Throughout history and around the world, money has taken diverse forms – from cowries, copper ingots, rum and gold coins in the past to coloured pieces of paper or polymers and digital bank records today. In Australia’s own history, a variety of tokens of exchange have been used as money. What connects these different forms of money are not their physical properties but the functions they perform: each in its era was relied upon as a reliable way to pay or be paid, as a way to quote prices and as a way to store value over time. In other words, they were:
A widely accepted means of payment
A unit of account
A store of value.
These three characteristics are really the standard definition of what makes something ‘money’.
The material or object used as money does not necessarily have any value in itself. What is money? Some forms of money have this feature (e.g. gold coins, copper ingots), while others do not (e.g. paper banknotes). Rather, money derives its value from the trust people have in it. However, history has shown that this trust can be lost if mismanaged. For example, if too much paper currency is printed and issued, the value of the currency will fall; i.e. high inflation will result. In fact, hyperinflation can result. This has happened several times in history, including in Zimbabwe in the late 2000s, which resulted in the population abandoning the Zimbabwean dollar and switching to other more stable currencies such as the US dollar.
Maintaining a stable currency and avoiding high inflation is actually one of the main functions of central banks. Indeed, the Reserve Bank Act 1959, which established the Reserve Bank, explicitly highlighted ‘stability of the currency’ as one of the three objectives of the Reserve Bank Board (the other objectives being full employment, and the economic prosperity and welfare of the people of Australia).
When the colony of New South Wales was founded in 1788, the colonists relied on barter and rum (spirits) as a temporary currency. In 1792, a consignment of Spanish dollars was sent to Australia for use as currency alongside other international currencies that were used in the colony at the time. To overcome persistent coin shortages, new forms of currency were developed over the following decades. These included Governor Macquarie’s creation of hole-in-the-wall dollars and dumps (which made two coins from one), the use of promissory notes or IOUs, and copper tokens issued by businesses. The IOUs and copper tokens proved an unreliable source of currency, partly because they had no official guarantee.
In 1825, the British government legislated for a sterling currency for the colony, which remained the basis of Australian currency until the change to decimal currency, the Australian dollar, in 1966. Australia’s first gold coins were minted in the year of 1855. The gold rush spurred the growth of banking and commercial banks issued banknotes backed by gold, although these banknotes did not constitute a national currency. Like many other countries of the time, Australia followed the gold standard and the total amount of notes that banks could issue was limited by their gold reserves. Under the gold standard, money was ‘backed’ by gold – countries agreed to convert paper money into a certain amount of gold. At the turn of the twentieth century, Australia’s currency remained a mixture of British coins, Australian coins and notes from private banks and the Queensland Government.
In the year of 1910, legislation for a national currency was enacted. The Australian Government issued ‘superscribed’ banknotes, whereby words were overprinted on notes purchased from private banks. These were the first currency notes to be accepted nationwide. The first true Australian banknote was produced in May 1913, with additional denominations being produced from 1913 to 1915.
Money has value because people trust that it has value today and will continue to have value in the future. But history shows that this trust is sometimes broken, so why do people continue to use money? The answer is that it is incredibly useful for facilitating trade, which has resulted in higher standards of living.
Trade allows people to specialise in the production of things they have a comparative advantage in. Even the most able person would struggle if they had to find food, build shelter and make clothing entirely on their own. However, if that person lives within a community, and can trade with others, each member of the community can specialise in one area – perhaps fishing, building houses or making clothing – and become very efficient at that task. By trading with each other, each member of the community will benefit from the specialist skills developed by other community members.
So what is the role of money then? It enables large-scale production and trade. If you live in a small village where you know and trust everyone, you might be willing to give some of the fish you caught today to others, knowing that when you need (for example) clothes, the tailor will give you something to wear. If you live in a big city where you don’t know or trust people well, you probably won’t give your fish to anyone, because you probably can’t trust, for example, that a tailor will give you new clothes if you ask later. Although you can try to solve this problem of lack of trust by bartering, bartering usually doesn’t work very well. For example, the tailor may not want your fish when you need new clothes – in fact, the tailor may never want the fish at all, nor will he have the specific clothes you need. However, with money, you can sell your fish to whoever you want to fish for, save some of the money they give you and take it to the tailor when you need clothes (or whomever you want to buy something from and whomever you need it from).
