Difference between revisions of "Money" - New World Encyclopedia

From New World Encyclopedia
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[[Category:Economics]]
 
[[Category:Economics]]
 
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Money is whatever serves as the "medium of exchange." That is, as the quotation from Adam Smith says, “……..money is a commodity or token that everyone will accept in exchange for the things they have to sell……..”
  
 
[[Image:Moneybillscoins3.jpg|right|thumb|250px|Various denominations of [[currency]], one form of money]]
 
[[Image:Moneybillscoins3.jpg|right|thumb|250px|Various denominations of [[currency]], one form of money]]
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'''Money''' is any good or token that functions as a [[medium of exchange]] that is socially and legally accepted in [[payment]] for goods and services and in settlement of debts.
 
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Money also serves as a standard of value for measuring the relative worth of different goods and services and as a store of value. Some authors explicitly require money to be a [[standard of deferred payment]].<ref>[http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=standard%20of%20deferred%20payment amosweb.com]</ref>
 
  
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Money includes both [[currency]], particularly the many [[list of circulating currencies|circulating currencies]] with [[legal tender]] status, and various forms of financial deposit accounts, such as demand deposits, savings accounts, and certificates of deposit. In modern economies, currency is the smallest component of the [[money supply]].
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Different societies may have different monies. Some historical examples are, for instance:
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*Gold coins (in medieval Europe); and
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*Cowrie shells (in West Africa) .
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The cowrie shells used in West Africa are small seashells. This may sound "quaint," but cowrie-money was very successful. It continued to be used into the twentieth century, after the West African countries had become colonies. The colonies were required to use European money, and they did — but when the European monetary systems collapsed in hyperinflation, the West African people went back to using their cowrie-money to get past the crisis. It was the cowrie-money that proved most reliable for many years of the twentieth century.  
  
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Money is not the same as real value, the latter being the basic element in economics. Money is central to the study of [[economics]] and forms its most cogent link to [[finance]]. The absence of money causes an economy to be inefficient because it requires a [[coincidence of wants]] between traders, and an agreement that these needs are of equal value, before a [[barter]] exchange can occur. The efficiency gains through the use of money are thought to encourage trade and the division of labour, in turn increasing productivity and [[wealth]].
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[[Image:Blombosbeads3.jpg|thumb|left|250px| Shells of the pea-sized snail Nassarius kraussianus. Blombos Cave, South Africa, 75,000 B.C.E. Wear marks indicate the shells were strung on a necklace or bracelet.]]
  
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==Economic characteristics==
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We should say that the "commodity" that serves as money can be a purely symbolic token, like dollar bills in America. Indeed, all money has primarily symbolic value. Even the gold coins used in medieval Europe were probably valued more for their symbolic value than for the gold they contained.
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Money is generally considered to have the following characteristics, which are summed up in a rhyme found in older economics textbooks and a primer: "Money is a matter of functions four, a medium, a measure, a standard, a store."
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==Money, types of money , and general overview==
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Symbolic or not, money is an asset. Thus we claim that in any society, money is the asset, commodity or token, that serves as a medium of exchange.  
  
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There have been many historical arguments regarding the combination of money's functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. 'Financial capital' is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender.
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====Credit card is not money===
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Economists do not regard credit cards as money, because a credit card is not an asset but a line of credit.
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What is a "line of credit?" A "line of credit" is an agreement between a lender and a potential borrower, whereby the borrower can borrow up to some limit without any further approval. For example, if you were to build a house and act as your own prime contractor, you would need money to buy lumber and other supplies and to pay subcontractors from week to week. To do those things more conveniently, you might arrange with your banker to write checks for these expenses, even though you have no funds in the bank. Each check would be a loan, and the bank would honor them up to some agreed-on limit. Once your house is complete, you could refinance your loan as a long-term mortgage. This way, you wouldn't have to borrow the money (and thus pay interest on it) until you actually needed it.
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If you have a credit card with XYZ bank, that means you have a line of credit with that bank, and the card is the proof that the bank is willing to loan you money.  
  
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=== Medium of exchange ===
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===Major types of money in a historical context===
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{{Main|Medium of exchange}}
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As we have hinted, different societies have quite different money systems. The major historical types of money are:
  
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=== Unit of account ===
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*Commodity moneys.
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{{Main|Unit of account}}
 
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A '''unit of account''' is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a unit of account is a necessary pre-requisite for the formulation of commercial agreements that involve debt.  
 
  
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These are moneys that have value in non-monetary uses equivalent to the monetary value of the commodity. Any commodity used as a medium of exchange is commodity money. Well-known examples are gold, copper and silver metals, but sea-shells (that is, cowrie shells) tobacco, and cigarettes have all been used. One interesting example of commodity money is the huge [[limestone]] coins from the [[Micronesia]]n island of [[Yap]], quarried with great peril from a source several hundred miles away.
  
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* Divisible into small units without destroying its value; precious metals can be coined from bars, or melted down into bars again.
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[[Image:Yap Stone Money.jpg|thumb|left|160px|An 8-foot "coin" from the village of Gachpar, on [[Yap]].]]
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* [[Fungible]]: that is, one unit or piece must be exactly equivalent to another, which is why [[diamond]]s, works of [[art]] or [[real estate]] are not suitable as money.
 
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* A specific weight, or measure, or size to be verifiably countable.  For instance, coins are often made with ridges around the edges, so that any removal of material from the coin (lowering its commodity value) will be easy to detect.
 
  
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=== Store of value ===
 
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{{Main|Store of value}}
 
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To act as a '''store of value''', a commodity, a form of money, or [[financial capital]] must be able to be reliably saved, stored, and retrieved - and be predictably useful when it is so retrieved. Fiat currency like paper or electronic currency no longer backed by gold in most countries is not considered by some economists to be a store of value.
 
  
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=== Market liquidity ===
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The value of the coin was determined by its size &mdash; the largest of which could range from nine to twelve feet in diameter and weigh several tons. Displaying a large coin, often outside one's home, was a considerable [[status symbol]] and source of prestige in that society.
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{{Main|Market liquidity}}
 
  
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It is important for any economy to move beyond a simple system of bartering. '''Liquidity''' describes how easily an item can be traded for another item, or into the common currency within an economy. Money is the most liquid asset because it is universally recognised and accepted as the common currency. In this way, money gives consumers the freedom to trade goods and services easily without having to barter.
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*Metallic coin: Historically, copper, gold and silver coins have been the most used in European and East Asian societies. The typical feature of these metallic coins  is that have values roughly equal to the price the metal would command as jewelry.  
  
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Liquid financial instruments are easily [[tradable]] and have low [[transaction cost]]s. There should be no—or minimal—[[Bid/offer spread|spread]] between the prices to buy and sell the instrument being used as money.
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EXAMPLE: Standardized coinage
  
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== Types of money ==
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[[Image:Maximinus denarius.jpg|right|frame|A [[Ancient Rome|Roman]] [[denarius]], a standardized [[silver coin]].]]
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In economics, money is a broad term that refers to any instrument that can be used in the resolution of debt. However, different types of money have different economic strengths and liabilities. Theoretician Ludwig von Mises made that point in his book [[The Theory of Money and Credit]], and he argued for the importance of distinguishing among three types of money: commodity money, fiat money, and credit money.  Modern monetary theory also distinguishes among different types of money, using a categorization system that focuses on the liquidity of money.
 
  
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=== Commodity money ===
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It was the discovery of the [[touchstone]] which led the way for metal-based commodity money and coinage. Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. As a result, monetary gold spread very quickly from [[Asia Minor]], where it first gained wide usage, to the entire world.
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{{Main|Commodity money}}
 
  
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Commodity money is any money that is both used as a general purpose medium of exchange and as a tradable commodity in its own right.<ref name="Mises"/>
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Using such a system still required several steps and mathematical calculation. The touchstone allows one to estimate the amount of gold in an [[alloy]], which is then multiplied by the weight to find the amount of gold alone in a lump.
  
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Commodity based currencies are often viewed as more stable, but this is not always the case. The value of a commodity based currency as a medium of exchange depends on its supply relative to other goods and services available in the economy. Historically, gold, silver and other metals commonly used in commodity based monetary systems have been subject to regular and sometimes extraordinary fluctuations in purchasing power. This not only damages its stability as a medium of exchange; it also reduces its effectiveness as a store of value.  In the 1500s and 1600s huge quantities of gold and even larger amounts of silver were discovered in the New World and brought back to Europe for conversion into coin.  As a result, the purchasing power of those coins fell by 60% to 80%, i.e. the prices of goods rose, because the supply of goods did not keep pace with the increased supply of money.<ref> Galbraith, J.K., ''Money: Whence it came, where it went'', Penguin, UK, 1975, p.20-21.</ref>  In addition, the relative value of silver to gold shifted dramatically downward.<ref> Weatherford, J., "Indian Givers: How the Indians of the Americas Transformed the World," Ballantine Books, US 1988, p16</ref>  Such discoveries of huge sources of gold or silver are a thing of the past, and lend to their supply stability. More recently, from 1980 to 2001, gold was a particularly poor store of value, as gold prices dropped from a high of $850/oz. ($27.30 /g) to a low of $255/oz. ($8.20 /g).{{fact|date=2007 August}} It should be noted that gold was not a currency at this time, and was fluctuating due to its status as a final store of value - that is, the price never goes to zero as fiat currencies inevitably do.  The advantage of gold and silver, however, lies in the fact that, unlike fiat paper currency, the supply cannot be increased arbitrarily by a central bank.
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[[Image:Shapuri.jpg|right|200px|thumb|A [[Persian Empire|Persian]] coin.]]
  
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It is also possible for the trading value of a commodity money to be greater than its value as a medium of exchange when governments attempt to fix exchange rates between different commodity monies.  When this happens people will often start melting down coins and reselling the metal used to make them. This has happened periodically in the United States, eventually causing it to move away from pure silver nickels and pure copper pennies.{{Fact|date=May 2007}}  Shipping coins from one jurisdiction to another so that they could be reminted was sometimes a lucrative trade before the advent of trusted paper money. {{Fact|date=May 2007}}
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To make this process easier, the concept of standard coinage was introduced. [[Coin]]s were pre-weighed and pre-alloyed, so as long as the manufacturer was aware of the origin of the coin, no use of the touchstone was required. Coins were typically [[mint (coin)|minted]] by governments in a carefully protected process, and then stamped with an emblem that guaranteed the weight and value of the metal. It was, however, extremely common for governments to assert the value of such money lay in its emblem and thus to subsequently debase the currency by lowering the content of valuable metal.
  
