Money as a means of exchange

Two stone figures are exhcnaging various forms of payments in form of a 100 Euro note and some gold nuggets

We all use money in different forms and for different purposes. Money plays an essential role in the economy.

Read on to learn more about how money evolved, what forms of money there are and what influences its exchange value.

The history of money

Money has many functions in the economy. We can use it in exchange for a wide range of goods and services. We can also use it to compare the value of different goods and services by looking at their prices. And we can use it to save up for future needs or expenses or to build up capital.

But how did money evolve? People began to trade and exchange goods and services very early in the history of mankind. Before they had money, they traded goods for other goods: grain for wood, meat for a plow or a knife for a pelt. Or they traded goods for services and vice versa. But this type of barter trade quickly reaches its limits. Let’s imagine a self-catering village in the early days. If somebody produced more grain than they could use themselves, they could only trade it for some other good that was produced in their village. And they would have to find someone in the village who needed their grain and was willing to trade it for something the farmer needed. Moreover, for the trade to be fair, the traded goods would have to have about the same value.

People realized very early on that to cope with such situations, they needed a means of exchange that would make trading easier – the idea of money was born. Money is basically any means of exchange or payment that is recognized in a society. As a means of exchange, money had to have specific properties. It had to be easy to divide, durable, easy to store and rare. Objects that had these properties and were available in the early periods of human history were e.g. amber, shells, metals (metallic money), spices and salt.

Around 2,700 years ago, in 650 BCE, the first coins evolved in the kingdom of Lydia in modern-day Turkey. They bore the ruler’s stamp which guaranteed that the metals used were genuine. These coins came in different sizes (weights) and metals, so the money was easy to divide. The rulers of ancient Greece and Rome took up this revolutionary idea and soon had their own coins minted. For more than a thousand years, coin money dominated trade across the world. And to this day, coins made of precious metals (e.g. gold) continue to be used as a store of value. The first banknotes, in contrast, were printed around 1,000 years ago in China, and Europe only began using banknotes in the early 17th century. With trade becoming more and more international and extending to more and more countries and regions, paper money had the advantage of being lighter and easier to transport than coins. Unlike coined money, whose metallic value guarantees a certain material value, paper money only relies on trust and the social consensus that it can be traded for goods.

Modern forms of money

Banknotes and coins continue to be important means of payment to this day. They are referred to as cash. In the 20th century, additional new forms of money have developed that are no longer material (tangible) but only exist in digital form. If a person transfers money from their bank account, this does not involve a physical transfer of money. It just means that the amount is credited to another bank account. Money that only exists digitally on bank accounts is called bank money. Nowadays, bank money accounts for most of the money stock. If we withdraw money from an ATM, we exchange bank money for cash.

Austria and many other European countries use the euro as their legal tender. The initial euro area countries first introduced the euro in 1999 as bank money that was only used for accounting purposes; euro banknotes and coins began to be issued in 2002. Today, 20 of 27 European Union (EU) member states use the euro as their official currency. An official currency like the euro has the advantage of being clearly regulated by law and managed by a central bank. A central bank is a public institution that is in charge of supplying a country or currency area with money. In cooperation with the national central banks of the euro area countries, the European Central Bank (ECB) fulfills this role for the euro area.

The euro area and its member states

Today, there are a number of payment instruments you can use for making cashless payments: credit cards, prepaid cards or mobile payment services like from known tech companies that are linked to your credit card and that you can use to make payments from smart devices (smartphone, smartwatch). These payment instruments use electronic money. When using these forms of payment, you typically either pay an amount in advance or you will be charged with the amount at a later date. If you pay with your credit card, for instance, the amount will not be debited to your account immediately but only at the end of the month or some specified later date.

A new form of “currency” is cryptoassets, which is mainly used as a store of value or for speculation. Cryptoassets is rarely used as a means of payment. Unlike legal currencies managed by a central bank, cryptocurrencies are created through digital calculations. This means cryptocurrencies are neither legal tender nor managed by the monetary authorities. The technology most often used in creating cryptoassets is blockchains. A prominent example of a cryptoassets is bitcoin. The value of a cryptoassets exclusively results from the fact that people have confidence in its value and exchange other currencies for it. As cryptocurrencies are not regulated by the state, they have many disadvantages when compared to legal tender. And because cryptocurrencies are mainly used as a store of value, their value may fluctuate strongly when market conditions change. Moreover, cryptocurrencies are very rarely accepted as a means of payment. Contracts based on cryptoassets as a means of payment involve a far higher degree of uncertainty than those based on state-regulated currencies like the euro.

See below for an overview of early and modern forms of money.

Early forms of money

Commodity money

The first forms of money were rare, easy-to-handle and durable objects like shells or metals.

Coined money

Unlike other metallic money, coins were officially stamped to indicate that their value was guaranteed.

