In everyday conversation, people often use the word money to mean “wealth.” If you ask, “How much money does Bill Gates have?” the answer will be something like, “Oh, $50 billion or so, but who’s counting?” That is, the number will include the value of the stocks, bonds, real estate, and other assets he owns.

But the economist’s definition of money doesn’t include all forms of wealth. The dollar bills in your wallet are money; other forms of wealth—such as cars, houses, and stock certificates—aren’t money. What, according to economists, distinguishes money from other forms of wealth?

Money is defined in terms of what it does: money is any asset that can easily be used to purchase goods and services. In Chapter 10 we defined an asset as liquid if it can easily be converted into cash. Money consists of cash itself, which is liquid by definition, as well as other assets that are highly liquid.

You can see the distinction between money and other assets by asking yourself how you pay for groceries. The person at the cash register will accept dollar bills in return for milk and frozen pizza—but he or she won’t accept stock certificates or a collection of vintage baseball cards. If you want to convert stock certificates or vintage baseball cards into groceries, you have to sell them—trade them for money—and then use the money to buy groceries.

Of course, many stores allow you to write a cheque on your bank account in payment for goods (or to pay with a debit card that is linked to your bank account). Does that make your bank account money, even if you haven’t converted it into cash? Yes. Currency in circulation—actual cash in the hands of the public—is considered money. So are chequeable deposits—bank accounts on which people can write cheques.

Are currency and chequeable bank deposits the only assets that are considered to be money? It depends. As we’ll see later, there are several widely used definitions of the money supply, the total value of financial assets in the economy that are considered money. The narrower definitions consider only the most liquid assets to be money: currency in circulation and chequeable deposits (also called demand deposits). The broader definitions include these two categories plus other assets that are almost chequeable, such as saving account deposits at chartered banks, trust and mortgage loan companies, credit unions, and caisses populaires. However, all of the definitions distinguish between assets that can easily be used to buy goods and services and those that can’t.

Money plays a crucial role in generating gains from trade because it makes indirect exchange possible. Think of what happens when a cardiac surgeon buys a new refrigerator. The surgeon has valuable services to offer—namely, heart operations. The owner of the store has valuable goods to offer—refrigerators and other appliances. It would be extremely difficult for both parties if, instead of using money, they had to directly barter the goods and services they sell. In a barter system, a cardiac surgeon and an appliance store owner could trade only if the store owner happened to want a heart operation and the surgeon happened to want a new refrigerator.

This is known as the problem of finding a “double coincidence of wants”: in a barter system, two parties can trade only when each wants what the other has to offer. Money solves this problem: individuals can trade what they have to offer for money and trade money for what they want.

Because the ability to make transactions with money rather than relying on bartering makes it easier to achieve gains from trade, the existence of money increases welfare, even though money does not directly produce anything. In other words, it saves time and resources spent on finding another suitable party that is willing to trade with us. As Adam Smith put it, money “may very properly be compared to a highway, which, while it circulates and carries to market all the grass and corn of the country, produces itself not a single pile of either.”

Let’s take a closer look at the roles money plays in the economy.

Money plays three main roles in any modern economy: it is a medium of exchange, a store of value, and a unit of account.

1. Medium of Exchange Our cardiac surgeon/refrigerator example illustrates the role of money as a medium of exchange—an asset that individuals use to trade for goods and services rather than for consumption. People can’t eat dollar bills; rather, they use dollar bills to trade for edible goods and their accompanying services.

In normal times, the official money of a given country—the Canadian dollar in Canada, the U.S. dollar in the U.S., the euro in Germany, and so on —is also the medium of exchange in virtually all transactions in that country. During troubled economic times, however, other goods or assets often play that role instead. For example, during economic turmoil people often turn to other countries’ moneys as the medium of exchange: U.S. dollars have played this role in troubled Latin American countries, as have euros in troubled Eastern European countries. In a famous example, cigarettes functioned as the medium of exchange in World War II prisoner-of-war camps: even non-smokers traded goods and services for cigarettes because the cigarettes could in turn be easily traded for other items. During the extreme German inflation of 1923, goods such as eggs and lumps of coal became, briefly, mediums of exchange.