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Commodity money's ability to function as a store of value is also limited by its very nature. Copper and tin risk rust and corrosion. Gold and silver are soft metals that can lose weight through scratches and abrasions, but this is nothing by comparison to fiat currencies, where billions of dollars can be injected ("printed") into the market within moments.
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Although gold and silver were commonly used to mint coins, other metals could be used. For instance, Ancient [[Sparta]] minted coins from [[iron]] to discourage its citizens from engaging in foreign trade. In the early seventeenth century Sweden lacked more precious metal and so produced "plate money," which were large slabs of copper approximately 50 cm or more in length and width, appropriately stamped with indications of their value.
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Metal based coins had the advantage of carrying their value within the coins themselves &mdash; on the other hand, they induced manipulations: the clipping of coins in the attempt to get and recycle the precious metal. A greater problem was the simultaneous co-existence of gold, silver and copper coins in Europe. English and Spanish traders valued gold coins more than silver coins, as many of their neighbors did, with the effect that the English gold-based guinea coin began to rise against the English silver based crown in the 1670s and 1680s. Consequently, silver was ultimately pulled out of England for dubious amounts of gold coming into the country at a rate no other European nation would share. The effect was worsened with Asian traders not sharing the European appreciation of gold altogether &mdash; gold left Asia and silver left Europe in quantities European observers like [http://www.pierre-marteau.com/editions/1701-25-mint-reports.html Isaac Newton], Master of the Royal Mint observed with unease.
  
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Stability aside, commodity-based currencies may have a tendency to restrain growth in a very active economy. For example, in order to maintain the price level, the supply of money in an any economy must be equal or greater than the volume of goods and services produced. If commodities are used as money, then the total production can easily outstrip the supply of those commodities, which leads to price deflation. The lower prices of goods would signal to their producers to reduce the supply of goods, hence restoring the price level. As such, production within commodity-based economies tends to be limited by the supply of the commodity currency.[citation needed]
 
  
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This problem is compounded by the fact that money also serves as a store of value. This encourages hoarding (in other circumstances known as "saving")and takes the commodity money out circulation, reducing the supply. The supply of circulating commodity currency is further reduced by the fact that commodity moneys also have competing non-monetary uses.  For example, gold and silver are used in jewelry, and nickel and copper have important industrial uses.
 
  
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Commodity based currencies also limit the geographic extent of the trading market. To make large purchases either a large volume or a high weight or both of the commodity must be transported to the seller. The cost of transportation of the currency raises the transaction cost and makes long distance sales less attractive.
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*Commodities: Other commodities were used too. As we have seen, seashells have been used as money, as have tobacco and, perhaps, oxen.
  
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[[Image:Banknotes.jpg|thumb|250px|right|Banknotes from all around the world donated by visitors to the [[British Museum]], London]]
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Commodity based currencies are often viewed as more stable, but this is not always the case. The value of a commodity based currency as a medium of exchange depends on its supply relative to other goods and services available in the economy. Historically, gold, silver and other metals commonly used in commodity based monetary systems have been subject to regular and sometimes extraordinary fluctuations in purchasing power. This not only damages its stability as a medium of exchange; it also reduces its effectiveness as a store of value.  In the 1500s and 1600s huge quantities of gold and even larger amounts of silver were discovered in the New World and brought back to Europe for conversion into coin. As a result, the purchasing power of those coins fell by 60% to 80%, i.e. the prices of goods rose, because the supply of goods did not keep pace with the increased supply of money ( Galbraith, 1975.)
  
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=== Fiat money ===
 
  
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{{Main|Fiat money}}
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*Fiat money.
  
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Fiat money is any money whose value is determined by legal means rather than the relative availability of goods and services. Fiat money may be symbolic of a commodity or government promises.<ref name="Mises"/>
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Fiat money is a monetary standard (usually paper money) that people are required by law to accept as a medium of exchange and/or a standard of deferred payment. It is money by the "fiat" — the command — of the sovereign.  
  
 
Fiat money provides solutions to several limitations of commodity money.  Depending on the laws, there may be little or no need to physically transport the money - an electronic exchange may be sufficient.  Its sole use is as a medium of exchange so its supply is not limited by competing alternate uses.  It can be printed without limit, so there is no limit on trade volumes.
 
Fiat money provides solutions to several limitations of commodity money.  Depending on the laws, there may be little or no need to physically transport the money - an electronic exchange may be sufficient.  Its sole use is as a medium of exchange so its supply is not limited by competing alternate uses.  It can be printed without limit, so there is no limit on trade volumes.
  
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Fiat money, especially in the form of paper or coins, can be easily damaged or destroyed.  However, it has an advantage over commodity money in that the same laws that created the money can also define rules for its replacement in case of damage or destruction.  For example, the US government will replace mutilated paper money if at least half of the bill can be reconstructed.<ref>[http://www.bep.treas.gov/section.cfm/8/39 Shredded and mutilated]. Bureau of engraving and printing.  Last accessed 2007-05-09</ref>.  By contrast commodity money is gone for good.
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Fiat money, especially in the form of paper or coins, can be easily damaged or destroyed.  However, it has an advantage over commodity money in that the same laws that created the money can also define rules for its replacement in case of damage or destruction.  For example, the US government will replace mutilated paper money if at least half of the bill can be reconstructed ( [http: //www. bep.treas.gov/section.cfm/8/39 Shredded and mutilated]. )
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Paper money is especially vulnerable to everyday hazards: from fire, water, termites, and simple wear and tear.  Money in the form of minted coins is sometimes destroyed by children placing it on railroad tracks or in amusement park machines that restamp it.  In order to reduce replacement costs, many countries are converting to plastic bills. For example, Mexico has changed its twenty and fifty pesos notes, Singapore its $2, $5, $10 and $50 bills, Malaysia with RM5 bill, and Australia and New Zealand their $5, $10, $20, $50 and $100 to plastic for the increased durability.
 
  
 
Some of the benefits of fiat money can be a double-edged sword.  For example, if the amount of money in active circulation outstrips the available goods and services for sale, the effect can be inflationary.  This can easily happen if governments print money without attention to the level of economic activity or counterfeiters are allowed to flourish.
 
Some of the benefits of fiat money can be a double-edged sword.  For example, if the amount of money in active circulation outstrips the available goods and services for sale, the effect can be inflationary.  This can easily happen if governments print money without attention to the level of economic activity or counterfeiters are allowed to flourish.
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Perhaps the biggest criticism of paper money relates to the fact that its stability is highly dependent on the stability of the legal system backing the currency.  Should the legal system fail, so would the currency that depends on it.
 
Perhaps the biggest criticism of paper money relates to the fact that its stability is highly dependent on the stability of the legal system backing the currency.  Should the legal system fail, so would the currency that depends on it.
  
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=== Credit money ===
 
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{{Main|Credit money}}
 
  
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[[Credit money]] is any claim against a physical or legal person that can be used for the purchase of goods and services<ref name="Mises">Mises, Ludwig von. [[The Theory of Money and Credit]]. Indianapolis, IN: Liberty Fund, Inc.. 1981, trans. H. E. Batson, 1981. [Online] available from http://www.econlib.org/library/mises/msT1.html; accessed 9 May 2007; Internet. [http://www.econlib.org/library/mises/msT1.html#Part%20I,Ch.3 Chapter I, section 3, paragraph 25].</ref>. Credit money differs from commodity and fiat money in two important ways: It is not payable on demand and there is some element of risk that the [[real value]] upon fulfillment of the claim will not be equal to real value expected at the time of purchase<ref name="Mises" />.
 
  
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This risk comes about in two ways and affects <em>both</em> buyer and seller. 
 
  
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First it is a claim and the claimant may default (not pay). High levels of default have destructive supply side effects.  If manufacturers and service providers do not receive payment for the goods they produce, they will not have the resources to buy the labor and materials needed to produce new goods and services.  This reduces supply, increases prices and raises unemployment, possibly triggering a period of stagflation.  In extreme cases, widespread defaults can cause a lack of confidence in lending institutions and lead to [[economic depression]].  For example, abuse of credit arrangements is considered one of the significant causes of the [[Great Depression]] of the 1930s. <ref>[http://www.bis.org/publ/work137.htm  Barry Eichengreen and Kris Mitchener.  The [[Great Depression]] as a Credit Boom Gone Wrong].  Last accessed 2007-05-08.</ref>
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*Fiduciary money.
  
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The second source of risk is time.  Credit money is a promise of <em>future</em> payment.  If the interest rate on the claim fails to compensate for the combined impact of the [[inflation rate|inflation]] (or [[deflation]]) rate and the [[time value of money]], the seller will receive less real value than anticipated. If the interest rate on the claim overcompensates, the buyer will pay more than expected.
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Whenever a bank issues credible promises to pay in some other form of money, and the promises are transferable, they can circulate as money. Bank money is also called "fiduciary money," since it is based on the trust people have that the bank will keep faith (fides) and pay as promised. Fiduciary money may be based on promises to pay in commodity money (gold coin, for example) or in fiat money. We will go into much more detail later, because modern monetary systems are largely fiduciary. Two major instances of fiduciary money are:
  
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*Bank notes: These are bills issued by banks. They were widely used in the nineteenth century and are still used in some countries.
  
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Over the last two centuries, credit money has steadily risen as the main source of money creation, progressively replacing first commodity then fiat money.
 