Paper money

When coins proved to be too heavy to be used in great quantities in trade, paper money was invented. That was around 1,000 years ago.

Modern forms of money

Cash

Banknotes and coins are referred to as cash. The metallic value of modern coins is significantly lower that their face value.

Bank money

Money on bank accounts is called bank money. Bank money is not tangible; it only exists in digital form.

Electronic money

Today, it is possible to transfer money to payment cards or to your smartphone to make payments. These payment instruments use electronic money.

Possible future forms of money

The digital euro – a means of payment for the future?

Electronic and mobile payments are becoming more and more frequent even if we continue to pay with cash. Cash (banknotes and coins) is central bank money. In the euro area, central bank money is created by the euro area central banks.

But what exactly is central bank money?

At present, banknotes and coins are the only forms of central bank money that are generally available as legal tender. As central bank money is created by public institutions, it is also referred to as “public money.” Within the Eurosystem, the public institutions responsible for creating central bank money are the central banks of those EU countries whose official currency is the euro.

There is not only public money, however. There is also private money. Private money is created by commercial banks, mainly by means of extending loans to borrowers. Bank deposits and money in savings accounts are also considered private money. All payments made with debit cards, credit cards or via online payment services are private money transfers. They use private money created or managed by commercial banks. People have confidence in this money because it can be exchanged for central bank money on a 1:1 basis.

Central banks around the world are working to combine the advantages of central bank money with the ease and comfort of modern forms of payment. Providing public money in electronic form (e.g. a digital euro) could be one possible solution.

But why would we need a digital euro when there already are other electronic means of payment?

Because at the time being, there is no digital single currency that is accepted across the euro area. While we have been able to make physical payments with the single currency (euro cash) for more than 20 years, we still cannot make digital payments in central bank money. The digital euro could be a digital form of central bank money. The digital euro would complement euro cash. It would be issued by the ECB, and the ECB would guarantee that it can always be exchanged for euro cash on a 1:1 basis. With payments increasingly going digital and more and more people using digital means of payment on a daily basis, the ECB aims to ensure that people can pay with central bank money also in a digital environment.

In July 2021, the ECB therefore started an investigation phase for a digital euro, which ended in the fall of 2023. After that, the ECB decided to start a preparation phase of about two years that will also include testing. This phase will lay the foundations for a potential digital euro. This does not automatically mean, however, that the digital euro will actually be introduced.

What would be the advantages of a digital euro?

European infrastructure

With the digital euro, Europe would be less dependent on payment service providers from outside the euro area and the European economy would be more resilient. Currently, more than 80% of all electronic retail payments in Austria are processed by only two payment service providers from outside the EU.

Single payment solution for the euro area

At present, there is no single European digital payment option that works in all euro area countries. In 13 out of 20 Euro area countries, card payments can only be made using international payment card schemes. A digital euro would be a European electronic means of payment that could be used in all euro area countries.

European infrastructure

With the digital euro, Europe would be less dependent on payment service providers from outside the euro area and the European economy would be more resilient.

Noncash central bank money payment solution

A digital euro could be used for payments that can currently not be made in central bank money, e.g. when shopping online or making electronic payments between private individuals.

Privacy protection

Offline payments in digital euro would offer a level of privacy similar to cash payments. Personal transaction data would only be known to the payer and the payee. Upper limits on payments would be in place to prevent illegal activities. Online payments could also be made without disclosing personal data (unless disclosure is legally required to prevent illegal activities).

Inclusive payment solution

The digital euro would be accessible to everyone living in the euro area. People without bank accounts, for instance, could use a free ECB app or a free payment card.

Who would pay the costs of implementing the digital euro?

The Eurosystem would pay for implementing the digital euro system and infrastructure, just like it pays for producing and issuing euro banknotes. Whether the digital euro will be introduced and how it could be implemented will be discussed in detail in the coming years. To ensure that paying with the digital euro will offer a similar level of anonymity as paying with cash, work on an offline payment option for smaller amounts is underway. Please see the ECB and OeNB websites for current information on the digital euro project.

The exchange value of money

There are many different forms of money, but they all have a number of common features: They are generally accepted, easy to handle, easy to divide and rare. The main difference between earlier forms of money and modern money is that the value of modern money no longer depends on its material value. Modern coins, for example, are made of relatively cheap metals such as copper, tin, brass or nickel. And while producing a EUR 2 coin costs 20 cent, producing a EUR 10 banknote costs no more than about 10 cent. This could make you wonder why money is still valuable at all.

