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The love of money as a possession---as distinguished from the love of money as a means to the enjoyment of the realities of life---will be recognized for what it is, a somewhat disgusting morbidity, one of those semi-criminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease. John Maynard Keynes See Creation of Money Any list of inventions that shaped modern civilization would include the wheel, the wedge---and money. Suppose an anthropologist from Venus visited Earth. Venusians might be puzzled by why Earthlings work, invest, lie, cheat, steal, or commit murder for beads, bits of metal, dirty paper, or bookkeeping entries in computers in buildings called "banks." The role of money might seem inexplicable---unless Venus also had a monetary system. And, of course, it would.
Our first task in this chapter is to explain why societies everywhere use money to facilitate specialization and exchange. After an overview of the economic functions of money, we survey different types of money and the components of our money supply. Finally, we explore the processes of money creation and destruction.
Barter: Exchange without Money
Some pundits foresee a "cashless society" in which all transactions will be executed via computer. But can you imagine a society without money? Our ancestors used some form of money at least as early as the seventh century b.c., but we know that our earliest ancestors had no money. Only a few small, isolated tribes managed to enter the twentieth century without a monetary system.
If you lived in a society without money, you would be limited to producing or stealing everything you used---or you could engage in barter. Barter occurs when people directly exchange their goods for someone else's goods. Under barter, you must find someone who has what you want and who wants what you have to trade. This requirement is called the double coincidence of wants. Even a double coincidence of wants, however, does not ensure that even most beneficial exchanges will be consummated. If you had a spare pony and wanted a loaf of bread, and met a baker loaded with bread who wanted a pony, you still might not strike a bargain---making change would be nearly impossible.
The basic problem is that barter systems fail to generate efficient amounts of information about potentially beneficial agreements. Transactions are infrequent because information is extremely costly. Consequently, specialization of labor and trade according to comparative advantage tend to be minimal. Most people are largely self-sufficient producers/consumers , so standards of living are primitive. Small wonder that money is rated with the wheel as an invention crucial to the development of the modern world.
What Is Money?
I measure everything I do by the size of a silver dollar. If it don't come up to that standard then I know it's no good. Thomas A. Edison
What money is may seem obvious, but how would you respond if asked how much money you have? You could count only the cash in your purse or pocket. More likely, you would extend this to "money" held in checking accounts or savings accounts. You might include the total value of any U.S. Savings Bonds or corporate stocks or bonds you own. But why stop there? Most of your possessions are worth money. How about the values of your other assets---a car, clothes, books, a ping-pong table, or other things you own. Just how much money do you have? Ambiguities in this question arise from failure to differentiate between wealth and money. Your wealth is the difference between the value of your assets and the value of your liabilities. In addition to being an asset itself, money has the unique characteristic of being the unit by which other assets or liabilities are measured.
Functions of Money
A descriptive definition of money emerges from certain functions it performs: Money is (a) a medium of exchange, (b) a measure of value or unit of account, (c) a store of value, and (d) a standard of deferred payment. Memorizing this list might help you on an exam, but learning what each part of this description implies will help you understand the essence of money. You may even be able to anticipate operational definitions of money used by modern analysts.
Medium of Exchange
Money makes the world go around. Unknown The necessity of a double coincidence of wants under barter is finessed by money. Money performs as a medium of exchange when it is used to execute transactions. This is the most important and most easily understood function of money. If you sell assets (for example, labor services), you normally expect cash or a check, although you may be willing to trade your assets for other assets. To acquire something from someone else, you generally expect to shell out cash or a check, although you might use a credit card or take out a loan. Credit is simply an extension of money.
The prominent economist Robert Clower characterizes monetary economies as societies in which "money is traded for goods, and goods are traded for money, but goods are not traded for goods." His statement requires a slight qualifier: Goods seldom trade for goods in a monetary economy---but barter organizations that spring up to avoid or evade taxes use bookkeeping "credits" that are actually a form of money. A plumber who trades credits from fixing your pipes for a pet pygmy pig is using these credits as money.
Measure of Value
Money is an elastic yardstick. Unknown
If we did not have money to measure relative prices, the values of bearskin rugs might be stated in terms of bath brushes or Butterfingers, which in turn might be stated relative to shirts or shoelaces. Money serves as a measure of value or standard unit of account when used as a common denominator to rank the relative prices of goods. Use of money as a standard unit of account reduces the information needed to make sound market decisions. Measuring the values of all goods in terms of all other goods would be extremely tedious, involving enormous transaction costs, because the relative prices between goods increase faster than the number of goods considered.
