In everyday conversation, people often use the word money to mean “wealth.” If you ask, “How much money does Mark Zuckerberg have?” the answer will be something like, “Oh, $30 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 check 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 checkable bank deposits—bank accounts on which people can write checks.

Are currency and checkable bank deposits the only assets that are considered money? It depends. As we’ll see later, there are two widely used definitions of the money supply, the total value of financial assets in the economy that are considered money. The narrower definition considers only the most liquid assets to be money: currency in circulation, traveler’s checks, and checkable bank deposits. The broader definition includes these three categories plus other assets that are “almost” checkable, such as savings account deposits that can be transferred into a checking account with a phone call or a mouse click. Both definitions of the money supply, however, make a distinction between those assets that can easily be used to purchase 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. 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 dollar in the United States, the peso in Mexico, 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 nonsmokers 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.

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 labor 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 pound of steak every day, whereas Ms. Jones wants you to clean her house just once a week but wants four pounds 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, cigarettes, which 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 jewelry and ornamentation, aside from the fact that it was minted into coins.

By 1776, the year in which the United States declared independence and Adam Smith published 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 private 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 U.S. 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 U.S. 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 U.S. 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 U.S. federal government, which covers a small but nontrivial part of its own expenses by issuing new currency to meet a growing demand for money.

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 Federal Reserve calculates the size of two monetary aggregates, overall measures of the money supply, which differ in how strictly money is defined. The two aggregates are known, rather cryptically, as M1 and M2. (There used to be a third aggregate named—you guessed it—M3, but in 2006 the Federal Reserve concluded that measuring it was no longer useful.)

M1, the narrowest definition, contains only currency in circulation (also known as cash), traveler’s checks, and checkable bank deposits. M2 adds several other kinds of assets, often referred to as near-moneys—financial assets that aren’t directly usable as a medium of exchange but can be readily converted into cash or checkable bank deposits, such as savings accounts. Examples are time deposits such as small-denomination CDs, which aren’t checkable but can be withdrawn at any time before their maturity date by paying a penalty. Because currency and checkable deposits are directly usable as a medium of exchange, M1 is the most liquid measure of money.

Figure 14-1 shows the actual composition of M1 and M2 in December 2013, in billions of dollars. M1 was valued at $2,639 billion, with about 44% accounted for by currency in circulation, almost all the rest accounted for by checkable bank deposits, and a tiny slice accounted for by traveler’s checks. In turn, M1 made up 24% of M2, valued at $10,969 billion. M2 consists of M1 plus other types of assets: two types of bank deposits, known as savings deposits and time deposits, both of which are considered noncheckable, plus money market funds, which are mutual funds that invest only in liquid assets and bear a close resemblance to bank deposits. These near-moneys pay interest, although cash (currency in circulation) does not, and they typically pay higher interest rates than any offered on checkable bank deposits.