In the modern world we take money for granted. However, pause for a moment and imagine what life would be like without money. Suppose that you want to consume a particular good or service, such as a pair of shoes. If money didn't exist, you would need to barter with the cobbler for the pair of shoes that you want. Barter is the process of directly exchanging one good or service for another. In order to purchase the pair of shoes, you would need to have something to trade for the shoes. If you specialized in growing peaches, you would need to bring enough bushels of peaches to the cobbler's shop to purchase the pair of shoes. If the cobbler wanted your peaches and you wanted his shoes, then a double coincidence of wants would exist and trade could take place.
But what if the cobbler didn't want your peaches? In that case you would have to find out what he did want, for example, beef. Then you would have to trade your peaches for beef and the beef for shoes. But what if the person selling beef had no desire for peaches, but instead wants a computer? Then you would have to trade your peaches for a computer—and it would take a lot of peaches to buy a computer. Then you would have to trade your computer for beef and the beef for shoes. But what if…? At some point it would become easier to make the shoes yourself or to just do without.
The Evolution of Money
Money evolved as a way of avoiding the complexities and difficulties of barter. Money is any asset that is recognized by an economic community as having value. Historically, such assets have included, among other things, shells, stone disks (which can be somewhat difficult to carry around), gold, and bank notes.
The modern monetary system has its roots in the gold of medieval Europe. In the Middle Ages, gold and gold coins were the common currency. However, the wealthy found that carrying large quantities of gold around was difficult and made them the target of thieves. To avoid carrying gold coins, people began depositing them for safekeeping with goldsmiths, who often had heavily guarded vaults in which to store their valuable inventories of gold. The goldsmiths charged a fee for their services and issued receipts, or gold notes, in the amount of the deposits. Exchanging these receipts was much simpler and safer than carrying around gold coins. In addition, the depositors could retrieve their gold on demand.
Goldsmiths during this time became aware that few people actually wanted their gold coins back when the gold notes were so easy to use for exchange. They therefore began lending some of the gold on deposit to borrowers who paid a fee, called interest. These goldsmiths were the precursors to our modern fractional reserve banking system.
Functions of Money
Regardless of what asset is recognized by an economic community as money, in general it serves three functions:
- Money is a medium of exchange.
- Money is a measure of value.
- Money is a store of value.
Money as a medium of exchange. Used as a medium of exchange, money means that parties to a transaction no longer need to barter one good for another. Because money is accepted as a medium of exchange, you can sell your peaches for money and purchase the desired shoes with the proceeds of the sale. You no longer need to trade peaches—a lot of them—for a computer and then the computer for beef and then the beef for the shoes. As a medium of exchange, money tends to encourage specialization and division of labor, promoting economic efficiency.
Money is a measure of value. As a measure of value, money makes transactions significantly simpler. Instead of markets determining the price of peaches relative to computers and to beef and to shoes, as well as the price of computers relative to beef and to shoes, as well as the price of beef relative to shoes (i.e., a total of six prices for only four goods), the markets only need to determine the price of each of the four goods in terms of money. If we were to add a fifth good to our simple economy, then we would add four more prices to the number of good-for-good prices that the markets must determine. As the number of goods in our economy grew, the number of good-for-good prices would grow rapidly. In an economy with ten goods, there would be forty-five good-for-good prices but only ten money prices. In an economy with twenty goods there would be one hundred and ninety good-for-good prices but only twenty money prices. Imagine all of the good-for-good prices in a more realistic economy with thousands of goods and services available.
Using money as a measure of value reduces the number of prices determined in markets and vastly reduces the cost of collecting price information for market participants. Instead of focusing on such information, market participants can focus their effort on producing the good or service in which they specialize.
Money as a store of value. Money can also serve as a store of value, since it can quickly be exchanged for desired goods and services. Many assets can be used as a store of value, including stocks, bonds, and real estate. However, there are transaction costs associated with converting these assets into money in order to purchase a desired good or service. These transaction costs could include monetary fees as well as time delays involved in the liquidation process.
In contrast, money is a poor store of value during periods of inflation, while the value of real estate tends to appreciate during such periods. Thus, the benefits of holding money must by balanced against the risks of holding money.
Summary
Money simplifies the exchange of goods and services and facilitates specialization and division of labor. It does this by serving as a medium of exchange, as a measure of value, and as a store of value.
