How is it Measured?

Sure, money is the $10 bill you lent to your friend the other day and don't expect back anytime soon. But exactly how much money is out there and what forms does it take? Economists and investors ask this question everyday to see whether there is inflation or deflation. To make money more discernible for measurement purposes, they have separated it into three categories:

• M1 – This category of money includes all physical denominations of coins and currency, demand deposits, which are checking accounts and NOW accounts, and travelers' checks. This category of money is the narrowest of the three and can be better visualized as the money used to make payments.
  
• M2 – With broader criteria, this category adds all the money found in M1 to all time-related deposits, savings deposits, and non-institutional money-market funds. This category represents money that can be readily transferred into cash.
  
• M3 – The broadest class of money, M3 combines all money found in the M2 definition and adds to it all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.

By adding these three categories together, we arrive at a country's money supply, or total amount of money within an economy.

How Money is Created
Now that we've discussed why and how money, a representation of perceived value, is created in the economy, we need to touch on how the central bank (the Federal Reserve in the U.S.) can manipulate the money supply.

Among other things, a central bank has the ability to influence the level of a country's money supply. Let's look at a simplified example of how this is done. If it wants to increase the amount of money in circulation, the central bank can, of course, simply print it, but as we learned, the physical bills are only a small part of the money supply.

Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market. When the central bank buys these government securities, it puts money in the hands of the public. How does a central bank such as the Federal Reserve pay for this? As strange as it sounds, they simply create the money out of thin air and transfer it to those people selling the securities! To shrink the money supply, the central bank does the opposite and sells government securities. The money with which the buyer pays the central bank is essentially taken out of circulation. Keep in mind that we are generalizing in this example to keep things simple. (For more information, see the Federal (the Fed) Reserve Tutorial.)

Conclusion
Remember, as long as people have faith in the currency, a central bank can issue more of it. But if the Fed issues too much money, the value will go down, as with anything that has a higher supply than demand. So even though technically it can create money "out of thin air," the central bank cannot simply print money as it wants.

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What is Money Actually?

Before the development of a medium of exchange, people would barter to obtain the goods and services they needed. This is basically how it worked: two individuals each possessing a commodity the other wanted or needed would enter into an agreement to trade their goods.

This early form of barter, however, does not provide the transferability and divisibility that makes trading efficient. For instance, if you have cows but need bananas, you must find someone who not only has bananas but also the desire for meat. What if you find someone who has the need for meat but no bananas and can only offer you bunnies? To get your meat, he or she must find someone who has bananas and wants bunnies ...

The lack of transferability of bartering for goods, as you can see, is tiring, confusing and inefficient. But that is not where the problems end: even if you find someone with whom to trade meat for bananas, you may not think a bunch of them is worth a whole cow. You would then have to devise a way to divide your cow (a messy business) and determine how many bananas you are willing to take for certain parts of your cow. (It can be hard to talk about money with your children, especially when times are tough. Talking About Money When Times Are Tough has some tips to make it easy.)

To solve these problems came commodity money, which is a kind of currency based on the value of an underlying commodity. Colonialists, for example, used beaver pelts and dried corn as currency for transactions. These kinds of commodities were chosen for a number of reasons. They were widely desired and therefore valuable, but they were also durable, portable and easily stored.

Another example of commodity money is the U.S. currency before 1971, which was backed by gold. Foreign governments were able to take their U.S. currency and exchange it for gold with the U.S. Federal Reserve. If we think about this relationship between money and gold, we can gain some insight into how money gains its value: like the beaver pelts and dried corn, gold is valuable purely because people want it.

It is not necessarily useful - after all, you can't eat it, and it won't keep you warm at night, but the majority of people think it is beautiful, and they know others think it is beautiful. Gold is something you can safely believe is valuable. Before 1971, gold therefore served as a physical token of what is valuable based on people's perception. (You don't need an MBA to learn how to save money and invest in your future. Follow 8 Financial Tips For Young Adults, to find out more.)

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Importance of Money

A great philosopher once said "Money is a barrier against all possible evils." Let's explore and expand on this thought.

Money can prevent the sufferings that come with poverty like cold and hunger. While sickness can not be totally obliterated by money, it can be considerably relieved by it. Generating wealth and Giving away money to charity can also provide us with the satisfaction of relieving others from suffering.

With money, we can obtain an advanced education that may aid us in the development of genius and extraordinary achievements. It gives us the leisure to devote a part of our time to culture and art. Money can provide a powerful diversion for all or our troubles by permitting distraction from societys anxieties that assail us.

So we must try to get a thorough understanding of all that we may possibly do, in an honorable and legitimate way, to conserve wealth. Even to those who have inherited wealth, idleness can be a certain cause of ruin. A great fortune needs genuine labor for efficient administration. Those who leave this duty to strangers may pay a penalty for their negligence. This is why a rich man, who wants to create wealth, preserve and increase his fortune, should be his own business manager.

Even artists must know the price that their work is worth. It is necessary for the artist to be a businessman in order to have the right to be a genius. History is full of example of this. The great Shakespeare labored as a theatre manager to obtain the necessary leisure to produce his dramatic masterpieces. Edison worked as a telegraph operator to pay the bills while he "moonlighted" as an inventor.

From the bottom to the top of the ladder, it is necessary to amass money in order to apply it to some great cause. Money is the means by which we may fulfill our purpose in a larger and better way.

Everyone should, in his own way, make an effort to amass some money. Some will apply money to their daily wants. Others seek to swell the fortune that they desire to leave to their children. Some only desire money so they can devote it to some noble enterprise or charity. Finally, a large number see money chiefly as a means of immediate gratification.

Whatever the reason, everyone capable of earning money should learn how to manage it properly in order to ensure that they will have enough of it to apply to the causes that they choose.