  
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The main problem with credit money is that its supply  moves in line with credit booms and bust. When  lenders are optimistic (notably when the debt level is low), they increase their lendings activity, thus creating new money and triggering inflation, when they are pessimistic (for instance because the debt level is perceived as so high that defaults can only follow), they reduce their lending activities, bankruptcies and deflation follows.
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[[Image:Banknotes.jpg|thumb|250px|right|Banknotes from all around the world donated by visitors to the [[British Museum]], London]]
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===Money supply===
 
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{{Main|Money supply}}
 
  
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The money supply is the amount of money within a specific economy available for purchasing goods or services. The supply in the US is usually considered as four escalating categories M0, M1, M2 and M3. The categories grow in size with M3 representing all forms of money (including credit) and M0 being just base money (coins, bills, and central bank deposits). M0 is also money that can satisfy private banks' reserve requirements. In the US, the [[Federal Reserve]] is responsible for controlling the money supply, while in the [[Euro area]] the respective institution is the [[European Central Bank]]. Other central banks with significant impact on global finances are the [[Bank of Japan]], [[People's Bank of China]] and the [[Bank of England]].
 
  
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When gold is used as money, the money supply can grow in either of two ways.  First, the money supply can increase as the amount of gold increases by new gold mining at about 2% per year, but it can also increase more during periods of gold rushes and discoveries, such as when Columbus discovered the new world and brought gold back to Spain, or when gold was discovered in California in 1848.  This kind of increase helps debtors, and causes inflation, as the value of gold goes down.  Second, the money supply can increase when the value of gold goes up.  This kind of increase in the value of gold helps savers and creditors and is called deflation, where items for sale are less expensive in terms of gold.  Deflation was the more typical situation for over a [[century]] when gold and credit money backed by gold were used as money in the US from 1792 to 1913.
 
  
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=== Monetary policy ===
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*Checking accounts: In our society, checks are acceptable as money, so by the definition of money -- a commodity or token that serves as a medium of exchange — checks are money, just as real as any other kind of money.  
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{{Main|Monetary policy}}
 
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Monetary policy is the process by which a [[government]], central bank, or monetary authority manages the [[money supply]] to achieve specific goals.  Usually the goal of monetary policy is to accommodate economic growth in an environment of stable prices. For example, it is clearly stated in the [[Federal Reserve Act]] that the [[Board of Governors]] and the [[Federal Open Market Committee]] should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” <ref> The Federal Reserve. [http://www.federalreserve.gov/pf/pdf/pf_2.pdf 'Monetary Policy and the Economy".] ''Board of Governors of the Federal Reserve System'', (2005-07-05). Retrieved 2007-05-15.</ref>
 
  
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A failed monetary policy can have significant detrimental effects on an economy and the society that depends on it. These include [[hyperinflation]], [[stagflation]], [[recession]], high [[unemployment]], shortages of imported goods, inability to export goods, and even total monetary collapse and the adoption of a much less efficient barter economy. This happened in Russia, for instance, after the [[History of the Soviet Union (1985-1991)|fall of the Soviet Union]].
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Both fiat money and fiduciary money are tokens, of course, as distinct from commodity moneys. These token moneys are much the most important kinds of money in the modern world.
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=== Functions of Money===
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We say traditionally that money has four major functions. The money is:
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*Medium of exchange.  
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Whatever people usually give in exchange for the things that they buy is the medium of exchange. As we have seen, this is the function that defines money.  
  
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Governments and central banks have taken both regulatory and free market approaches to monetary policy. Some of the tools used to control the money supply include:
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*Unit of account.
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The unit of account is the unit in which values are stated, recorded and settled. The differences between this and the medium of exchange may seem subtle, but there are a few cases in which the unit of account is different from the unit in which the medium of exchange is expressed. In Britain a few decades ago, Guineas were often used as the unit of account, while the medium of exchange was expressed in Pounds. Both Guineas and Pounds in turn could be expressed in shillings — the Pound was 20 shillings and the Guinea was 21 shillings. (British currency has since been redefined).
  
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* currency purchases or sales
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*Standard of deferred payment.
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* increasing or lowering government spending
 
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* increasing or lowering government borrowing
 
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* changing the [[interest rate|rate]] at which the government loans or borrows money
 
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* manipulation of [[exchange rate]]s
 
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* taxation or tax breaks on imports or exports of capital into a country
 
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* raising or lowering bank reserve requirements
 
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* regulation or prohibition of private currencies
 
  
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For many years much of monetary policy was influenced by an economic theory known as monetarism. [[Monetarism]] is an economic theory which argues that management of the money supply should be the primary means of regulating economic activity. The stability of the demand for money prior to the 1980s was a key finding of [[Milton Friedman]] and [[Anna Schwartz]] <ref>{{cite book |author=Milton Friedman, Anna Jacobson Schwartz, |title=Monetary History of the United States, 1867-1960 |publisher=Princeton University Press |location=Princeton, N.J |year=1971 |pages= |isbn=0-691-00354-8 |oclc= |doi=}}</ref> supported by the work of [[David Laidler]]<ref>{{cite book |author=David Laidler, |title=Money and Macroeconomics: The Selected Essays of David Laidler (Economists of the Twentieth Century) |publisher=Edward Elgar Publishing |location= |year= |pages= |isbn=1-85898-596-X |oclc= |doi=}}</ref>, and many others.
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This is the unit in which debt contracts are stated. Deferred payment means a payment made in the future, not now. Here, again, it is usually the same as the medium of exchange, but not always. During periods of inflation, people may accept paper money for immediate payment, but insist on some other medium, such as real goods and services or gold, for deferred payment — because the medium of exchange would lose much of its value in the meanwhile.  
  
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The nature of the demand for money changed during the 1980s owing to technical, institutional, and legal factors and the influence of monetarism has since decreased.
 
  
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==History of money==
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*Store of value.
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The first golden coins in history were coined by [[Lydia]]n king [[Croesus]], around 560 B.C.E. The first Greek coins were made initially of [[copper]], then of [[iron]] because copper and iron were powerful materials used to make weapons. [[Pheidon]] king of [[Argos]], around 700 B.C.E., changed the coins from iron to a rather useless and ornamental metal, [[silver]], and, according to [[Aristotle]], dedicated some of the remaining iron coins (which were actually iron sticks) to the temple of Hera[http://www.metrum.org/money/heraion.htm]. King Pheidon coined the silver coins at [[Aegina]], at the temple of the goddess of wisdom and war [[Athena]] the [[Aphaia]] (the vanisher), and engraved the coins with a [[Chelone]], which is to this day as a symbol of
 
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[[capitalism]]. Chelone coins[http://www.snible.org/coins/hn/aegina.html] were the first medium of exchange that was not backed by a real value good. They were widely accepted and used as the international medium of exchange until the days of [[Peloponnesian War]], when the Athenian [[Drachma]] replace them. According other fables, inventors of money were [[Demodike]](or [[Hermodike]]) of [[Kymi]] (the wife of [[Midas]]), [[Lycus|Lykos]] (son of [[Pandion II]] and ancestor of the [[Lycia]]ns) and [[Erichthonius of Athens|Erichthonius]], the [[Lydia]]ns or the [[Naxos, Greece|Naxians]].
 
  
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Again, this is something that people keep in order to maintain the value of their wealth. Again, while it would usually be the same as the medium of exchange, in inflationary times other media might be substituted, such as jewelry, land or collectable goods. In this sense, money is "set aside" for the future.
  
−
The '''history of money''' is a story spanning thousands of years. Related to this, [[Numismatics]] is the scientific study of [[money]] and its [[history]] in all its varied forms.
+
However, the fact that money – and sometimes the ultimate commodity for which it freely exchanges, such as  ‘gold’ — also serves as a store of value creates a problem . This encourages hoarding ( in other circumstances known as "saving" )  and takes the commodity money out circulation, reducing the supply. The supply of circulating commodity currency is further reduced by the fact that commodity moneys also have competing non-monetary uses.  For example, gold and silver are used in jewelry, and nickel and copper have important industrial uses.
  
−
Money itself must be a [[scarcity|scarce]] good. Many items have been used as money, from naturally scarce [[precious metal]]s and [[conch shell]]s through [[cigarette]]s to entirely artificial money such as [[banknote]]s. Modern money (and most ancient money too) is essentially a token—in other words, an abstraction. Paper currency is perhaps the most common type of physical money today. <!-- Question: why 'perhaps'? Why can't this article say whether it is or isn't? —>However, goods such as [[gold]] or [[silver]] retain many of money's essential properties.
 