For example, suppose apples (a) and burritos (b) are the only two goods in an economy. In this case, there is only one relative price to consider. If you know how many apples must be traded to get a burrito, you automatically know how many burritos must be traded for an apple. Introducing a third good, carrots (c), complicates things. You still need to know rates of exchange between apples and burritos, but it is now also necessary to know the price of carrots in terms of both burritos and apples. Three relative prices are now important: Pa/Pb, Pa/Pc, and Pb/Pc. Adding a fourth good, doughnuts (d), yields six relative prices. Table 1 will help you grasp why the number of relative prices expands faster than the number of goods exchanged.
The formula for determining the number of basic relative prices in an n-good economy (where n equals the number of goods) is {n(n - 1)}/2. The formula becomes {4(4 - 1)}/2= 6 prices in the case of four goods. For 100 goods, relative prices jump to 4,950 in number. Imagine how complex pricing would be in a barter system where millions of different goods were traded. Thus, using money as a unit of account "greases the wheels" of exchange by reducing information costs. Small groups can rely less on self-production because monetary exchange substantially boosts the value of total output. People depend on monetary prices as guides that signal them to specialize in producing goods in which they have comparative advantages.
Store of Value
Money . . . lulls our disquietude. John Maynard Keynes
People hold money not only for transactions they anticipate, but also because money is normally a relatively riskless way to hold wealth. Money performs as a store of value when people hold it as an asset because it is relatively less risky or because they view the transaction costs of conversion into other assets as too high. You can hold money without paying brokerage fees, but you would probably incur such fees if you bought stocks, bonds, capital equipment, or real estate. The values of these other assets also tend to be more volatile than the purchasing power of money. There is some risk, however, because money loses value during inflation (but bonds, for example, do also).
Another way risk enters the picture emerges from diversification. The values of diverse assets are unlikely to be affected in the same ways by the same things. For example, if you own both a new-car dealership and a junkyard, a recession may kill new car sales while your junkyard does quite well. You learned earlier that the purchasing power of a dollar is 1/P, where P is (1/100th of) the price level: Doubling the price level cuts the value of a dollar in half. Since World War II, inflation has steadily pushed up the price level. Even so, the old saying "Don't put all of your eggs in one basket" suggests that it can be wise for people to include some money in their portfolios of assets.
Prior to the Depression-era writings of John Maynard Keynes, orthodox economists rejected the notion that you might want money for other than reasonably immediate purchases. Since then, money has played an integral role in the development of modern portfolio theory, which is a vital part of modern financial analysis in American business.
Standard of Deferred Payment
Money is a contract with parties unknown for the future delivery of pleasures undecided upon. David Bazelon, The Paper Economy (1965)
Money as a standard of deferred payment is implicit in the other three functions of money, but it is worth discussing to illustrate the relationship between time and money. Money performs as a standard of deferred payment by allowing intertemporal contracts. Money is a link between the past, present, and future.
Many forms of production require time for completion and would not be done without a contract specifying future monetary payments. Military or construction contracts are examples. Such repetitive exchanges as labor contracts are also conducted much more efficiently if only one contract is used for many present and future transactions. Still other deals require immediate delivery of a good with delayed payment for the buyer's convenience. For example, you may be borrowing to finance your education. When you sign a credit contract, you agree to make later payment of the funds you borrow---plus interest. All these contracts are measured in money.
Liquidity and Money
A vital characteristic of any asset is its liquidity, which depends on the costs incurred in converting it into cash. Many people think that liquidity is defined only by the time required for conversion, but almost any asset can be converted into cash almost immediately. If you are willing to sell your stereo system for $10, I will buy it right now. Time required to sell and certainty about price are two crucial aspects of asset liquidity. Liquidity is negatively related to the proportion of the transaction costs incurred in purchase or sale of an asset. One way to rank an asset's liquidity is to estimate the percentage you would lose if you had to sell it immediately. Houses are relatively illiquid. You usually pay realtor fees and other transaction costs when you sell one home and buy another. In contrast, most savings accounts are highly liquid. You can close one savings account at your bank and open another, losing almost no interest or principal in the process---just your time.
Types of Money
An incredible variety of items have served as money at various times and places, but all can be classified as either commodity money or fiat money. Commodity money is valuable apart from what it will buy. Gold, for example, is useful in jewelry or dentistry, even when it is not used for money. But some money are useless except when treated as money. Fiat money has value only because of its use as money. Certain pieces of paper of which you would probably like more (e.g., $100 bills) are examples of fiat money. Use of fiat money is ultimately based on faith---faith in its purchasing power, in its general acceptability, and in the stability of the government that issues it.
Commodity Monies
Rubber balls once served as money in the Amazon jungles. Members of the African Masai tribe once measured their wealth in cattle, but had no money per se. Early in our history, beads, stone spearheads, and arrowheads were used as money on every inhabited continent.
