Friday, June 5, 2009

The Evolution of Money

Money

# A medium that can be exchanged for goods and services and is used as a measure of their values on the market, including among its forms a commodity such as gold, an officially issued coin or note, or a deposit in a checking account or other readily liquefiable account.

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 Macbook. If money didn't exist, you would need to barter with the retailer for the Macbook that you want.

Barter

Barter is the process of directly exchanging one good or service for another. In order to purchase the Macbook, you would need to have something to trade for the Macbook. If you specialized in growing orange, you would need to bring enough boxes of oranges to the retailer's shop to purchase the Macbook. If the retailer wanted your oranges and you wanted his Macbook, then a double coincidence of wants would exist and trade could take place.

But what if the retailer didn't want your oranges? In that case you would have to find out what he did want, for example, chicken. Then you would have to trade your oranges for chicken and the chicken for Macbook.

But what if the person selling chicken had no desire for oranges, but instead wants a cooker? Then you would have to trade your oranges for a cooker—and it would take a lot of oranges to buy a cooker. Then you would have to trade your cooker for chicken and the chicken for Macbook.

But what if…?

At some point it would become easier to make the Macbook yourself or to just do without.

Cool 0r Cool!

“Wealth is define by the numbers of days you can lives forward if you stop working now”

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 lemons for money and purchase the desired Macbook with the proceeds of the sale. You no longer need to trade lemons—a lot of them—for a cooker and then the cooker for chicken and then the chicken for the Macbook. As a medium of exchange, money tends to encourage specialization and division of labour, 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 oranges relative to cookers and to chicken and to Macbook, as well as the price of cookers relative to chicken and to Macbook, as well as the price of chicken relative to Macbooks (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.


“Value is the river in which wealth flows”

Summary

Money simplifies the exchange of goods and services and facilitates specialization and division of labour. It does this by serving as a medium of exchange, as a measure of value, and as a store of value.