2. Store of Value In order to act as a medium of exchange, money must also be a store of value—a means of holding purchasing power over time. To see why this is necessary, imagine trying to operate an economy in which ice cream cones were the medium of exchange. Such an economy would quickly suffer from, well, monetary meltdown: your medium of exchange would often turn into a sticky puddle before you could use it to buy something else. (As we’ll see in Chapter 16, one of the problems caused by high inflation is that, in effect, it causes the value of money to “melt.”) Of course, money is by no means the only store of value. Any asset that holds its purchasing power over time is a store of value. So the store-of-value role is a necessary but not distinctive feature of money. Gold is an asset with intrinsic value that can serve as a store of value. During unstable times such as wars or periods of hyperinflation, people often hold gold rather than paper money to better store or preserve their wealth.

3. Unit of Account Finally, money normally serves as the unit of account—the commonly accepted measure individuals use to set prices and make economic calculations. To understand the importance of this role, consider a historical fact: during the Middle Ages, peasants typically were required to provide landowners with goods and labour rather than money. A peasant might, for example, be required to work on the lord’s land one day a week and hand over one-fifth of his harvest.

Today, rents, like other prices, are almost always specified in money terms. That makes things much clearer: imagine how hard it would be to decide which apartment to rent if modern landlords followed medieval practice. Suppose, for example, that Mr. Smith says he’ll let you have a place if you clean his house twice a week and bring him a kilogram of steak every day, whereas Ms. Jones wants you to clean her house just once a week but wants four kilograms of chicken every day. Who’s offering the better deal? It’s hard to say. If, instead, Smith wants $600 a month and Jones wants $700, the comparison is easy. In other words, without a commonly accepted measure, the terms of a transaction are harder to determine, making it more difficult to make transactions and achieve gains from trade.

In some form or another, money has been in use for thousands of years. For most of that period, people used commodity money: the medium of exchange was a good, normally gold or silver, that had intrinsic value in other uses. These alternative uses gave commodity money value independent of its role as a medium of exchange. For example, the cigarettes that served as money in World War II prisoner-of-war camps were also valuable because many prisoners smoked. Gold was valuable because it was used for jewellery and ornamentation, aside from the fact that it was minted into coins.

In 1776, when Adam Smith wrote The Wealth of Nations, there was widespread use of paper money in addition to gold or silver coins. Unlike modern dollar bills, however, this paper money consisted of notes issued by privately owned banks, which promised to exchange their notes for gold or silver coins on demand. So the paper currency that initially replaced commodity money was commodity-backed money, a medium of exchange with no intrinsic value whose ultimate value was guaranteed by a promise that it could always be converted into valuable goods on demand.

The big advantage of commodity-backed money over simple commodity money, like gold and silver coins, was that it tied up fewer valuable resources. Although a note-issuing bank still had to keep some gold and silver on hand, it had to keep only enough to satisfy demands for redemption of its notes. And it could rely on the fact that on a normal day only a fraction of its paper notes would be redeemed. So the bank needed to keep only a portion of the total value of its notes in circulation in the form of gold and silver in its vaults. It could lend out the remaining gold and silver to those who wished to use it. This allowed society to use the remaining gold and silver for other purposes, all with no loss in the ability to achieve gains from trade.

In a famous passage in The Wealth of Nations, Adam Smith described paper money as a “waggon-way through the air.” Smith was making an analogy between money and an imaginary highway that did not absorb valuable land beneath it. An actual highway provides a useful service but at a cost: land that could be used to grow crops is instead paved over. If the highway could be built through the air, it wouldn’t destroy useful land. As Smith understood, when banks replaced gold and silver money with paper notes, they accomplished a similar feat: they reduced the amount of real resources used by society to provide the functions of money.

At this point you may ask: why make any use at all of gold and silver in the monetary system, even to back paper money? In fact, today’s monetary system goes even further than the system Smith admired, having eliminated any role for gold and silver. A Canadian dollar bill isn’t commodity money, and it isn’t even commodity-backed. Rather, its value arises entirely from the fact that it is generally accepted as a means of payment, a role that is ultimately decreed by the Canadian government. Money whose value derives entirely from its official status as a means of exchange is known as fiat money because it exists by government fiat, a historical term for a policy declared by a ruler.

