What is money?

When people say "money" they usually mean one of three things, and each is a promise from a different institution.

• Cash. Australian banknotes are issued by the Reserve Bank of Australia (RBA) and count as its liability: something the RBA owes the holder. Coins are issued separately and are not an RBA liability.
• Bank deposits. The balance in your account is what your bank owes you. This is most of the money Australians use. In mid-2018 the public held about $74 billion in notes and coins, out of roughly $2.1 trillion of broad money: about 3.5 per cent.
• Settlement balances. Banks hold accounts at the RBA called exchange settlement accounts, and use the balances in them (often called reserves) to settle payments with each other. Households and ordinary businesses cannot hold them.

When you transfer $50 from your bank to a friend at a different bank, your deposit falls and your friend's rises. Behind the scenes, your bank pays your friend's bank by moving settlement balances at the RBA. The Australian Government's own payments and tax receipts run through these accounts too, which matters in Topic 2.

A balance sheet lists what someone owns (their assets) and what they owe (their liabilities). The idea that unlocks the rest of this site is simple: every financial asset is someone else's liability.

Suppose you have $1,000 in a savings account. On your balance sheet it is an asset, money you own. On your bank's balance sheet the same $1,000 is a liability, money it owes you. A $50 note in your wallet works the same way: an asset to you, a liability of the RBA.

That is why the Bank of England calls modern money an IOU, short for "I owe you". The question "what is money?" becomes "whose promise is it, and why do people trust it?" A promise from the RBA is accepted almost everywhere in Australia. A promise from a big bank is accepted nearly as widely, partly because the bank must turn it into cash on request. A promise from your neighbour is accepted only by people who know them.

Thinking in balance sheets also helps you check claims. If someone says money was "created", ask: whose asset went up, and whose liability went up with it?

How money began is a historical question, and there are three main theories. They rest on different evidence, and none is settled fact.

• Commodity theory. Adam Smith and later Carl Menger argued that money grew out of barter: traders came to accept the most widely wanted goods, such as metals, and these became money. This is the story most textbooks still tell.
• Credit theory. Alfred Mitchell-Innes, writing in 1913, argued that money began as records of debts, and that buying and selling create credits and debts measured in a unit of account.
• State theory, or chartalism. Georg Friedrich Knapp argued that money is whatever the state accepts in payment, especially for taxes and fines.

What does the evidence show? Anthropologists have not found a society that ran mainly on barter before money. The earliest Mesopotamian records, thousands of years older than coins, are accounts of goods and dues. The earliest known coins in the Mediterranean world appear in Lydia, in today's Turkey, in the seventh century BCE; China and India developed coinage independently within a century or two. This weighs heavily against barter as history, but it does not decide between the credit and state theories, and many historians combine them. MMT economists draw on both.

A banknote costs little to print and cannot be swapped for gold, yet people work hard to earn Australian dollars. Why?

Several reasons work together:

• The law. Australian banknotes are legal tender, although businesses can usually set other payment terms in advance.
• Taxes. Tax debts to the Australian Government are owed in Australian dollars, so everyone with a tax bill needs them.
• Everyone else uses it. Wages, rents, prices and loans are all written in dollars, so it is the obvious thing to accept.
• It holds its value. People accept dollars today because they expect them to buy roughly as much next month. Keeping that trust is a central bank's job.

Economists weigh these differently. MMT economists argue the tax obligation is the foundation: it guarantees demand for the currency and so gives it value. Many others treat taxes as one support among several, and put more weight on trust, habit and the central bank keeping inflation low. The Bank of England's 2014 paper mentions both taxes and trust. Kelton's video in this topic makes the case for taxes; keep the alternatives in mind as you watch.