  
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===The emergence of money===
+
====Early History of Money====
 +
Money has been used for something like 3000 years. City-states in the ancient near east had extensive trade from city to city, and they used precious metals as a medium of exchange. When trades were settled a certain amount of metal could be used to settle the difference. There was a problem of quality control, however. There were problems of determining that the quantity and purity of the metal was as agreed.
 +
The answer was quality control and certification. The early kings of Lydia standardized the hunks of metal and guaranteed their quality by stamping the king's picture on them. These were the first coins. This guarantee of quality by the Lydian kingdom — already a rich and powerful one — was very successful, and made the Kingdom of Lydia even richer, indeed proverbially rich. Croesus and Midas — of all kings the most proverbially wealthy ones — were among the kings of Lydia.
 +
But what Lydia could do, other kingdoms could also do. By 1000 C.E., metallic coin monetary systems had spread through much of the old world.
 +
As in so many other things, the Chinese were the innovators for the next step. The Chinese invented printing, and not too much later, they also invented paper money. It was widespread in China by around 1000 C.E., but the Chinese abandoned it after about 1500, in the general decline of Chinese society after the Mongol conquest.
 +
Paper money was to evolve much more indirectly in Europe, though.
 +
====A Tale about Money and Banking====
 +
Let us start with a short story:
 +
*Fred, as a goldsmith, he has a strong vault.
 +
*He stores the gold owned by other citizens for a small fee. (A business that stores money in its vaults for a fee is called a bank of deposit.)
 +
*Fred gives his customers receipts for their deposits.
 +
*After a while, some of Fred's customers use receipts for the gold they have deposited to make payments and settle debts.
 +
EXAMPLE: One customer may hand over a receipt in payment for a wagon. Then the wagon-maker may leave the gold on deposit, and pass the receipt on to the cooper (that is, the barrel-maker) to pay for some barrels.
 +
Fred's receipts have become "banknotes" and the Bank of Fred is now a "Bank of Issue" and new environment and issues have taken place ever since:
 +
*The Bank of Issue: One day Johann the Peasant comes in to ask for a loan. Johann is doing pretty well, and wants to buy a second ox so he can use a two-ox team to cultivate a larger field. Fred doesn't have any gold to loan — so he writes out some bank-notes and gives them to Johann the Peasant as a loan. The ox-seller accepts the bank-notes in payment for the ox, and at the end of the year, Johann sells some of his crop for bank-notes, and uses those bank-notes to repay the loan with interest. Fred has created money out of nothing (but trust)! And creating money is a profitable business.
 +
*The Limit: If many customers want to redeem their bank notes at once, the bank will not be able to comply. This is a "run" on the bank. The Bank of Fred will then be unable to redeem its notes, faith in them will collapse, and the bank-notes will cease to be money.
 +
Fred has to be careful to keep enough gold coins in reserve to avoid this danger. Suppose experience has taught Fred that he needs to keep one Florin in the vault for every three banknotes he has issued. That is, Fred has adopted a reserve ratio — a ratio of reserves to money issue — of 1/3.
 +
This determines how much money Fred can issue. If Fred has 1,000 Florins in the vault, then he can issue 3,000 Florins of bank-notes. If someone deposits another 100 Florins, Fred would then be able to issue 300 new bank-notes. Fred would give 100 to the new depositor as receipts for his deposits, but the other 200 Florins would be available for Fred to loan out and so increase his profits.
 +
So much for the story.
 +
It is, however, not a fairly tale but a reasonably fitting account of steps that had been done, before the real banking system became the  real power behind the “thrones” of the world.
 +
EXAMPLE: Among the real early bankers were the Medici(s), who started out as medical doctors, and ended as monarchs, and the Fuggers, who owned a silver mine.
 +
The above “story”  gives also an accurate portrayal of the workings of a bank of issue in a system of fiduciary money. The Bank of Fred is a good example of a bank of issue. But the story goes on:
 +
*Paper money system: By the 1700's, bank notes (called "fiduciary money") circulated widely in Western Europe, along with metallic coins. However, the Napoleonic Wars created problems.
 +
*Gold Standard: fter the war, the ( British ) government brought in a consultant — gentleman-economist [[David Ricardo]]. Ricardo designed a new, somewhat more streamlined monetary system.
 +
In the new monetary system, paper Pound notes were the main medium of exchange. They would be issued only in proportion to gold bullion held by the Bank of England, and redeemable for bullion in large quantities, mostly for international trade. This is the "classical" gold standard of the nineteenth century — strictly speaking, not a gold coin system but a paper money system with the paper (fiduciary) money exchangeable for gold bullion.
 +
*Federal Reserve System: During the 19th century, then, Britain was "on the gold standard." America was not. America was never on any very consistent monetary standard at all. In 1913, Congress established the Federal Reserve System (the "fed") to be the American central banking system — the "bankers' bank" and main control on the monetary system.
 +
The Federal Reserve system consists of 12 Banks for 12 districts in different parts of the country.
 +
The federal reserve banks are also bankers' banks. By controlling the amount of reserves, and regulating the reserve ratio, the Federal Reserve System controls the American Money Supply.
 +
Something similar could be said about most developed economies. In the modern world, money is not a commodity but a service provided by banks.
  
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[[Image:Blombosbeads3.jpg|thumb|left|250px| Shells of the pea-sized snail Nassarius kraussianus. Blombos Cave, South Africa, 75,000 B.C.E. Wear marks indicate the shells were strung on a necklace or bracelet.]]
+
This causes some concern. People worry about whether money is "based on" some commodity, and what commodity. But why worry?
−
The use of proto-money may date back to at least 100,000 B.C.E.[http://news.bbc.co.uk/2/hi/science/nature/5099104.stm]. Trading in [[red ochre]] is attested in [[Swaziland]], from about that date, and ochre seems to have functioned as a proto-money in [[Australian Aborigines|Aboriginal Australia]]. Shell [[jewellery]] in the form of strung beads would have served as good with the basic attributes needed of early money. In cultures where metal working was unknown, shell or ivory jewellery were the most divisible, easily storable and transportable, scarce, and hard to counterfeit objects that could be made. It is highly unlikely that there were formal markets in 100,000 [[Before Present|B.P]] (any more than there are in recently observed hunter-gatherer cultures). Nevertheless, proto-money would have been useful in reducing the costs of less frequent transactions that were crucial to hunter-gatherer cultures, especially bride purchase, splitting property upon death, tribute, and intertribal trade in hunting ground rights (“starvation insurance”) and implements. In the absence of a medium of exchange, all of these transactions suffer from the basic problem of [[barter]]—they require an improbable [[coincidence of wants]] or events. Jewellery has often been used for currency and wealth storage in some historical and contemporary societies, especially those in which modern forms of money are scarce, in addition to being used for decoration and display of status and wealth.
+
The answer comes in two stages.  
 +
*From many points of view, the effectiveness of the monetary system requires a fairly stable average price level. As we have seen in a previous chapter, inflation can and sometimes has destroyed the purchasing power of a monetary unit very rapidly.  
 +
*The danger of inflation was seen as being connected to the quantity of money in circulation by way of the "quantity theory of money" ( which is quite another topic altogether. )
 +
====Summary====
 +
*Checking accounts are money, fiduciary money created by banks.  
 +
*Creation of fiduciary money is limited by the supply of bank reserves.  
 +
*Bank reserves are obligations of the Federal Reserve, including deposits and vault cash.
 +
*Checks are "cleared" by the Federal Reserve by transferring deposits from the bank that issued the check to the bank that deposits it.  
 +
*A bank that has excess reserves may be able to create money and loan it, by establishing a checking account in the amount of the loan.  
 +
*Nevertheless, banks have to limit their lending to allow for "clearing" through the Federal Reserve.
 +
*An increase in reserves, for example by importing currency from abroad, increases the total money supply by a multiple of the increase in reserves.  
 +
*The multiple is the inverse of the required reserve ratio.
 +
==Conclusion==
  
−
In cultures, of any era, that lack money, [[barter]]ing and some system of in-kind "credit" or "gift exchange" would be the only ways to exchange goods. Bartering has several problems, most notably the [[coincidence of wants]] problem. If one wishes to trade fruit for wheat, it can only be done when the fruit and wheat are both available at the same time and place, which may be for a very brief time, or may be never. With an intermediate commodity (whether it be shells, rum, gold, etc.) fruit can be sold when it is ripe in exchange for the intermediate commodity. This intermediate commodity can then be used to buy wheat when the wheat harvest comes in. Thus the use of money makes all [[commodity|commodities]] become more [[liquidity|liquid]].
+
“……Money is not, properly speaking, one of the subjects of commerce; but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another. It is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy. If we consider any one kingdom by itself, it is evident, that the greater or less plenty of money is of no
 +
consequence; since the prices of commodities are always proportioned to the plenty of money, and a crown in Harry VII's time served the same purpose as a pound does at present…..” ( Hume, 1752. )
  
−
Where trade is common, [[barter|barter systems]] usually lead quite rapidly to several key goods being imbued with monetary properties. In the early British colony of [[New South Wales]] in [[Australia]], rum emerged quite soon after settlement as the most monetary of goods. When a nation is without a fiat currency system it is quite common for the fiat currency of a neighbouring nation to emerge as the dominant monetary good. In some prisons where conventional money is prohibited, it is quite common for goods such as cigarettes to take on a monetary quality. Gold has emerged naturally from the world of barter again and again to take on a monetary function. It should be noted that the emergence of monetary goods is not dependent on central authority or government. It is a quite natural market phenomenon.
+
“……It seems a maxim almost self-evident, that the prices of every thing depend on the proportion between commodities and money, and that any considerable alteration on either has the same effect, either of heightening or lowering the price. Increase the commodities, they become cheaper; increase the money, they rise in their value. As, on the other hand, a diminution of the former, and that of the latter, have contrary tendencies…….” ( ibid.,1752. )
  
−
===Commodity money===
+
“…..Because of the money increase ( in the certain economic area and era ) , every thing must become much cheaper in times of industry and refinement, than in rude, uncultivated ages. It is the proportion between the circulating money, and the commodities in the market, which determines the prices……. after money enters into all contracts and sales, and is every where the measure of exchange, the same national cash has a much greater task to perform; all commodities are then in the market; the sphere of circulation is enlarged; it is the same case as if that individual sum were to serve a larger kingdom; and therefore, the proportion being here lessened on the side of the money, every thing must become cheaper, and the prices gradually fall……”( ibid., 1752. )
−
{{Main|Commodity money}}
 
−
Many early instances of money were objects which were useful for their [[intrinsic value]] as well as their [[money|monetary properties]]. This has been called [[commodity money]]; historical examples include iron nails (in Scotland), [[pig]]s, rare [[seashell]]s, whale's teeth, and (often) [[cattle]]. In medieval [[Iraq]], [[bread]] was used as an early form of currency.
 
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[[Image:Manillaokhapo.JPG|thumb|left|<center>An Okpoho [[Manillas|manilla]] from Nigeria<center>]]
 
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[[Image:Katangacross.JPG|thumb|right|<center>A Katanga Cross. An archaic form of money from West Africa.<center>]]
 
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The use of shells or ivory was nearly universal before humans discovered how to work with precious metals; in [[China]], Africa, and many other areas, use of [[cowry|cowrie shells]] was common. In China the use of cowrie shells was superseded by metal representations of the shells, as well as representations of metal tools. These imitations may have been the precursors of coinage.
 
  
−
[[Salt]] and [[spices]] have been used as money. From 550 B.C.E., accepting salt from a person was synonymous with receiving a [[salary]], taking pay, or being in that person's service. Definite indications are available that both black and white [[black pepper|pepper]] have been used as commodity money for hundreds of years before [[Christ]], and several centuries thereafter. Being a valuable commodity, pepper has naturally been used as payment. [[Alaric I]] reportedly demanded 3,000 pounds in weight of pepper in 408 C.E. as part of a ransom for the city of Rome. In the [[Middle Ages]], there was a French saying, 'As dear as pepper'. In England, rent could be paid in pounds of pepper, and so a symbolic minimal amount is known as a "peppercorn rent."
+
And finally: We may have heard the fallacy circulated within the historians as well among the common folks:
−
[[Image:Gold ingots.jpg|thumb|right|150px|[[Precious metal]]s have been a common form of money, such as this [[gold]] from [[Sveriges Riksbank]].]]
 