Fiat money has two major advantages over commodity-backed money. First, it is even more of a “waggon-way through the air”—creating it doesn’t use up any real resources beyond the paper it’s printed on. Second, the supply of money can be adjusted based on the needs of the economy, instead of being determined by the amount of gold and silver prospectors happen to discover.

Fiat money, though, poses some risks. In this chapter’s opening story, we described one such risk—counterfeiting. Counterfeiters usurp a privilege of the Canadian government, which has the sole legal right to print dollar bills. And the benefit that counterfeiters get by exchanging fake bills for real goods and services comes at the expense of the Canadian federal government, which covers a small but non-trivial part of its own expenses by issuing new currency to meet a growing demand for money. According to the RCMP, the estimated value of counterfeit banknotes passed in our economy reached about $2.6 million in 2011, up 0.5% from the 2010 estimates. The $20 bill was the most popular counterfeit paper note, followed by the $100 bill. About 85% of the counterfeit banknotes were passed in Quebec, Ontario, and British Columbia.

The larger risk is that governments that can create money whenever they feel like it will be tempted to abuse the privilege. In Chapter 16 we’ll learn how governments sometimes rely too heavily on printing money to pay their bills, leading to high inflation. In this chapter, however, we’ll stay focused on the question of what money is and how it is managed.

The Bank of Canada (an institution we’ll talk more about shortly) calculates the size of several monetary aggregates, overall measures of the money supply, which differ in how strictly money is defined. These aggregates are known, rather cryptically, as M1, M1+, M2, M2+, and M3. All of these monetary aggregates include currency in circulation and deposits at financial institutions, but each one includes different types of deposits and financial institutions. In general terms, an aggregate without a “+” sign includes only deposits held at chartered banks. An aggregate with a “+” sign includes the deposits at chartered banks plus the same type(s) of deposits at smaller financial institutions, such as trust companies, mortgage and loan companies, credit unions, and caisses populaires.¹

More specifically, M1, the narrowest definition, consists only of currency in circulation (cash) and all chequeable (or demand) deposits at chartered banks. As the name suggests, demand deposits are bank deposits that can be withdrawn on demand by, for instance, writing cheques against these accounts, debit transactions, online banking, and accessing ATMs. These deposits pay little or no interest. M1+, a broader definition, consists of M1 plus the demand deposits at trust companies, mortgage and loan companies, credit unions, and caisses populaires. M2, the next step up, includes M1 plus the personal term deposits, non-personal demand deposits, and notice deposits in chartered banks. M2+ includes M2 plus such deposits at trust companies, mortgage and loan companies, credit unions, and caisses populaires as well as life insurance company individual annuities, personal deposits at other financial institutions, and money market mutual funds. M3, one of the broadest definitions of money supply, includes M2 plus bank non-personal term deposits and chartered bank foreign currency deposits of residents. Occasionally the terms of these aggregates may be adjusted, owing to a change in regulations or a merger between two financial institutions.

You may already have noticed that M1 and M1+ include only those assets we use for daily monetary transactions. These assets are the most liquid components of money, or the medium of exchange. However, as the definition of money widens, the monetary aggregates start to include what we call near-moneys. These financial assets cannot be used as a medium of exchange but can be converted into cash or chequing deposits readily. An example is a term deposit, which isn’t chequeable but can be withdrawn at any time before its maturity date by paying a penalty.

Figure 14-1 shows the actual composition of M1, M1+, M2, M2+, and M3 in Canada as of August 2012, in billions of dollars. M1 was valued at about $599.5 billion, with currency in circulation accounting for about 10% and demand deposits accounting for the remainder. In turn, M2 was valued at $1128.3 billion, with M1 accounting for 53%, and savings deposits, non-personal notice deposits, and demand deposits accounting for the remainder. M2+ was valued at about $1489.1 billion, of which M2 represented about 75%. M3 was valued at about $1583.6, of which M2 represented about 71%. The portions of M2+ and M3 that do not include M2 include different types of near-moneys. These near-moneys typically pay higher interest than chequeable bank deposits do.