Money and currency are often used interchangeably. But they are not the same. The primary difference is a modern currency doesn’t have intrinsic value. A fiat currency’s worth is derived from government decree (fiat). Money, on the other hand, has some intrinsic value as it grows in value. We’ll start with a basic understanding of currency and money. Then we discuss their differences.
Currency
Currency, or Fiat Currency, is usually government-issued form of payment. It’s usually only valid within the jurisdiction of that government. As pointed out in Mike Maloney’s informative video on Money vs Currency (25 minutes), a fiat currency is unlikely to last forever. The Zimbabwean Dollar is a recent example of how a currency can become worthless. A less severe example from another part of the world was India’s demonetization. It rendered 86% of the country’s currency invalid overnight.
The authority issuing the currency has full control over it. Therefore, the confidence and trust in that authority is tied to the worth of a currency.
Properties of Currency
- A medium of exchange.
- A unit of account.
- Portable. You can easily move it around in physical or electronic forms.
- Durable. Paper used to print modern currencies is durable and lasts a long time. Electronic records last forever until they are destroyed.
- Divisible. Modern currencies are easy to divide, even in a physical form. So, it is easy to pay small amounts for a small purchase. In an electronic form, you can divide a currency to your heart’s content.
- Fungible (interchangeable). It’s a property that makes each unit of the currency interchangeable. A unit of currency is identical in value to any other unit of the same denomination. For example, one US dollar bill is considered equal and exchangeable with any other US dollar bill. The physical condition of the bill or the year it was printed are irrelevant. Fungibility allows for the seamless exchange of money in everyday transactions without the need to assess the value of each individual unit. Imagine using apples as currency. They aren’t fungible because you would have to evaluate each apple individually. Even then, it’s only a matter of days before you would have to reevaluate it again as they ripen and eventually rot.
Money
Money shares all the properties of a currency. It’s a medium of exchange, a unit of account, portable, divisible, and fungible. In addition, crucially, it is also a store of value. This characteristic sets it apart from a currency. This means it can retain its worth over time, allowing individuals to save and retrieve value in the future. Currency, in contrast, may not hold its value over time, especially in cases of inflation or economic instability.
Currency vs Money
Most people implicitly understand that currency doesn’t hold value over time. So, we don’t hold large amounts of currency. We also implicitly understand that paper bills such as a Dollar or a Euro or a Rupee are currency. But what is money? What do you hold if you want to hold money? Let’s look at a few examples and evaluate their ability to hold value against inflation.
- Paper money such as units of Dollar, Pound, Euro, Yen, Dinar, Peso, and Rupee are currency. The longer you hold on to these, the less buying power they retain. That’s assuming the unit remains legal tender.
- Online Payment systems such as PayPal, Alipay, WeChat Pay, Google Pay, and Apple Pay hold your funds to facilitate payments. Think of them as a convenient form of currency. You can include debit cards in this category.
- Checking accounts are currency. They are also known as demand deposits because funds can be withdrawn instantly “on demand”. Such accounts yield little or no interest, so funds left in such accounts don’t keep up with inflation. Use them to hold funds meant to pay your bills and other such regular expenses.
- Savings accounts are a step up from checking accounts. They are designed to encourage savings. Banks may impose limits on how much and how often funds may be withdrawn from such accounts. They pay a little more interest than checking accounts. This is a better place to park funds needed on short notice, but not likely to be accessed frequently. A good example is a few weeks’ worth of living expenses. Or some cash reserves in case the checking account is overdrawn unexpectedly. Many banks link these two types of accounts, so an overdrawn checking account automatically triggers a transfer from the linked savings account.
- Money market accounts are a step up from a savings account, paying higher interest rates while preserving some ability to withdraw funds on demand. Use them to hold emergency funds or funds earmarked for a specific purpose such as down payment for a car or a home.
- Certificates of Deposit (CD), or fixed deposits, tend to offer higher rates but are tied up until a specific maturity date. They can be accessed before the maturity date by paying a small penalty. They are a good place to hold some emergency funds that you might need after a few weeks. For instance, if you have three months of living expenses in your emergency fund, the first month may be in a savings account and the remaining in a CD. In the unlikely event that your emergency needs extend beyond a month you can pay a small penalty and interrupt the CD.
- Government Bonds are issued by a government (duh) and, like a CD, have a maturity date. They are generally considered safe. Mind you, safety is a relative term when you compare different governments around the world. Governments borrow money to fund their various spending programs. They also have the power to tax. Taxes thus raised are used to pay back the borrowed funds, with the originally promised interest. So, how safe a government bond is dependent on its ability to collect sufficient taxes to pay back the loan. You may park some of your savings in government bonds. They are generally part of an investment portfolio designed to hold the conservative portion of that portfolio. These holdings are designed to offer a steady return; something you can count on.
- Private Bonds are bonds issued by non-government entities. A bond is a promise to repay a loan, so buying a bond implies you are lending to a borrower. You may be lending funds to a corporation via a corporate bond or to a foreign government via a sovereign bond. The rate of return depends on the credit worthiness of the borrower. Other than that, this is the same as buying a government bond. In practice, the key here is the ability to assess the credit worthiness of the borrower. Given the time and effort that goes into such an evaluation, it is better left to dedicated professionals. Even they can’t always get it right, so they often lump several such opportunities into one portfolio.
The specifics vary quite a bit depending on which currency, what form of money, and what timeframe you are looking at. Just remember that a currency tends to lose value to inflation while a carefully chosen form of money tends to hold up better against inflation.
Risk and Return
Currency carries two primary risks with it. First, it is issued by a government, who has full control over it. It can do whatever it chooses to, such as canceling some denominations overnight. Second, it fails to keep up with inflation.
The various forms of money we discussed above are designed to yield a return, which hopefully will keep up with inflation. The first risk with money is that it may not be able to keep up with inflation. For example, a government bond yielding 5% per year maturing in 5 years only works if inflation is below 5% during that period. The second risk is the potential loss of principal. Any entity that borrows your funds must find a way to return your funds with interest at the end of the term.
A government is in a unique position to levy taxes. That makes them a relatively safer borrower. Governments tend to be around for a long time, so they have a reputation to live up to. So, lending to a government generally carries lower risk.
It’s a bit different with non-government entities, such as corporations and individuals. Their ability to repay your loan depends on their assets and their future cash flows. If all goes well, you get your money back. If it doesn’t, they must find a way to keep the promise they made to you. The risk is generally higher when you are trying to generate a return by lending to a non-government entity. Returns tend to be higher, but so is the risk.
Lastly, an equally important risk to be aware of is the financial institution holding your funds. Every financial institution is lending or investing your funds (deposits) to someone else. They are making assumptions based on their assessment of economic conditions and opportunities. Despite our best efforts to measure and predict it, the world is unpredictable. Understand what risks you are taking. Understand the protections and insurance available to help protect your savings.
In the United States, the FDIC program is designed to protect your deposits in a bank. Other countries have similar schemes in place, but coverages and policies vary widely. Most aren’t as generous as the FDIC coverage offered in the USA.
Are Gold, Bitcoin etc. Money?
Gold was used in the past as currency, but they no longer play that role in the modern financial system. As money, where the ability to keep up with inflation is paramount, gold has not been reliable in shorter time frames.
We’ll discuss this topic in more detail in a separate post.
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Very well written. Easy to read and understand. Thank you.