What caused these forms of money to fall into disuse? Several characteristics are necessary for use of any commodity as money over a long period: 1. Acceptability. 2. Durability. 3. Divisibility. 4. Homogeneity (uniformity or standardization). 5. Portability (high value-to-weight and value-to-volume ratios). 6. Relative stability of supply. 7. Optimal scarcity (and hard to counterfeit).
These attributes are reasonably self-explanatory. Pet snakes for example, could never gain wide acceptability. Ice cream lacks durability (it melts). Diamonds are too heterogeneous---there are fine diamonds, and then there are those sold by shifty-eyed rascals in back alleys. Elephants are not reliably portable, nor are they divisible. (If divided, they are not durable.) The wheat supply is too volatile---a bumper crop would cause money's value to plummet. Economic activity would be linked too tightly to good or bad harvests. Optimal scarcity means that any commodity used as money cannot be too common, nor can it be counterfeited easily. Bricks or two-by-fours are insufficiently scarce.
Historically, the commodities that best combine the characteristics for use as money are rare metals, especially gold and silver. Standardization was achieved by making coins of these precious metals and stamping "face values" on them. The earliest known metal coins date back to Imperial Rome in the sixth century B.C.
When the world relied almost exclusively on gold and silver coins for money, feudal royalty often found their treasuries inadequate for the palaces, ornate finery, and large armies and navies they thought due them. A common solution was to wage war to capture foreign treasure. This strategy was seldom successful. (War is a negative-sum game, which means that the total losses to all participants outweigh the gains to the "winners," if any.) An alternative for heads of state was to debase the coinage so that profits from seignorage rolled in. The profit government makes when it coins or prints currencies whose face values exceed their commodity values is known as seignorage.
Early government mints "stretched" relatively pure gold and silver coins by melting them down and adding generous portions of nickel, copper, zinc, or lead before restamping coins. (Similar ideas have inspired people to put soybeans and sawdust into hamburgers.) One consequence of debasement is that it limits private profits from melting coins down whenever face values are less than the value of the gold or silver the coins contain.
Inflationary pressure that may arise from debasement is a major reason some advocates of laissez-faire capitalism vehemently oppose government discretion in printing money. Many "gold bugs" favor a return to a gold standard in which every dollar would be backed by a dollar's worth of gold. The amount of money in circulation would then be controlled by the forces of supply and demand. Gold bugs are willing to accept the inefficiency of producing money through mining and then burying gold or silver in a place like Fort Knox; they view this costly process as worthwhile because it limits government's control over the money supply.
Paper money dates back to the Ming Dynasty in China (1368--1399). Until recently, many paper monies could have been classified as "pseudo-commodity" money because governments would convert the paper money into specified amounts of gold or silver on demand. The United States was the last country to abandon the gold and silver standards; it was not until 1933 that this country went off the gold standard domestically. From 1933 until 1974, foreign bankers and governments could proffer $35 in bills and get an ounce of gold from the United States Treasury, but it was illegal for American citizens to hold gold coins or ingots. U.S. dollars were, however, redeemable for silver until the late 1960s.
Fiat Money
Some Americans still believe that currency is "backed by gold in Fort Knox." Paper money and coins are collectively called currency. Recall that fiat money has value only because it is money. Take a close look ar a dollar. You will see "Federal Reserve Note" above George Washington's picture, but nothing about the worth of the bill in gold or silver. Now look at any "silver" coin. These coins are sandwiches of cupronickel (not silver) around copper---face values of coins are about 15 to 40 times the total value of the metal. What makes these bits of metal and paper valuable if they are not backed by gold or silver? One hint lies to the left of George's picture: THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE. The government declares that pieces of paper printed by the Federal Reserve System and bits of metal from the U. S. Mint are money by fiat. (Fiat can be interpreted as: "Because we command.")
Now that you know that our money has no gold or silver backing, should your behavior change in any way? No! Even if you are convinced that the government commits fraud by issuing coins and bills, you can buy just about anything for which you have the money, so you will continue to try to get money in the same ways as previously. The real foundation for fiat money is the faith we have that it can be used to buy goods and services. In other words, our money is "backed" by pizzas, theater tickets, and haircuts---and also by government's ability and willingness to maintain money at a relatively stable value by controlling the money supply.
Major advantages of fiat money are that (a) its supply can be controlled fairly precisely by government; (b) it is much less costly to produce than commodity money, making its use relatively efficient; and (c) if monetary policymakers do a good job, fiat money has all the qualities required of a good commodity money. The major disadvantage of fiat money is that if irresponsible monetary policy makers run the printing presses too fast, they wreak havoc on the financial system and the economy in general.
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