In short, money makes it possible to trade with people we may not know or trust, and trade makes a society richer. Trust is now placed on the value of money, not on everyone we want to buy or sell to.
Two main forms of money exist in modern economies:
Coins and banknotes (i.e. currency)
Deposits held in accounts with banks or other authorized deposit-taking institutions.
Currency is the tangible physical aspect of money and deposits held in accounts at financial institutions are the immaterial or intangible aspect of money, which is the bulk of the money operated by most modern economies. They are even more distinct from each other. Currency is backed by the central bank, which makes default non-issue, while deposit account balances are liabilities of privately owned financial institutions (deposits can be demanded back by the depositor) and as such, these institutions potentially default. However, while this risk has materialised in some countries, this risk is very low in Australia. (Well capitalised and regulated banks where depositors are paid first if a bank gets into trouble and there is a limited government guaranteed financial claims scheme for individuals holding household deposits of less than $250,000.)
Legal tender refers to a mode of payment recognized by the state, such that when it is offered by the debtor for payment of a debt, that debt will be considered discharged, i.e., the creditor cannot refuse the legal tender and, later, sue for that debt. As defined in the Reserve Bank Act 1959, banknotes are legal tender while by virtue of the Currency Act 1965, coins are also legal tender. Thus, a currency system in which a country’s currency is not backed by a physical commodity (e.g., gold) but is supported by government directives that make it legal tender is called fiat.
Banknotes are minted by the Reserve Bank of Australia and coins are minted by the Royal Australian Mint. Most of the value of physical currency is contained in banknotes, and we will focus on them in this explainer. Commercial banks are obliged to obtain banknotes from the Reserve Bank whenever required to meet the needs of their customers under agreed contracts. An increase in the value of banknotes in circulation, therefore, indicates an increase in the demand for cash by the general public.
From a money ‘creation’ perspective, deposits can also be created when financial intermediaries make loans. While the process of lending is central to the process of money creation, this does not mean that financial intermediaries are able to make loans and create money without limit. Deposit-taking institutions need to meet certain regulatory requirements and must be satisfied that borrowers can pay back their loans.
Deposits can also be created by the Reserve Bank, such as when the Reserve Bank buys government bonds (for more information, see explainer: How the Reserve Bank implements monetary policy). When the Reserve Bank buys government bonds from the non-bank private sector, households and businesses eventually deposit the sale proceeds into the banking system, which adds to the total deposits.
Bitcoin and other ‘cryptocurrencies’ meet some of the characteristics of money, but not all. Most notably, they can be used as a medium of exchange – some businesses and individuals will accept Bitcoin as payment, although the number of businesses willing to accept Bitcoin is low (i.e. it is not a widely accepted means of payment). On the other two characteristics of money – being a unit of account and a store of value – Bitcoin fails. Shops do not quote prices in Bitcoin; rather, shops that accept Bitcoin usually quote prices in the local currency and then convert to Bitcoin at the current exchange rate if someone wants to pay that way. They do this partly because the price of Bitcoin is very volatile, this volatility being one of the reasons why Bitcoin is a poor store of value.
While a single, stable form of money used by every country in the world would help people spend and save with confidence and plan for the future, it would also make it harder for individual economies to respond to economic shocks. By having their own unit of account (i.e. their own currency), countries have greater flexibility in economic management. They can choose to allow the value of their currency to fluctuate freely in response to economic events and to conduct their economic policies (particularly monetary policy) independently of other countries. As a result, individual countries (or groups of countries with similar economic characteristics, such as member countries of the euro zone) usually have their own currency.
Money came into being with the development of complex societies and its forms have changed many times. The only reliably optimistic prediction that can be made about money is that it will exist as long as people seek to trade with each other, and although its functions vary according to the role they play in sustaining economic activity.
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