  
−
Even in the modern world, in the absence of other types of money, people have occasionally used commodities such as [[tobacco]] as money. This happened on a wide scale after [[World War II]] when cigarettes became used unofficially in [[Europe]], in parallel with other currencies, for a short time. It also occurs in some remote parts of countries such as [[Colombia]] and [[Bolivia]], where [[cocaine]], or its precursor, [[coca]] paste, is used as commodity money.
+
“…… that any particular state is weak, though fertile, populous, and well cultivated, merely because it wants money. …….It appears, that the want of money can never injure any state within itself: For men and commodities are the real strength of any community. It is the simple manner of living which here hurts the public, by confining the gold and silver to few hands, and preventing its universal diffusion and circulation. On the contrary, industry and refinements of all kinds incorporate it with the whole state, however small its quantity may be: They digest it into every vein, so to speak; and make it enter into every transaction and contract. No hand is entirely empty of it. And as the prices of every thing fall by that means, the sovereign has a double advantage: He may draw money by his taxes from every part of the state; and what he receives, goes farther in every purchase and payment……..” ( ibid., 1752. )
 +
 
 +
====NOTE: Quotations on money====
  
−
Another example of "commodity money" is ''shell money'' in the [[Solomon Islands]]. Shells are painstakingly chipped into rough circles, filed down, and threaded onto large necklaces, which are then used during marriage proposals; for instance, a father may charge twenty shell money necklaces for his daughter's hand in marriage.
+
*''"No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one, and despise the other. Ye cannot serve God and [[Mammon]]"'' ( [[Gospel of Matthew]] 6:24 (KJV. )
  
−
One interesting example of commodity money is the huge [[limestone]] coins from the [[Micronesia]]n island of [[Yap]], quarried with great peril from a source several hundred miles away. The value of the coin was determined by its size &mdash; the largest of which could range from nine to twelve feet in diameter and weigh several tons. Displaying a large coin, often outside one's home, was a considerable [[status symbol]] and source of prestige in that society. (Owing to the great inconvenience, islanders would often trade only promises of ownership of an individual coin instead of actually moving it. In some cases, coins which had been lost at sea were still used for exchange in this way. These agreements could be thought of as a kind of ''representative money'', described below.)
+
*''"For the love of money is the root of all evil: which while some coveted after, they have erred from the faith, and pierced themselves through with many sorrows."'' ( [[First Epistle to Timothy]] 6:10 (KJV. )
  
−
Once a commodity becomes used as money, it takes on a value that is often different from its intrinsic worth or usefulness. Having the property of money adds an extra use to the commodity, and so increases its value. This extra use is a convention of society, and the scope of its use as money within the society affects the value of the monetary commodity. So although commodity money is real, it should not be seen as having a fixed value in absolute terms. To a large extent its value is still socially determined. A prime example is gold, which has been valued differently by many different societies, but perhaps valued most by those who used it as money. Fluctuations in the value of commodity money can be strongly influenced by [[supply]] and [[demand]], whether current or predicted (if a local [[gold mine]] is about to run out of ore, the relative market value of gold may go up in anticipation of a shortage).
+
*''"When it's a question of money, everybody is of the same religion"'' ( [[Voltaire.]] )
−
[[Image:Yap Stone Money.jpg|thumb|left|160px|An 8-foot "coin" from the village of Gachpar, on [[Yap]].]]
 
  
−
Money can be anything which the trading parties agree has transferable value, but the usability of a particular sort of money varies widely. Desirable features of a good basis for money include being able to be stored for long periods of time, dense so it can be carried about easily, and difficult to find on its own so it is actually worth something.
+
*''"Only when the last tree has died and the last river been poisoned and the last fish been caught will we realise we cannot eat money"'' ( Cree proverb. )
  
−
Metals like [[gold]] and [[silver]] have been used as commodity money for thousands of years, being in the form of metal dust, nuggets, rings, bracelets and assorted pieces. Eventually the [[Lydians]] began coining gold and silver around 560 B.C.E.
+
*''"So you think that money is the root of all evil? Have you ever asked what is the root of money? Money is a tool of exchange, which can't exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears or of the looters, who take it from you by force. Money is made possible only by the men who produce. Is this what you consider evil?"'' ([[Ayn Rand.]] )
  
−
Gold and silver are both quite soft metals, and coins minted from the pure metals suffer from wear or deformation in daily use. Fortunately these metals are also easily [[alloy]]ed with a less expensive metal, frequently copper, to improve durability of the resulting coins. Typically alloys of [[coinage metal]]s, such as [[sterling silver]] or 22 [[carat (purity)|carat]] (92%) gold, are used to make coins more durable. These are alloys of 90% or more precious metal, for alloys of less than 90% do not improve hardness or durability much, and so are typically considered to be liable to fall into monetary debasement.
+
*''"The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled"'' ( [[John Kenneth Galbraith.]] )  
  
−
===Standardized coinage===
 
  
−
[[Image:Maximinus denarius.jpg|right|frame|A [[Ancient Rome|Roman]] [[denarius]], a standardized [[silver coin]].]]
+
==References==
−
It was the discovery of the [[touchstone]] which led the way for metal-based commodity money and coinage. Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. As a result, monetary gold spread very quickly from [[Asia Minor]], where it first gained wide usage, to the entire world.
+
*Davies, Glyn, [http://www.exeter.ac.uk/~RDavies/arian/llyfr.html History of Money from Ancient Times to the Present Day]
 +
*Galbraith, J.K., ''Money: Whence it came, where it went'', Penguin, UK, 1975, p.20-21
 +
*Hume, D. , “Of Money,” in: Political Discourses, 1752
 +
*Jevons, W. S., Money and the Mechanism of Exchange, London, Macmillan, 1875
 +
*Menger, Carl, [http://socserv.mcmaster.ca/econ/ugcm/3ll3/menger/money.txt "On the Origin of Money"]
 +
*Szabo, Nick, [http://szabo.best.vwh.net/shell.html Shelling Out—The Origins of Money]
 +
*[http://www.usmint.gov/ United States Mint]
 +
*[http://www.royalmint.com/RoyalMint/web/site/Corporate/Home/corporate_homepage.asp Royal Mint]
 +
*[http://www.money.org/AM/Template.cfm?Section=Home American Numismatic Association]
 +
*[http://www.worldbank.org/index.html World Bank]
 +
*[http://www.bep.treas.gov/section.cfm/8/39 Shredded and mutilated]. Bureau of engraving and printing.
  
−
Using such a system still required several steps and mathematical calculation. The touchstone allows one to estimate the amount of gold in an [[alloy]], which is then multiplied by the weight to find the amount of gold alone in a lump.
 
−
[[Image:Shapuri.jpg|right|200px|thumb|A [[Persian Empire|Persian]] coin.]]
 
−
To make this process easier, the concept of standard coinage was introduced. [[Coin]]s were pre-weighed and pre-alloyed, so as long as the manufacturer was aware of the origin of the coin, no use of the touchstone was required. Coins were typically [[mint (coin)|minted]] by governments in a carefully protected process, and then stamped with an emblem that guaranteed the weight and value of the metal. It was, however, extremely common for governments to assert the value of such money lay in its emblem and thus to subsequently debase the currency by lowering the content of valuable metal.
 
  
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Although gold and silver were commonly used to mint coins, other metals could be used. For instance, Ancient [[Sparta]] minted coins from [[iron]] to discourage its citizens from engaging in foreign trade. In the early seventeenth century Sweden lacked more precious metal and so produced "plate money," which were large slabs of copper approximately 50 cm or more in length and width, appropriately stamped with indications of their value.
 
−
 
−
Metal based coins had the advantage of carrying their value within the coins themselves &mdash; on the other hand, they induced manipulations: the clipping of coins in the attempt to get and recycle the precious metal. A greater problem was the simultaneous co-existence of gold, silver and copper coins in Europe. English and Spanish traders valued gold coins more than silver coins, as many of their neighbors did, with the effect that the English gold-based guinea coin began to rise against the English silver based crown in the 1670s and 1680s. Consequently, silver was ultimately pulled out of England for dubious amounts of gold coming into the country at a rate no other European nation would share. The effect was worsened with Asian traders not sharing the European appreciation of gold altogether &mdash; gold left Asia and silver left Europe in quantities European observers like [http://www.pierre-marteau.com/editions/1701-25-mint-reports.html Isaac Newton], Master of the Royal Mint observed with unease.
 
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−
Stability came into the system with national Banks guaranteeing to change money into gold at a promised rate; it did, however, not come easily. The Bank of England risked a national financial catastrophe in the 1730s when customers demanded their money be changed into gold in a moment of crisis. Eventually London's merchants saved the bank and the nation with financial guarantees.
 
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−
See also: [[Roman currency]], [[coinage metal]], for conversions of the European coins before the introduction of paper money: [http://www.pierre-marteau.com/currency/converter.html The Marteau Early 18th-Century Currency Converter].
 
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−
===Representative money===
 
−
 
−
[[Image:5 Silver US Dollars 1896.jpg|thumb|right|300px|An example of representative money, this 1896 note could be exchanged for five [[US Dollar]]s worth of [[silver]].]]
 
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−
The system of [[commodity money]] in many instances evolved into a system of [[representative money]]. This occurred because banks would issue a paper receipt to their depositors, indicating that the receipt was redeemable for whatever precious goods were being stored (usually gold or silver money). It didn't take long before the receipts were traded as money, because everyone knew they were "as good as gold." Representative paper money made possible the practice of [[fractional reserve banking]], in which bankers would print receipts above and beyond the amount of actual precious metal on deposit.
 
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−
So in this system, paper [[currency]] and non-precious coinage had very little intrinsic value, but achieved significant market value by being backed by a promise to redeem it for a given weight of precious metal, such as silver. This is the origin of the term "British Pound" for instance; it was a unit of money backed by a [[Pound (mass)|Tower pound]] of [[sterling silver]], hence the currency [[Pound Sterling]]. For much of the nineteenth and twentieth centuries, many currencies were based on [[representative money]] through use of the [[gold standard]].
 