If the value of money is not ensured by the use of rare raw materials, then it must be ensured by the state. In modern economies, the central bank is responsible for providing sufficient money to the economy. Currencies managed by central banks, like the euro or the US dollar, are also referred to as fiat currencies or fiat money. Unlike with commodity money, the value and importance of fiat currencies relies on the fact that they are the official currencies of a country and that their guaranteed value does not depend on their material value or the gold reserves of the responsible central bank. There are various ways for central banks to put money into circulation or take it out of circulation. To keep the value of money stable, there should be neither too much nor too little money in circulation. The money stock should correspond to the quantity of goods and services traded in the economic cycle. Let’s do a quick thought experiment:

Example

Imagine you live in a small community on an isolated Pacific island. The island has a currency of its own so that coconuts can be traded. This year (year 1), a total of 100 coconuts are for sale. And there are 1,000 currency units. We can calculate the price of one coconut by using a simple equation: We equate the available quantity of goods (100 coconuts) with the available quantity of currency units (1,000): 100 coconuts = 1,000 currency units. To find the price of 1 coconut, we divide both terms by 100. 1 coconut therefore costs 10 currency units (1,000 currency units / 100).

How the quantities of currency units and goods are related becomes clear when we change either quantity.

Case 1: Let’s assume that in year 2, the coconut harvest is only half as good as in year 1 (only 50 coconuts), while the quantity of currency units remains the same. So our equation is 50 coconuts = 1,000 currency units. This means that 1 coconut will cost 20 currency units (1,000 currency units / 50). So the price of 1 coconut has doubled while the currency’s exchange value has decreased.

Case 2: Let’s assume that in year 2, the coconut harvest is the same as in year 1 (100 coconuts), while the island community decides to halve the quantity of currency units. Our equation is thus 100 coconuts = 500 currency units. This means that 1 coconut will cost 5 currency units (500 currency units / 100). So the price of 1 coconut has decreased while the currency’s exchange value has increased.

Case 3: There are 100 coconuts like in case 2, but the quantity of currency units has doubled to 2,000. Our equation is now 100 coconuts = 2,000 currency units. This means that 1 coconut will cost 20 currency units (2,000 currency units / 100). The price per coconut has gone up because the quantity of currency units has risen while that of coconuts has remained stable. The currency’s exchange value has decreased.

Case 4: Let’s assume that in year 2, the coconut harvest is only half as good as in year 1 (50 coconuts), but the island community decides to halve the quantity of currency units (500 currency units). The resulting equation is 50 coconuts = 500 currency units. This means 1 coconut will cost 10 currency units (500 currency units / 50) and the price will be the same as in year 1.

Overview of cases 1 to 4
Kokosnüsse (pieces) Currency unit (CU) Price for 1 coconut Price Exchange value
Initial situation 100 pieces 1,000 CU 10 CU
Case 1: Fewer goods 50 pieces 1,000 CU 20 CU increases decreases
Case 2: Fewer currency units 100 pieces 500 CU 5 CU decreases increases
Case 3: Doubling of currency units 100 pieces 2,000 CU 20 CU increases decreases
Case 4: Fewer good and fewer currency units 50 pieces 500 CU 10 CU unchanged unchanged

Of course an island as described above does not exist. In our globalized and interconnected world, we can choose from countless goods and services, both from Austria and abroad, that can be exchanged for money – not just coconuts. Nevertheless, the above example helps illustrate a key point: The price level always depends on the ratio between the quantity of goods and the quantity of money available in an economic area. This ratio is also referred to as the currency’s purchasing power. Both a change in the quantity of goods and a change in the quantity of money can cause a change in the exchange value of money or its purchasing power.

Central banks can hardly influence the quantity of goods in an economy, but they can influence the quantity of money put into circulation. So central banks take care to regularly adjust the quantity of money in circulation to the quantity of goods available in their currency area, for example by buying securities to inject money into the economy. This ensures that there is an adequate amount of money in circulation and the currency keeps its exchange value. For an economy to function, it is essential that people have confidence in the state and the central bank (see Money and its value (inflation) for more information on price stability and the role of central banks, see here in chapter The value of money and inflation).

A brief recap

What is money?

Money is a means of exchange that serves to facilitate the exchange of goods and services between economic agents.

What functions does money fulfill in our economy?

Money is a means of payment – you can pay with it. Money serves as a store of value – you can use it to make savings. And money is a measure of value – it helps you compare prices.

How did money evolve?

People have been exchanging goods and services for thousands of years; in general, they used valuable, durable and easy-to-divide items as a medium of exchange. Coins and later banknotes began to be used because they were lighter and easier to transport than earlier forms of money. In our modern economy, we primarily use bank money alongside cash.

What forms of money are there today?

We basically distinguish between cash and bank money. Cash is banknotes and coins, and bank money is money on bank accounts that we have access to.

What determines the exchange value of money?

The exchange value of money depends on how many goods we can by for a certain amount of money. When prices go up, we can buy less for the same amount of money. This means the currency’s exchange value decreases.

Back to top