically:

1. Currency (banknotes and coin). This includes currency held by consumers and currency held by commercial banks in their tills.
2. Central Bank Reserves. These are electronic IOUs from the central bank to commercial banks.

Significance: Base money is important because the central bank uses its position as the only issuer of base money to implement monetary policy. The central bank can vary the interest rate paid on reserves to affect spending and inflation.

Alternative Names: Base money is also known as Monetary base, Central bank money, Outside money (in the UK context), and High-powered money, including the specific measure M0.

III. Relationship Between the Measures

The balance sheets of the three main groups (Central Bank, Commercial Banks, and Consumers) illustrate the relationship between these measures:

• Broad money is the sum of the assets (deposits and currency) held by the Consumers [31, Figure 2].
• Base money is the sum of the central bank's IOUs (reserves and currency), which are assets held by the Commercial Banks and Consumers [31, Figure 2].

The sources emphasize that the total amount of broad money is greater than the amount of base money. This highlights that the majority of the money supply (deposits) is created by commercial banks through the lending process, not directly by the central bank issuing base money.

The sources define money in the modern economy as a special kind of IOU that is universally trusted money in the modern economy as a special kind of IOU that is universally trusted. Money’s universal acceptance is necessary because it fulfills key roles that facilitate exchange and specialization in the economy.

One common way of defining money, which provides the traditional context for its role in the modern economy, is through the three important functions it performs.

I. Medium of Exchange

The medium of exchange is often viewed by economists as the most important function of money.

Definition and Function: Money must be a medium of exchange—something that people hold because they plan to swap it for something else, rather than wanting the item itself.

Role in the Economy:

• Facilitating Trade: Money is essential for moving an economy from a self-sufficient subsistence economy (where people consume only what they produce) to an exchange economy where people specialize in production and trade. In a subsistence economy, like the example of Robinson Crusoe alone on a desert island, money is unnecessary. However, specialization and trade allow people (like Robinson Crusoe and Man Friday) to consume more by focusing on what they are best at producing.
• Overcoming Barter Limitations: While direct swapping (barter) is possible, exchanges in the modern economy are far more complicated due to the large number of people involved and the lack of coincident timing of exchanges. Money, as a universally trusted IOU, solves the problem of a complex web of individual IOUs and the lack of trust inherent in such systems, becoming universally acceptable as the medium of exchange.
• Modern Examples: Bank deposits are increasingly used as the medium of exchange in the modern economy. When a consumer pays a shop by debit card, bank deposits are used directly without conversion to currency.

II. Unit of Account

The unit of account is the standard measure in which goods and services are priced.

Definition and Function: The unit of account is the thing that goods and services are priced in terms of, appearing on menus, contracts, or price labels. In modern economies, the unit of account is usually the national currency, such as the pound in the United Kingdom. Historically, items might have been priced in common goods like "bushels of wheat" or farm animals.

Efficiency Link: It is generally considered efficient for the medium of exchange to also be the unit of account. If items were priced in one currency (e.g., US dollars) but payment was accepted in another (e.g., sterling), customers would constantly have to calculate the exchange rate, which would take time and effort.

III. Store of Value

Money is expected to retain its purchasing power over time.

Definition and Function: The store of value is something that is expected to retain its value in a reasonably predictable way over time. Historically, assets like gold or silver have been good stores of value, unlike perishable food.

Interdependence with Medium of Exchange: The functions are closely linked: an asset is less useful as the medium of exchange if it will not be worth as much tomorrow (i.e., if it is not a good store of value).

• For example, during hyperinflation in countries like Germany after World War I, the local currency became such a poor store of value that people began using foreign currencies as an alternative medium of exchange.
• To ensure sterling retains its usefulness in exchange, the Bank of England's objective is to safeguard the value of the currency, primarily by maintaining an inflation target.
• However, not all good stores of value are good media of exchange; for instance, houses retain value over time but cannot be easily passed around as payment.

Summary of Modern Money Functions

In the context of the modern economy, money, which is mostly bank deposits and fiat currency, performs these three traditional functions. The trust placed in this special IOU is maintained by measures like deposit guarantees and the central bank's commitment to low and stable inflation, ensuring that modern money remains effective as a store of value and thus universally acceptable as a medium of exchange.

The sources discuss **The sources discuss recent developments in payment technologies and alternative currencies as innovations that are related to, but distinct from, the traditional types of money (currency, bank deposits, and central bank reserves) circulating in the modern economy.

In the larger context of money in the modern economy, which is primarily composed of universally trusted IOUs (bank deposits and fiat currency), these innovations generally perform some of the functions of money, but are not typically accepted as a medium of exchange to the same extent as currency, central bank reserves, or bank deposits.

The sources categorize these innovations into three main groups: electronic forms of money (e-money), local currencies, and digital currencies (such as Bitcoin).

I. Electronic Forms of Money (E-Money)

These innovations focus on improving the convenience of making payments using existing money, particularly bank deposits.

• Definition: E-money allows households and businesses to convert their existing bank deposits into purely electronic forms of money.
• Examples: PayPal and Google Wallet are cited as examples of these technologies.
• Functions:
  • Store of Value: E-money serves as a store of value, provided that the companies supplying it are seen as trustworthy.
  • Medium of Exchange: E-money can be used as a medium of exchange with businesses (such as online sellers) or individuals who accept it.
  • Unit of Account: Transactions using these technologies are typically denominated in the existing unit of account (e.g., pounds sterling in the United Kingdom).
• Limitations: While potentially more convenient than banknotes for some transactions, e-money is still not as widely accepted as other media of exchange; for example, it is generally not accepted by high street shops.

II. Local Currencies

Local currencies aim to encourage economic activity within a specific, defined environment.

• Definition: These are complementary currencies, such as the Bristol, Brixton, or Lewes Pounds in the United Kingdom.
• Creation and Exchange: Local currencies are obtained by swapping them for standard currency (e.g., pounds sterling) at fixed rates (e.g., one sterling pound for one Bristol Pound).
• Functions and Limitations:
  • Unit of Account: Local currency can be exchanged for goods and services priced in their own unit of account (e.g., Brixton Pounds rather than sterling pounds).
  • Medium of Exchange: Their use as a medium of exchange is intentionally limited. For instance, the Lewes Pound can only be used at participating retailers located in the Lewes area.
• Supply: The amount of money held in local currencies depends entirely on the demand for them, as they are only put into circulation when exchanged for pounds sterling.

III. Digital Currencies

Digital currencies, such as Bitcoin, Litecoin, and Ripple, represent a further category of innovation.

• Key Difference: Unlike local currencies, the exchange rate between digital currencies and traditional currencies is not fixed.
• Functions and Use:
  • Medium of Exchange: Digital currencies are not at present widely used as a medium of exchange.
  • Asset Class: Their popularity largely stems from their ability to serve as an asset class, suggesting they may have more conceptual similarities to commodities, such as gold, than money.
• Creation and Supply: Digital currencies differ fundamentally from the other technologies mentioned because they can be created out of nothing, although typically at pre-determined rates. Conversely, the supply of digital currencies is usually limited, contrasting with e-money and local currencies, whose amounts depend on demand.

In sum, while innovation is ongoing, the sources indicate that as of the time of publication, none of these alternative payment technologies or currencies have achieved the level of universal trust and acceptance necessary to supplant the established forms of money (bank deposits and currency) as the primary medium of exchange in the modern economy. They function on the periphery, often leveraging the stability and established unit of account provided by the existing monetary system.