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−
===Fiat money===
 
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−
[[Fiat money]] refers to money that is not backed by reserves of another commodity. The money itself is given value by government ''[[Fiat currency|fiat]]'' ([[Latin]] for "let it be done") or decree, enforcing ''legal tender laws'', previously known as "forced tender," whereby debtors are legally relieved of the debt if they (offer to) pay it off in the government's money. By law the refusal of "[[legal tender]]" money in favor of some other form of payment is illegal, and has at times in history ([[Roman Empire|Rome]] under [[Diocletian]], and [[French revolution|post-revolutionary France]] during the collapse of the assignats) invoked the [[death penalty]].
 
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Governments through history have often switched to forms of fiat money in times of need such as war, sometimes by suspending the service they provided of exchanging their money for gold, and other times by simply printing the money that they needed. When governments produce money more rapidly than economic growth, the money supply overtakes economic value. Therefore, the excess money eventually dilutes the market value of all money issued. This is called [[inflation]]. See [[open market operations]].
 
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−
In 1971 the [[United States|US]] finally switched to fiat money indefinitely. At this point in time many of the economically developed countries' currencies were fixed to the [[US dollar]] (see [[Bretton Woods Conference]]), and so this single step meant that much of the western world's currencies became fiat money based.
 
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−
Following the first [[Gulf War]] the president of Iraq, [[Saddam Hussein]], repealed the existing Iraqi fiat currency and replaced it with a new currency. Despite having no backing by a commodity and with no central authority mandating its use or defending its value the old currency continued to circulate within the politically isolated [[Kurd]]ish regions of Iraq. It became known as the [[Swiss Dinar]]. This currency remained relatively strong and stable for over a decade. It was formally replaced following the [[2003 invasion of Iraq|second Gulf War]].
 
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===Credit money===
 
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[[Credit money]] often exists in conjunction with other money such as fiat money or commodity money, and from the user's point of view is indistinguishable from it. Most of the western world's money is credit money derived from national fiat money currencies.
 
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−
In a modern economy, a bank will lend all but a small portion of its deposits to borrowers, this is known as [[fractional reserve banking]]. In doing so, it increases the total [[money supply]] above that of the total amount of the fiat money in existence (also known as M0). While a bank will not have access to sufficient cash (fiat money) to meet all the obligations it has to depositors if they wish to withdraw the balance of their cheque accounts (credit money), the majority of transactions will occur using the credit money (cheques and electronic transfers).
 
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Strictly speaking a debt is not money, primarily because debt can not act as a unit of account. All debts are denominated in units of something external to the debt. However, credit money certainly acts as a substitute for money when it is used in other functions of money (medium of exchange and store of value).
 
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===Indo-European and Semitic etymology===
 
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−
The origin of the word "money" comes from the Latin word "moneta," an epithet of [[Juno (mythology)|Juno]] ([[Hera]])—Juno Moneta, "June the Alone"—the deity that protected and oversaw finances in the [[History of Rome#Roman Republic|early days of Rome]].
 
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In [[Greek language]], "''Hera Mone tas''" means the lonely Hera ("''Mone tas''" in [[Doric Greek]], "''Mone tes''" in [[Ionic dialect]]). [[Zeus]] punished Hera and tied her with a golden chain between the earth and sky. Hera, because she was alone between the sky and earth tied with gold, was called moneres or mone (μόνη) (lonely in Greek), and the word money was derived from this. Hera, with the help of [[Hephaestus]], broke the golden chain and released herself. It is said that all gold found on earth (which forms approximately a single cube 20 m a side) originates from the fragments of this golden chain, which fall from the sky and became human's mone (money).
 
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Perhaps because of this fable, gold was used in ancient Greece only in temples, graves and jewels and there is not any ancient Greek golden coin, until the days around 390 B.C.E., when the Greek king [[Philip II of Macedon]] minted golden coins. The first golden coins in history were coined by [[Lydia]]n king [[Croesus]], around 560 B.C.E. The first Greek coins were made initially of [[copper]], then of [[iron]] because copper and iron were powerful materials used to make weapons. [[Pheidon]] king of [[Argos]], around 700 B.C.E., changed the coins from iron to a rather useless and ornamental metal, [[silver]], and, according to [[Aristotle]], dedicated some of the remaining iron coins (which were actually iron sticks) to the temple of Hera[http://www.metrum.org/money/heraion.htm]. King Pheidon coined the silver coins at [[Aegina]], at the temple of the goddess of wisdom and war [[Athena]] the [[Aphaia]] (the vanisher), and engraved the coins with a [[Chelone]], which is to this day as a symbol of
 
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[[capitalism]]. Chelone coins[http://www.snible.org/coins/hn/aegina.html] were the first medium of exchange that was not backed by a real value good. They were widely accepted and used as the international medium of exchange until the days of [[Peloponnesian War]], when the Athenian [[Drachma]] replace them. According other fables, inventors of money were [[Demodike]](or [[Hermodike]]) of [[Kymi]] (the wife of [[Midas]]), [[Lycus|Lykos]] (son of [[Pandion II]] and ancestor of the [[Lycia]]ns) and [[Erichthonius of Athens|Erichthonius]], the [[Lydia]]ns or the [[Naxos, Greece|Naxians]].
 
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The Romans of the late Republic had their own alternative theories for why the Temple of Juno was known as Juno Moneta. Cicero, and others, claimed the epithet was of goddess, in honor of Juno's role as warder (monitor) who sent warnings to Rome, often through her geese; alternately, the name could be the name of the temple itself, Juno of the Hill (mons, montis).[http://vernondent.blogspot.com/2005/09/carnival-of-etymologies_22.html]
 
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It is very unusual for someone to share his money with others and let them know where his/her money is, almost everyone wants to be alone in front of it and tries to hide it and protect it from others. Everyone is alone in front of money, and money makes everyone to be alone. So the etymology of money deriving from the Greek μόνη (lonely) makes sense.
 
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The word money in [[Greek language]] is not μόνη (money), it is νόμισμα (nomisma or numisma) which derives from the word νομίζω (nomizo=putative, I think so, I suppose so) and from the word νόμος (nomos=law). So [[Numismatic|numisma]] gives the exact meaning and definition of mone(y). It is something we think has value, or something which someone has convinced us has, but in reality has not. In case we are unconvinced that mone(y) has value and we do not recognize the mone(y) maker authority, mone(y) is also something that we are enforced by law to use it as the unique medium of exchange in trades. In case an individual or a community refuses to accept mone(y) as the unique medium of exchange, then the powerful mone(y) maker authority, using violence and the [[tax]]es procedure, steals the real value goods (home,food,transport,energy) that the individual or the community owns. That is why
 
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many individuals or communities hide their goods from mone(y)-maker authorities. The crime of hiding goods from a mone(y)-maker authority is called [[tax evasion]].
 
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"'' He who has an ear, let him hear what the Spirit says to the churches. To the winner, I will give some of the hidden [[manna]] and I will also give him a white vote with a new name written on it which no one knows except the one who receives it.''"([[Book of Revelation]] 2:17).
 
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One of the words for money in the [[Hebrew language]] is [[mammon]]. Mammon does have more than one meaning depending on its linguistic and etymological contexts. The [[Hebrew Bible|Hebrew]] and [[Christian]] [[Bible]] gives the word mammon a broader context in its [[socioeconomic]], cultural, and [[theological]] usages.
 
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Mammon, a word of [[Aramaic]] origin, means "riches," but has an unclear etymology; scholars have suggested connections with a word meaning "entrusted," or with the [[Hebrew (language)|Hebrew]] word "matmon," meaning "treasure." {{Fact|date=March 2007}} It is also used in Hebrew as a word for "money" - ממון.
 
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The [[Greek language|Greek]] word for "Mammon," ''mamonas'', occurs in the [[Sermon on the Mount]] ([[Book of Matthew|Matthew]] vi 24) and in the parable of the Unjust Steward (Luke xvi 9-13). The [[Authorised Version]] keeps the Syriac word. Wycliffe uses "richessis." Other scholars derive Mammon from [[Phoenician languages|Phoenician]] "mommon," benefit. It is interesting to note that if mammon(as) (μαμων{{Polytonic|ᾶ}}ς) is considered as a Greek word and as a composite one (the majority of Greek words are composites), the two parts "[[Manna|mam]]-mon(as)" could be explained (in Greek doric) as "lonely mother," which recalls Hera's myth mentioned above. Other explanations could be
 
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mamm(means "mother" or "food")-onas(means "a place where you can find mamm"), also mam(means "mother" or "food")-m(means "with")-on(means "being")-as(with [[Circumflex]], means "owner or seller").
 
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Another word for money in Hebrew is the word Kessef-כסף, that translates to silver. Also the French word for money, [[Argent]], derives from the Greek ''άργυρος'', and translates also to silver.
 
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According to the Book of Revelation, the [[mark of the beast]] seems to be a form of money:
 
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"''And he causeth all, both small and great, rich and poor, free and bond, to receive a mark in their right hand, or in their foreheads: And that '''no man might buy or sell, save he that had the [[Mark of the Beast|mark]]''', or the name of the beast, or the number of his name. Here is wisdom. Let him that hath understanding vote the number of the beast: for it is the number of a man; and his(its) number is ΧΞς.''" ([[Book of Revelation]] 13:16-13:18).
 
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==Quotations on money==
 
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*''"God made Man. Man made Money. Money made Man mad."''
 
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*''"No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one, and despise the other. Ye cannot serve God and [[Mammon]]."''  [[Gospel of Matthew]] 6:24 (KJV)
 
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*''"For the love of money is the root of all evil: which while some coveted after, they have erred from the faith, and pierced themselves through with many sorrows."'' [[First Epistle to Timothy]] 6:10 (KJV)
 
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*''"When it's a question of money, everybody is of the same religion."'' [[Voltaire]]
 
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*''"Only when the last tree has died and the last river been poisoned and the last fish been caught will we realise we cannot eat money."'' [[Cree]] [[proverb]]
 
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*''"When I have money, I get rid of it quickly, lest it find a way into my heart."'' [[John Wesley]]
 
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*''"Money. It's a gas."'' [[Pink Floyd]]
 
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*''"Everybody loves 'money'. That's why it's called money."'' [[Danny DeVito]]
 
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*''"Money doesn't talk, it swears."'' [[Bob Dylan]]
 
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*''"So you think that money is the root of all evil? Have you ever asked what is the root of money? Money is a tool of exchange, which can't exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears or of the looters, who take it from you by force. Money is made possible only by the men who produce. Is this what you consider evil?"'' [[Ayn Rand]]
 
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*''"The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled."'' [[John Kenneth Galbraith]]
 
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*''"Money is a stupid measure of achievement, but fortunately it is the only universal measure we have."'' - [[Charles Steinmetz]]
 
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*''"When money talks, bullshit walks"'' ''Proverb used by officials in finance''
 
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*''"Money don't make a man, but man make money, because if you plan to be the man it's gonna take money."'' [[Da'unda'dogg]]
 
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*''"What is money? Money is what makes a man act funny"'' [[Eminem]]
 
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==Notes==
 
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<references/>
 
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==References==
 
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* Davies, Glyn, [http://www.exeter.ac.uk/~RDavies/arian/llyfr.html History of Money from Ancient Times to the Present Day]
 
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* Jevons, W. S. (1875), Money and the Mechanism of Exchange, London: Macmillan.
 
