Economics isn't all about money, but money makes economists of us all. Ask someone to pay a price for something -- as opposed to offering it for free, or for a favor -- and you'll flick an invisible switch inside them.
Behavioral economist Dan Ariely used an experiment to prove this. He offered students a piece of Starbucks candy at a cost of 1 cent each. On average they took four pieces. Then he changed the price to zero -- free. Traditional economics would assume that, with the price lower, demand would increase, but no. Once money had been taken out of the equation, something strange happened. Almost none of the students took more than one piece each.

Money Makes the World Go Round

Money is one of the key elements in an economy. Without it, we would be forced to barter, i.e. exchange goods or offer someone a favor or a service in order to pay for something. Just as communication becomes far easier when both participants in a conversation have a common language, as opposed to relying on gestures and noises, so money provides a simple medium of exchange without which every transaction simply becomes unbearably complicated.

In countries where people lose faith in money -- perhaps because of hyperinflation -- they often resort to a barter economy. When the Soviet Union was collapsing in the late 1980s many started to use cigarettes as currency. However, barter economies are highly inefficient -- imagine having to come up with a different compelling offer of services or goods every time you wanted to visit the shops. You might as well stay at home.

In addition to this primary function as a medium of exchange, money has two other purposes. First, it is a unit of account, meaning it is a yardstick against which things can be priced, helping us to judge the value of something. Second, it is a store of value, meaning it will not lose its worth over time -- though it is debatable whether modern paper currencies fulfill this function. We are all familiar with what constitutes money -- whether it be dollar bills, pound coins, euro cents or other types of currency -- but technically any kind of tradable unit can be treated as money: for example, shells, jewelery, cigarettes and drugs (the last two often serve as money in prisons). And, more than ever before, money today constitutes invisible flows of credit -- borrowed money -- between lenders and borrowers.

Types of Money

It is possible to distinguish between two major categories of money:

Commodity Money
This has intrinsic value, even though it is not actually a form of money. Gold is perhaps the most obvious example, since it can be used to make jewelery and is a key metal for use in industry. Other types of commodity money include silver, copper, foods (like rice and peppercorns), alcohol, cigarettes and drugs.

Fiat Money
This is money without intrinsic value. From the Latin 'let it be', it simply means that a government has decreed that coins and notes of negligible intrinsic value are legally worth a certain amount. This is the system in place in modem advanced economies. Dollar bills are issued by the Federal Reserve and the US Treasury, and £5, £10 and £20 notes (and so on) are issued by the Bank of England. Originally, paper money was convertible into commodity money, so that, technically, citizens could demand a certain amount of gold in exchange for their dollar bills.

However, since August 15, 1971, following an order from President Nixon, convertibility stopped and the dollar became a pure fiat currency. Fiat currencies are reliant for their stability on people's faith in the country's legal system and in the government's economic credibility.

Measuring Money

Measuring how much money is flowing round an economy is one of the key ways to determine that economy's health. When people have more money, they feel wealthier and tend to spend more, while businesses respond to their increased sales by ordering more raw materials and raising production. This in turn pushes up share prices and economic growth.

Central banks measure money in various ways. The most popular is what the Federal Reserve calls M1. This measures the amount of currency in circulation outside banks and the amount of funds people have left in their bank accounts. In other words, M1 represents how much cash people have readily available. There are also other, broader measures of money: M2, which includes less liquid (readily accessible) assets such as savings accounts that require notice for withdrawals; and M3, which covers financial instruments regarded by many as close substitutes for money, such as long-term savings and money-market funds. For some reason, in the UK the Bank of England's equivalent of M3 is called M4.

At the turn of the millennium, there was around $580 billion worth of US dollars floating around, while there was a further $599 billion sitting in people's instant-access bank accounts. If you divide the amount of currency by every US adult -- 212 million -- this implies that each adult holds around $2,736 of currency, which is clearly more than most people hold in their wallets. The reason the apparent per capita share is so high is partly because much of the money is actually held overseas, since dollars are used as currency in many countries other than the US, and partly because some people -- for example criminals, including those who work in the black market -- prefer to keep their money in cash rather than putting it in a bank account.

Money is more than merely currency. It is more, even, than the stock of currency in circulation and in people's bank accounts. It is also a state of mind. The paper notes and brass and nickel coins we carry around in our pockets are worth only a fraction of the amount they denominate -- and the electronic transfer of cash from one bank account to another has even less intrinsic value. Which is why money must be backed up by trust -- trust both that the payer is good for his cash and that the government will ensure the money is worth something in the future.