Money 101 — part 1

The Nature and Origin of Money

Imagine three people living in prehistoric times. Aya has a green pepper, which she rightly regards as pretty but of disgusting flavor. She comes upon Gus, who has some fine-looking strawberries; Gus has no fondness for green peppers either, and asks Aya if she has any okra. Aya shudders at the thought of okra, and sadly admits that she has none. She goes away, and meets Tor, who has okra, and asks if she would like it in exchange for the green pepper. But she has no love of Tor (Eater of Green Peppers!), the green pepper is at least pretty, and the okra is not.


In a pure barter economy, we have tragedy; there is no double co-incidence of wants to effect a trade.

But then Aya makes one of the most important leaps in human history. She trades her pretty, foul-tasting green pepper for the ugly, foul-tasting okra; and then runs to Gus, and trades the ugly, foul tasting okra for the delightful strawberries.

Aya traded for something, with the intention of trading that something away. The something (in this case okra) thus used is a medium of exchange. Aya has just invented money.

In the three-person example, Aya uses okra for money, but Gus could have used pepper for money, or Tor could have used strawberries for money.

The employment of media of exchange is invented repeatedly, and copied by others. It can be extended to trades that involve more that two trades for each person to get what he or she wants.


(In this n-person example, each of the commodities shown might be used as money.)

And patterns may be more complicated than simply a set of one-for-one trades with each commodity going to exactly and only one person.

The next step in the development of money is what might be called sensible speculation. In the three-person example, Aya had a specific expectation about the person with whom she would trade the okra, and about what she would get with it. In the more complicated example, Aya might specifically plan to trade with Briga, and Briga with Galt. But people may reälize that there is something that others will frequently want, and with which they may acquire a broad range of other things; then that particular medium of exchange has a special desirability because of its broad exchangability. And, as that broad exchangability is recognized by others, they seek it as well, so that the exchangability is increased; the money-ness is self-reïnforcing. Within a community, some set of things is so routinely used as money that that community thinks only of them as money.

Many things have historically served as money. But things work especially well as money if they are easily portable, durable, and divisible. And it also helps if the stuff has fairly stable values in trade. Some metals have been at times popular as money because they've had these attributes.

If money has these attributes then, as well as being the medium of exchange, it comes to be the unit of account (a quasi-measure[1] of trading value), the standard of deferred payment (what we use to write our contracts), and a store of value (a good means of socking-away wealth).

The philosopher John Locke was quite enthusiastic about the use of durable money as a store of value because, as he noted, it meant that people could hold lots of wealth without anything rotting in store-houses. (We'll have reason to return to that thought.)

To the extent that money does not lose value, it serves as a store of value. But for it to work well as a unit of account, it must neither lose nor gain value. If money is losing or gaining value but we are using it as our unit of account, then we are miscalculating.

Various ostensible authorities have insisted that these additional rôles — unit of account, standard of deferred payment, and store of value — are essential features of money as such. But in times of significant general price rises or price falls, what was used as money ceases to be the unit of account. (If we are adjusting our economic calculations to account for an increase or decrease in the value of money, then we are implicitly or explicitly using something else as our unit of account.) It may likewise cease to be the standard of deferred payment. And in times of dramatic price rises it ceases to be a good store of value. Yet, so long as it serves as a medium of exchange, people continue to refer to it using their word for money.

In the hypothetical three-person case of Aya, Gus, and Tor, and presumably in the n-person case, the logic of trade rested upon that commodity used as money being desired by someone for other than monetary use. In the three-person example, it would make no sense for Aya to use the strawberries as money, for Gus to use the okra as money, nor for Tor to use the pepper as money, because no one else desires these things.

It seems implausible that the original inventor of money would imagine the commodity going along a path that never led to its non-monetary use. Surely even the first instance of what I've called sensible speculation involved an implicit presumption that the thing used as money would eventually reach someone with no plans to exchange it.

For some given stock of a commodity to be used as money rather than otherwise, it must have a use as money whose value to the possessor is greater than that of any other use.[2] For example, for a gold coin to remain in circulation, it must never fall into the hands of a goldsmith, of a dentist, or of an electrical technician who would rather put that gold to other use than as a coin. While we might imagine that those who at any given time want the monetary commodity as other than money change their minds before it reaches them, with some other persons meanwhile developing such desire, we cannot explain the value of an indefinitely circulating money as the value of the commodity in non-monetary use. If it could never find its way into the hands of someone who valued it in non-monetary use more than as money, then its value as money could not be fully explained by its value in non-monetary use. It would somehow have additional value associated exactly with its use as money![3]

And yet we seem to arrive at money that circulates indefinitely, even when the money is a commodity. I have labored this issue in a previous 'blog entry. I did not then offer an explanation, nor do I offer one here.

[To continue reading, click on one of the section headings below.]

The Equation of Exchange and the Price Level

[Read more.]

The Inflationary Process

[Read more.]

Commodity-Based Money

[Read more.]

The Nationalization of Money and Fiat Money

[Read more.]

Partial-Reserve Issuance — the Charge of Fraud

[Read more.]

The Effects of Inequality in the Accumulation of Money

[Read more.]

[1] I'm here using the term quasi-measure; there may be some better term to be found or to be coined. In any case, what here seems to be measured is not, but in many contexts it is for practical purposes as if there is a measurement.

[2] Neo-classical fudges not-withstanding, in the case that the marginal value as money were somehow equal to that in other use, decision paralysis would result, during which time the coin would neither circulate nor be put to other use.

[3] However, if the money is a commodity, and the value at the margin of monetary use is more than minimally greater than the value at the margin of the non-monetary use, then stocks of the commodity will be shifted to monetary use. This shift will cause the value at the margin of the monetary use to decline (as per the discussion below on the relationship of the money supply to prices), and cause the value at the margin of non-monetary use to increase (as the commodity is first diverted from its least-valued uses). Such a shift will continue until the value at the margin of monetary use is so little different from that of non-monetary use that any discernible further shift would tip the balance the other way, or would not cover the transformation costs (eg, minting). Hence, while the monetary value of an indefinitely circulating monetary commodity as money must exceed the value in other use for all traders, the uses must be adjacent or very nearly adjacent in rank. Metaphorically expressed, the difference will be small.