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* Menger, Carl, [http://socserv.mcmaster.ca/econ/ugcm/3ll3/menger/money.txt "On the Origin of Money"]
 
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* Szabo, Nick, [http://szabo.best.vwh.net/shell.html Shelling Out—The Origins of Money]
 
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* [http://www.usmint.gov/ United States Mint]
 
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* [http://www.royalmint.com/RoyalMint/web/site/Corporate/Home/corporate_homepage.asp Royal Mint]
 
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* [http://www.money.org/AM/Template.cfm?Section=Home American Numismatic Association]
 
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* [http://www.worldbank.org/index.html World Bank]
 
  
 
==External links==
 
==External links==

Revision as of 20:17, 25 September 2007


Money is whatever serves as the "medium of exchange." That is, as the quotation from Adam Smith says, “……..money is a commodity or token that everyone will accept in exchange for the things they have to sell……..”

File:Moneybillscoins3.jpg
Various denominations of currency, one form of money
Different societies may have different monies. Some historical examples are, for instance:
  • Gold coins (in medieval Europe); and
  • Cowrie shells (in West Africa) .

The cowrie shells used in West Africa are small seashells. This may sound "quaint," but cowrie-money was very successful. It continued to be used into the twentieth century, after the West African countries had become colonies. The colonies were required to use European money, and they did — but when the European monetary systems collapsed in hyperinflation, the West African people went back to using their cowrie-money to get past the crisis. It was the cowrie-money that proved most reliable for many years of the twentieth century.

File:Blombosbeads3.jpg
Shells of the pea-sized snail Nassarius kraussianus. Blombos Cave, South Africa, 75,000 B.C.E. Wear marks indicate the shells were strung on a necklace or bracelet.

We should say that the "commodity" that serves as money can be a purely symbolic token, like dollar bills in America. Indeed, all money has primarily symbolic value. Even the gold coins used in medieval Europe were probably valued more for their symbolic value than for the gold they contained. 

==Money, types of money , and general overview==

Symbolic or not, money is an asset. Thus we claim that in any society, money is the asset, commodity or token, that serves as a medium of exchange.

=Credit card is not money

Economists do not regard credit cards as money, because a credit card is not an asset but a line of credit. What is a "line of credit?" A "line of credit" is an agreement between a lender and a potential borrower, whereby the borrower can borrow up to some limit without any further approval. For example, if you were to build a house and act as your own prime contractor, you would need money to buy lumber and other supplies and to pay subcontractors from week to week. To do those things more conveniently, you might arrange with your banker to write checks for these expenses, even though you have no funds in the bank. Each check would be a loan, and the bank would honor them up to some agreed-on limit. Once your house is complete, you could refinance your loan as a long-term mortgage. This way, you wouldn't have to borrow the money (and thus pay interest on it) until you actually needed it. If you have a credit card with XYZ bank, that means you have a line of credit with that bank, and the card is the proof that the bank is willing to loan you money.

Major types of money in a historical context

As we have hinted, different societies have quite different money systems. The major historical types of money are:

  • Commodity moneys.


These are moneys that have value in non-monetary uses equivalent to the monetary value of the commodity. Any commodity used as a medium of exchange is commodity money. Well-known examples are gold, copper and silver metals, but sea-shells (that is, cowrie shells) tobacco, and cigarettes have all been used. One interesting example of commodity money is the huge limestone coins from the Micronesian island of Yap, quarried with great peril from a source several hundred miles away.

An 8-foot "coin" from the village of Gachpar, on Yap.


The value of the coin was determined by its size — the largest of which could range from nine to twelve feet in diameter and weigh several tons. Displaying a large coin, often outside one's home, was a considerable status symbol and source of prestige in that society. 

*Metallic coin: Historically, copper, gold and silver coins have been the most used in European and East Asian societies.  The typical feature of these metallic coins  is that have values roughly equal to the price the metal would command as jewelry.

EXAMPLE: Standardized coinage

File:Maximinus denarius.jpg
A Roman denarius, a standardized silver coin.

It was the discovery of the touchstone which led the way for metal-based commodity money and coinage. Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. As a result, monetary gold spread very quickly from Asia Minor, where it first gained wide usage, to the entire world.

Using such a system still required several steps and mathematical calculation. The touchstone allows one to estimate the amount of gold in an alloy, which is then multiplied by the weight to find the amount of gold alone in a lump.

File:Shapuri.jpg
A Persian coin.

To make this process easier, the concept of standard coinage was introduced. Coins were pre-weighed and pre-alloyed, so as long as the manufacturer was aware of the origin of the coin, no use of the touchstone was required. Coins were typically minted by governments in a carefully protected process, and then stamped with an emblem that guaranteed the weight and value of the metal. It was, however, extremely common for governments to assert the value of such money lay in its emblem and thus to subsequently debase the currency by lowering the content of valuable metal.

Although gold and silver were commonly used to mint coins, other metals could be used. For instance, Ancient Sparta minted coins from iron to discourage its citizens from engaging in foreign trade. In the early seventeenth century Sweden lacked more precious metal and so produced "plate money," which were large slabs of copper approximately 50 cm or more in length and width, appropriately stamped with indications of their value.

Metal based coins had the advantage of carrying their value within the coins themselves — on the other hand, they induced manipulations: the clipping of coins in the attempt to get and recycle the precious metal. A greater problem was the simultaneous co-existence of gold, silver and copper coins in Europe. English and Spanish traders valued gold coins more than silver coins, as many of their neighbors did, with the effect that the English gold-based guinea coin began to rise against the English silver based crown in the 1670s and 1680s. Consequently, silver was ultimately pulled out of England for dubious amounts of gold coming into the country at a rate no other European nation would share. The effect was worsened with Asian traders not sharing the European appreciation of gold altogether — gold left Asia and silver left Europe in quantities European observers like Isaac Newton, Master of the Royal Mint observed with unease.


  • Commodities: Other commodities were used too. As we have seen, seashells have been used as money, as have tobacco and, perhaps, oxen.

Commodity based currencies are often viewed as more stable, but this is not always the case. The value of a commodity based currency as a medium of exchange depends on its supply relative to other goods and services available in the economy. Historically, gold, silver and other metals commonly used in commodity based monetary systems have been subject to regular and sometimes extraordinary fluctuations in purchasing power. This not only damages its stability as a medium of exchange; it also reduces its effectiveness as a store of value. In the 1500s and 1600s huge quantities of gold and even larger amounts of silver were discovered in the New World and brought back to Europe for conversion into coin. As a result, the purchasing power of those coins fell by 60% to 80%, i.e. the prices of goods rose, because the supply of goods did not keep pace with the increased supply of money ( Galbraith, 1975.)


  • Fiat money.

Fiat money is a monetary standard (usually paper money) that people are required by law to accept as a medium of exchange and/or a standard of deferred payment. It is money by the "fiat" — the command — of the sovereign.

Fiat money provides solutions to several limitations of commodity money. Depending on the laws, there may be little or no need to physically transport the money - an electronic exchange may be sufficient. Its sole use is as a medium of exchange so its supply is not limited by competing alternate uses. It can be printed without limit, so there is no limit on trade volumes.

Fiat money, especially in the form of paper or coins, can be easily damaged or destroyed. However, it has an advantage over commodity money in that the same laws that created the money can also define rules for its replacement in case of damage or destruction. For example, the US government will replace mutilated paper money if at least half of the bill can be reconstructed ( [http: //www. bep.treas.gov/section.cfm/8/39 Shredded and mutilated]. )

Some of the benefits of fiat money can be a double-edged sword. For example, if the amount of money in active circulation outstrips the available goods and services for sale, the effect can be inflationary. This can easily happen if governments print money without attention to the level of economic activity or counterfeiters are allowed to flourish.

Perhaps the biggest criticism of paper money relates to the fact that its stability is highly dependent on the stability of the legal system backing the currency. Should the legal system fail, so would the currency that depends on it.


  • Fiduciary money.


Whenever a bank issues credible promises to pay in some other form of money, and the promises are transferable, they can circulate as money. Bank money is also called "fiduciary money," since it is based on the trust people have that the bank will keep faith (fides) and pay as promised. Fiduciary money may be based on promises to pay in commodity money (gold coin, for example) or in fiat money. We will go into much more detail later, because modern monetary systems are largely fiduciary. Two major instances of fiduciary money are:

  • Bank notes: These are bills issued by banks. They were widely used in the nineteenth century and are still used in some countries.


File:Banknotes.jpg
Banknotes from all around the world donated by visitors to the British Museum, London


  • Checking accounts: In our society, checks are acceptable as money, so by the definition of money — a commodity or token that serves as a medium of exchange — checks are money, just as real as any other kind of money.

Both fiat money and fiduciary money are tokens, of course, as distinct from commodity moneys. These token moneys are much the most important kinds of money in the modern world.

Functions of Money

We say traditionally that money has four major functions. The money is:

  • Medium of exchange.

Whatever people usually give in exchange for the things that they buy is the medium of exchange. As we have seen, this is the function that defines money.

  • Unit of account.

The unit of account is the unit in which values are stated, recorded and settled. The differences between this and the medium of exchange may seem subtle, but there are a few cases in which the unit of account is different from the unit in which the medium of exchange is expressed. In Britain a few decades ago, Guineas were often used as the unit of account, while the medium of exchange was expressed in Pounds. Both Guineas and Pounds in turn could be expressed in shillings — the Pound was 20 shillings and the Guinea was 21 shillings. (British currency has since been redefined).

