Money

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. However, "asset" is the key words in excluding credit cards, also known as "plastic money", from the monetary environment.

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.

EXAMPLE: If you are 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, on the other hand, 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.Other commodities were used too; apart from the seashells and tobacco, sometimes perhaps, oxen.

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.

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.)

• Metallic coins.

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. 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.

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.

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 bankers --- like Isaac Newton, Master of the Royal Mint --- watched with unease.

• 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",i.e. 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.

On the other hand, 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]. )

Still, some of the benefits of fiat money can be a double-edged sword.

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.

But 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.

EXAMPLE: 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 ( NOTE: 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 might lose much of its value in the meantime.

• Store of value.

Similarly to the above notions, this is something that people keep, in order to maintain the value of their wealth. And 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.

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. Problems of determining that of the quantity and, above all, the purity of the metal was were the source of agreements.

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 do too. 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 in so far the the next step went. 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 C.E., in the general decline of Chinese society after the Mongol conquest.

Instead, 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, has a strong vault.

• He stores the gold owned by other citizens for a small fee. ( NOTE: 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.

EXAMPLE: 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 fairy 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.

( NOTE: 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: After the war, the ( British ) government brought in a consultant: a 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.

These 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; 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

ISBN links support NWE through referral fees

• Davies, Glyn, 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, "On the Origin of Money"
• Szabo, Nick, Shelling Out—The Origins of Money
• United States Mint
• Royal Mint
• American Numismatic Association
• World Bank
• Shredded and mutilated. Bureau of engraving and printing.

External links

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

• 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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