Money is a fascinating topic. It is arguably one the most influential factors in all our lives and yet it is arguably the least understood. So what exactly is money? Have you ever asked yourself what it is, how it works, and where it comes from?
These are some of the questions I aim to address. It is not a simple task. However, in 2014 the Bank of England (BOE) published a paper which describes and discusses what money is and the role it has in the modern economy. My aim is to summarise this work and bring it into an Australian context.
Due to the amount of content I have split this work into two parts. Part one will introduce the BOE’s definition of money and highlights the first type of money in the modern economy. Part two continues the conversation and explains the other two types of modern money.
So let’s begin.
What is money?
At a fundamental level, money can be thought of as any ‘thing’ in the economy that acts as a medium of exchange in transactions. The BOE article suggests that many goods or assets have been used historically as money (e.g. food, silver, and gold), but today money is commonly defined by its function. That is, by its ability to fulfill three important roles:
- A store of value – something that should keep its value in a fairly predictable way over time. For example perishable food would be a poor choice, but gold or silver may be ok.
- A unit of account – a ‘unit’ that goods and services can be priced in. In the modern economy, this is usually a currency unit (e.g. Australian Dollar).
- A medium of exchange – something that can be readily swapped between people, rather than the goods or services themselves.
In the modern world, the exchanges people make are complicated. Not everyone wants to consume the same types of goods/services they have produced, and not everyone wants to consume goods/services at the same time as they produce them. This creates a web of interaction in the modern world where some people wish to BORROW and others wish to hold claims to be repaid at a later time – or IOUs. This leads the BOE to their definition of money in the modern economy. That is:
[money is] just a special form of IOU, or in the language of economic accounts, a financial asset.
If this is true, and money is just an IOU, then what is to stop me writing my own IOU every time I want to pay for something? And what is to stop everybody in the economy doing the same? Nothing really! Except that this would rely on everyone being completely trustworthy.
Would you trust everybody’s IOU? Even if you did trust the people you knew directly, what if those people held IOUs from other people you didn’t know? Would you trust those IOUs? It could get messy quickly!
This is exactly why the BOE states that modern money is special because it is not only an IOU, but an IOU that everyone in the economy trusts and are willing to accept in exchange for goods and services.
Let us summarise so far. According to the BOE, at its core, money in the modern economy is a special type of financial asset – or IOU – that everyone in the economy trusts.
OK, but what are these IOUs in the real world? And how do they get their special status as money?
The BOE article goes on to describe this in some detail in the context of the United Kingdom and its banking institutions. However, I am going to take this and bring it into the Australian banking and economic domain.
Following the BOE article, let us first split the Australian economy into three main groups.
- The central bank (The Reserve Bank of Australia, RBA)
- The commercial banks
- The private sector of households and companies
Then let us define and explore the following three types of modern money:
1. The first type of money is CURRENCY
What is it?
Currency is made up of banknotes and coins. Generally speaking these are an IOU from the RBA to the holder of the note – primarily consumers in the economy. This can be seen in the balance sheet of the RBA which shows banknotes as a financial liability or IOU (source RBA).
This ‘currency’ is probably what most of us think of as ‘money’ (see Fig 1). Specifically it consists of:
- Australian banknotes – these are the $5, $10, $20, $50 and $100 notes which are legal tender under the Reserve Bank Act 1959
- Australian coins – these are the 5c, 10c, 20c, 50c, $1, and $2 coins which are legal tender under the Currency Act 1965
- Interestingly, the 1c and 2c coins are also still technically legal tender although they were taken out of circulation starting February 1992 (source Royal Australian Mint).
Why do we use it?
This ‘currency’ is known as fiat money – which means it is not convertible to any other asset of value (e.g. gold). In essence, there is no intrinsic value to the Australian currency (except maybe the plastic and metal used to make it). But if it has no intrinsic value, then why do we use it?
Fundamentally, we [Australians] use it because we all agree it has value. Interestingly, according to the BOE, this value only comes from everyone in the economy agreeing (and trusting) to use it for exchange of real goods and services. But where does this trust come from?
The BOE suggests that governments plays a relatively important role in influencing the universal acceptance of currency (banknotes and coins) in a modern economy. They does so by:
- Accepting the currency as tax payments
- Deeming that the currency represents ‘legal tender’ (In Australia see Reserve Bank Act 1959 and Currency Act 1965)
- Ensuring the economy trusts the currency is valuable and will store its value over time by:
Overall, governments help to ensure the currency – whatever currency that is – remains trusted and valued by all players in the economy.
How is it created?
The RBA manages the issuance and distribution of banknotes to commercial banks. Commercial banks purchase banknotes directly from the RBA. Those banknotes are transported and stored by the banks at approved cash centres located throughout Australia (source RBA).
Australian banknotes are printed by Note Printing Australia Limited (NPA). Since July 1998, NPA has been a separately incorporated, wholly owned subsidiary of the Reserve Bank of Australia. Australian coins are made by the Royal Australian Mint (see this video to see how coins are made) (source RBA).
According to the BOE, commercial banks in the UK pay for the new currency (banknotes), a paper IOU of the BOE, by swapping it for electronic IOUs called central bank reserves1.
In Australia the process appears to work the same. Commercial banks hold exchange settlement accounts (ESA) at the RBA. When the RBA issues the commercial bank with new banknotes (paper IOUs), it reduces the commercial banks ESA balance (electronic IOU) (Source Baker and Jacobs, 2010).
This process will be covered in more detail later but for now let us consider an interesting question. How much ‘currency’ is circulating in the Australian economy?
This information is readily accessed from the RBA’s website here. I’ve downloaded and plotted the data to create Chart 1, which shows the amount of currency in Australia starting from 1959 up until today in $Billions of dollars.
Interestingly, as of January 2019, there is $75.3 Billion worth of Australian currency held by banks, households, or companies, the vast majority of which is in the form of banknotes (source RBA).
Let us take a moment to consider this. If currency is what we consider ‘money’ in Australia, could this really be all the ‘money’? No? Why not? Take Woolworths group for example. In 2018, Woolworths group reported total sales of $61.51 Billion (source Woolworths).
If you think about it, this means that if the $75.3 billion of currency reported by the RBA is referring to all the money in Australia, then Woolworths group alone turned over about 81% of this in one year. What about the other ~2400 companies listed on the Australian securities exchange, let alone all the private companies, charities, and government agencies?
Obviously, there is more to our ‘money’ than can be explained with currency alone!
Indeed, this inconsistency is a perfect segue to the next type of money that is found in the modern economy. The next type of money is Bank Deposits.
- Central bank reserves are the third type of money in the modern economy according to the BOE and are discussed in detail in part two of this series.