1.3 Money, Income, and Wealth
OK, let’s talk more about money. Money is an asset that is generally accepted as payment for goods or services. Money is also an instrument that can be used to repay debt. For something to be considered money, it must have three characteristics:
Means of payment
Unit of account
Store of value
Let’s talk about each characteristic in more detail. What we mean by a means of payment is that money can be used to finalize any exchange between two people. Remember the earlier example where we talked about a wheat farmer needing meat and the rancher not needing wheat? A transaction between the two did not occur because a barter requires a double coincidence of wants or needs; both the wheat farmer must need meat and the rancher must need wheat in order for an exchange to take place. Money is typically superior to barter because it is easier to finalize payments. Money allows the wheat farmer to purchase meat from the rancher regardless of whether the rancher needs wheat. This is because the rancher can take the money made from the wheat farmer and use it to purchase any good or service the rancher needs. As the number of participants in the economy increases, money makes these transactions even smoother.
For money to have a unit of account, it must hold some standard value used to quote prices. For items with intrinsic value, such as gold, value is measured in weight. For a fiat money such as the U.S. dollar, the value is printed on the bill or coin and guaranteed by the U.S. Treasury Department (we will cover this in more detail later). By having a unit of account, money can provide necessary information to ensure the best allocation of resources. Money ensures the wheat farmer and the person purchasing the wheat both get a standard, fair value price for the exchange and makes the relative price comparisons clear.
The last characteristic of money is that it must store value. This means it is durable and capable of transferring purchasing power from one day to the next. For example, if you receive $20 for your old lawn mower, that $20 needs to exchange with anyone else in the economy for $20 today or in the future (ignoring inflation for now). Liquidity refers to how easily any asset can be converted into a means of payment without losing significant value. Cash is the most liquid asset. A $20 bill is extremely liquid; a house is not. Liquidity is needed for markets to function smoothly. The financial crisis of 2008 led to a sudden loss of liquidity, which led to the crash. Liquidity is a valuable resource that can disappear when it’s most needed.
The last two important terms for this section are income and wealth. Income refers to the flow of earnings over time, such as a paycheck. Wealth (also known as net worth), on the other hand, is the value of assets minus liabilities. Cash is considered a part of your wealth, as well as stocks, bonds, or other investments. It’s important to note that wealth is not the same as liquid cash.