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What is Money?

February 1, 2013

In every trade, each side has something that the other wants. When goods are bartered for goods, each side must have the exact good that the other wants. With money, you only need to do one half of the transaction (buying or selling) at a time. First, you sell what you have for money (usually labor), and then you buy what you want with the money. When stores sell goods, they don’t even have to know what their employees want. They just know that those employees will be happy getting money.

Each person can trade what they have for money, and then trade the money for what they want. Indirect exchange works even when none of them could barter for what they wanted directly. For example in the picture below, the farmer wants to sell food and buy clothes. By first trading for money with the carpenter, he can then buy the clothes from the tailor without worrying about what the tailor wants.

Circle of trade

Money did not spring out of existence from nothing; it evolved over time. In the ancient world, people used commonly desired goods as money such as grain, as well as tokens, metal coins and shells. Any good could theoretically be used as money, but some goods are better than others. There are several characteristics that improve the functioning of money:

Wide Acceptance: The more people who accept the money in exchange for goods and services, the more who can engage in indirect exchange with one another. As long as you can find someone in the entire economy to buy what you have for money, you can buy any good from anyone else using that money.

Store of Value: All exchange takes place over time. It takes time to work and earn, and time to spend the money. Some purchases need to be made every few days, such as food, and others need to be made rarely, such as buying a car or a house. Large purchases require saving, so if the money lost value quickly over time, it wouldn’t be as useful. Money should be hard to forge, because forgery lowers the value of the currency.

Convenience: The money must be portable and durable so that it does not get damaged and become worthless over time. Additionally, money must be uniform so that people can display prices, write well defined contracts and define debts in a common unit.

Low opportunity cost: The material used as money should be as useless as possible, because materials used as money can’t be used for anything else. For example, if grain were used as money, people couldn’t eat the grain that they were intending to exchange. Gold made a good money precisely because it is not a practical material for many applications in the ancient world. Paper is even better, since the marginal cost of paper money is very low.

Units of Account
What makes money special is that it alone is the unit of account, which is the unit of measurement of value. You can trade using goods other than money, and you can store value by buying stocks, bonds, precious metals, or real estate. But when the value of money changes, the price of all other goods change. If one store of value declined in value, people would find some other way to store value. If it became difficult to use one medium of exchange, people would switch to another one. But there is no way to escape money’s use as the unit of account.

It’s hard to visualize this when you’re dealing with fiat (paper) currency, so suppose you are on a gold standard and someone discovers a new gold mine. That shifts the supply curve of gold to the right, lowering the price of gold. If gold were not the unit of account, its price would simply drop. But if gold were the unit of account, the price of everything else would have to increase. In fact, this is exactly what happened when Spain started importing massive quantities of silver from South America during its imperialist period.

Supply increase

If prices were perfectly flexible, changes in the value of money wouldn’t impact the economy. However, some prices are sticky, meaning they only change slowly. That means that when the value of money changes, some things are too expensive and others are too cheap. That’s why money matters so much to the proper functioning of the economy.

Further reading:
Wikipedia’s article on money
Sumner on the Unit of Account

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