  • Standard of deferred payment.


This is the unit in which debt contracts are stated. Deferred payment means a payment made in the future, not now. Here, again, it is usually the same as the medium of exchange, but not always. During periods of inflation, people may accept paper money for immediate payment, but insist on some other medium, such as real goods and services or gold, for deferred payment — because the medium of exchange would lose much of its value in the meanwhile.


  • Store of value.


Again, this is something that people keep in order to maintain the value of their wealth. Again, while it would usually be the same as the medium of exchange, in inflationary times other media might be substituted, such as jewelry, land or collectable goods. In this sense, money is "set aside" for the future.

However, the fact that money – and sometimes the ultimate commodity for which it freely exchanges, such as ‘gold’ — also serves as a store of value creates a problem . This encourages hoarding ( in other circumstances known as "saving" ) and takes the commodity money out circulation, reducing the supply. The supply of circulating commodity currency is further reduced by the fact that commodity moneys also have competing non-monetary uses. For example, gold and silver are used in jewelry, and nickel and copper have important industrial uses.


Early History of Money

Money has been used for something like 3000 years. City-states in the ancient near east had extensive trade from city to city, and they used precious metals as a medium of exchange. When trades were settled a certain amount of metal could be used to settle the difference. There was a problem of quality control, however. There were problems of determining that the quantity and purity of the metal was as agreed. The answer was quality control and certification. The early kings of Lydia standardized the hunks of metal and guaranteed their quality by stamping the king's picture on them. These were the first coins. This guarantee of quality by the Lydian kingdom — already a rich and powerful one — was very successful, and made the Kingdom of Lydia even richer, indeed proverbially rich. Croesus and Midas — of all kings the most proverbially wealthy ones — were among the kings of Lydia. But what Lydia could do, other kingdoms could also do. By 1000 C.E., metallic coin monetary systems had spread through much of the old world. As in so many other things, the Chinese were the innovators for the next step. The Chinese invented printing, and not too much later, they also invented paper money. It was widespread in China by around 1000 C.E., but the Chinese abandoned it after about 1500, in the general decline of Chinese society after the Mongol conquest. Paper money was to evolve much more indirectly in Europe, though.

A Tale about Money and Banking

Let us start with a short story:

  • Fred, as a goldsmith, he has a strong vault.
  • He stores the gold owned by other citizens for a small fee. (A business that stores money in its vaults for a fee is called a bank of deposit.)
  • Fred gives his customers receipts for their deposits.
  • After a while, some of Fred's customers use receipts for the gold they have deposited to make payments and settle debts.

EXAMPLE: One customer may hand over a receipt in payment for a wagon. Then the wagon-maker may leave the gold on deposit, and pass the receipt on to the cooper (that is, the barrel-maker) to pay for some barrels. Fred's receipts have become "banknotes" and the Bank of Fred is now a "Bank of Issue" and new environment and issues have taken place ever since:

  • The Bank of Issue: One day Johann the Peasant comes in to ask for a loan. Johann is doing pretty well, and wants to buy a second ox so he can use a two-ox team to cultivate a larger field. Fred doesn't have any gold to loan — so he writes out some bank-notes and gives them to Johann the Peasant as a loan. The ox-seller accepts the bank-notes in payment for the ox, and at the end of the year, Johann sells some of his crop for bank-notes, and uses those bank-notes to repay the loan with interest. Fred has created money out of nothing (but trust)! And creating money is a profitable business.
  • The Limit: If many customers want to redeem their bank notes at once, the bank will not be able to comply. This is a "run" on the bank. The Bank of Fred will then be unable to redeem its notes, faith in them will collapse, and the bank-notes will cease to be money.

Fred has to be careful to keep enough gold coins in reserve to avoid this danger. Suppose experience has taught Fred that he needs to keep one Florin in the vault for every three banknotes he has issued. That is, Fred has adopted a reserve ratio — a ratio of reserves to money issue — of 1/3. This determines how much money Fred can issue. If Fred has 1,000 Florins in the vault, then he can issue 3,000 Florins of bank-notes. If someone deposits another 100 Florins, Fred would then be able to issue 300 new bank-notes. Fred would give 100 to the new depositor as receipts for his deposits, but the other 200 Florins would be available for Fred to loan out and so increase his profits. So much for the story. It is, however, not a fairly tale but a reasonably fitting account of steps that had been done, before the real banking system became the real power behind the “thrones” of the world. EXAMPLE: Among the real early bankers were the Medici(s), who started out as medical doctors, and ended as monarchs, and the Fuggers, who owned a silver mine. The above “story” gives also an accurate portrayal of the workings of a bank of issue in a system of fiduciary money. The Bank of Fred is a good example of a bank of issue. But the story goes on:

  • Paper money system: By the 1700's, bank notes (called "fiduciary money") circulated widely in Western Europe, along with metallic coins. However, the Napoleonic Wars created problems.
  • Gold Standard: fter the war, the ( British ) government brought in a consultant — gentleman-economist David Ricardo. Ricardo designed a new, somewhat more streamlined monetary system.

In the new monetary system, paper Pound notes were the main medium of exchange. They would be issued only in proportion to gold bullion held by the Bank of England, and redeemable for bullion in large quantities, mostly for international trade. This is the "classical" gold standard of the nineteenth century — strictly speaking, not a gold coin system but a paper money system with the paper (fiduciary) money exchangeable for gold bullion.

  • Federal Reserve System: During the 19th century, then, Britain was "on the gold standard." America was not. America was never on any very consistent monetary standard at all. In 1913, Congress established the Federal Reserve System (the "fed") to be the American central banking system — the "bankers' bank" and main control on the monetary system.

The Federal Reserve system consists of 12 Banks for 12 districts in different parts of the country. The federal reserve banks are also bankers' banks. By controlling the amount of reserves, and regulating the reserve ratio, the Federal Reserve System controls the American Money Supply. Something similar could be said about most developed economies. In the modern world, money is not a commodity but a service provided by banks.

This causes some concern. People worry about whether money is "based on" some commodity, and what commodity. But why worry? The answer comes in two stages.

  • From many points of view, the effectiveness of the monetary system requires a fairly stable average price level. As we have seen in a previous chapter, inflation can and sometimes has destroyed the purchasing power of a monetary unit very rapidly.
  • The danger of inflation was seen as being connected to the quantity of money in circulation by way of the "quantity theory of money" ( which is quite another topic altogether. )

Summary

  • Checking accounts are money, fiduciary money created by banks.
  • Creation of fiduciary money is limited by the supply of bank reserves.
  • Bank reserves are obligations of the Federal Reserve, including deposits and vault cash.
  • Checks are "cleared" by the Federal Reserve by transferring deposits from the bank that issued the check to the bank that deposits it.
  • A bank that has excess reserves may be able to create money and loan it, by establishing a checking account in the amount of the loan.
  • Nevertheless, banks have to limit their lending to allow for "clearing" through the Federal Reserve.
  • An increase in reserves, for example by importing currency from abroad, increases the total money supply by a multiple of the increase in reserves.
  • The multiple is the inverse of the required reserve ratio.

Conclusion

“……Money is not, properly speaking, one of the subjects of commerce; but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another. It is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy. If we consider any one kingdom by itself, it is evident, that the greater or less plenty of money is of no consequence; since the prices of commodities are always proportioned to the plenty of money, and a crown in Harry VII's time served the same purpose as a pound does at present…..” ( Hume, 1752. )

“……It seems a maxim almost self-evident, that the prices of every thing depend on the proportion between commodities and money, and that any considerable alteration on either has the same effect, either of heightening or lowering the price. Increase the commodities, they become cheaper; increase the money, they rise in their value. As, on the other hand, a diminution of the former, and that of the latter, have contrary tendencies…….” ( ibid.,1752. )

“…..Because of the money increase ( in the certain economic area and era ) , every thing must become much cheaper in times of industry and refinement, than in rude, uncultivated ages. It is the proportion between the circulating money, and the commodities in the market, which determines the prices……. after money enters into all contracts and sales, and is every where the measure of exchange, the same national cash has a much greater task to perform; all commodities are then in the market; the sphere of circulation is enlarged; it is the same case as if that individual sum were to serve a larger kingdom; and therefore, the proportion being here lessened on the side of the money, every thing must become cheaper, and the prices gradually fall……”( ibid., 1752. )

And finally: We may have heard the fallacy circulated within the historians as well among the common folks: 

“…… that any particular state is weak, though fertile, populous, and well cultivated, merely because it wants money. …….It appears, that the want of money can never injure any state within itself: For men and commodities are the real strength of any community. It is the simple manner of living which here hurts the public, by confining the gold and silver to few hands, and preventing its universal diffusion and circulation. On the contrary, industry and refinements of all kinds incorporate it with the whole state, however small its quantity may be: They digest it into every vein, so to speak; and make it enter into every transaction and contract. No hand is entirely empty of it. And as the prices of every thing fall by that means, the sovereign has a double advantage: He may draw money by his taxes from every part of the state; and what he receives, goes farther in every purchase and payment……..” ( ibid., 1752. )

NOTE: Quotations on money

  • "No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one, and despise the other. Ye cannot serve God and Mammon" ( Gospel of Matthew 6:24 (KJV. )
  • "For the love of money is the root of all evil: which while some coveted after, they have erred from the faith, and pierced themselves through with many sorrows." ( First Epistle to Timothy 6:10 (KJV. )
  • "When it's a question of money, everybody is of the same religion" ( Voltaire. )
  • "Only when the last tree has died and the last river been poisoned and the last fish been caught will we realise we cannot eat money" ( Cree proverb. )
  • "So you think that money is the root of all evil? Have you ever asked what is the root of money? Money is a tool of exchange, which can't exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears or of the looters, who take it from you by force. Money is made possible only by the men who produce. Is this what you consider evil?" (Ayn Rand. )
  • "The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled" ( John Kenneth Galbraith. )


References
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External links

  • Linguistic and Commodity Exchanges by Elmer G. Wiens. Examines the structural differences between barter and monetary commodity exchanges and oral and written linguistic exchanges.


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