The Role of Money in the Modern Economy


Money is essential to the workings of a modern economy, but its nature has varied substantially over time.

  • Money today is a type of IOU, but one that is special because everyone in the economy trusts that it will be accepted by other people in exchange for goods and services.
  • There are three main types of money: currency, bank deposits and central bank reserves. Each represents an IOU from one sector of the economy to another. Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves. 

The following diagram explains why we have money in the modern economy:

Watch the following video for a summary of money in the economy:

So why do countries have different currencies?
The short answer is that different countries have different economic realities. For example, a country that makes their money through exports will want a low-value currency to keep a trade advantage.  In contrast, a country that wants to boost spending and investment will want a currency that is appreciating in value.  If these two countries had the same currency then it could lead to conflict as they would have opposing monetary policies. 
However, some people have forwarded the idea of a single, global currency, including the famous 1940s economist John Maynard Keynes. The Euro is an example of a joint currency that is shared by 19 out of 28 EU member countries