What Is Money? A definition: money is the medium of exchange. It is the item or promise that is generally accepted in exchange even though no one ever expects to use the item in any other way than to buy something in a market.
Topics Discussed in This Chapter 1. The different types of money. 2. Money in the modern economy. 3. The marvel of money (appendix).
The Four Different Types of Money 1. Commodity Money 2. Representative Money 3. Credit Money 4. Government Money
First Type of Money: Commodity Money Commodity: a material good or resource. Commodity money: a material good or resource that not only has value in exchange but also has value in use. Example: a gold coin. If a gold coin was melted down, a grocer would trade almost the same amount of groceries for the gold metal as he would trade for the coin.
Gold Coins and The Mint Why a gold coin is worth more than the same weight of gold: it contains a stamp from a mint, which informs the user of its weight and purity. Mint: an organization that smelts metal ore into uniform coins or bars of fixed purity, size and weight. It then stamps them to signify their purity and weight.
Examples of Gold Coins and Bullion $5 $20 Gold Bar & Silver Ingot
Primitive Forms of Money Practical or ornamental items such as salt, tea, shells, weapons, tools, and jewelry served as humankind's earliest monies. The use of commodities as media of exchange persisted in some societies for hundreds of years after the invention of coinage.
Cowrie Shell Money Porcelain-like shells from mollusks found mainly in Indochina-Pacific Region were the first kind of money to circulate freely in trade in the ancient world.
Ghost Face Money Kuei T'ou C'ien (Ghost Face Money )
Ch'ing (Bridge Money) Bronze cast in the shape of miniature household tools and farm implements became a widely accepted form of Chinese currency as early as the 10th century BC. Some of these metallic pieces were still in use in the 2nd century AD.
Tea Brick Money Bricks of pressed tea leaves served as currency in Tibet, Mongolia, Siberia, and Northern China during the 19th and early 20th centuries. Pieces were cut from large bricks for use as small change.
Pan-Liang (221-118 BC) Money This is the famous coin of Emperor Shih Tuang Ti, builder of the Great Wall of China. The Pan Liang was the standard money of China for more than a century.
One Man Economy No need for exchangeNo need for exchange No need for moneyNo need for money
Money As a Medium of Exchange: Barter Society (1) People who obtain goods in trade expect to consume them. Example: fish for a blanket.
Money As a Medium of Exchange: Barter Society (2) People who obtain goods in trade may expect to trade them for other goods. A good that is acquired in order to trade for other goods functions as a medium of exchange. Example: in order to obtain nails, a person may first produce apples and then trade them for potatoes. Later, he trades the potatoes for nails. The potatoes function as media of exchange. But they are not generally accepted in exchange.
How A Money Economy Differs From A Barter Society At least one class of commodities is accepted in exchange by practically everyone in practically all circumstances. The class become generally accepted in exchange. It has value in exchange, regardless of its value in use. The use of a single class as money reduced the costs of making exchanges.
Barter in Colonial America Coins were scarce during the early colonial period, and much of the meager supply available went to pay for imported goods. Short of cash to spend at home, the settlers used tobacco, rice, corn, and numerous other commodities to buy goods and services and to pay debts.
Farm Products Corn and tobacco were the most important of the farm products that came into use as money substitutes. Both were declared legal tender and could be used to pay taxes and other debts.
Pelts Beaver pelts were used to pay court fines and debts and to buy goods. Sought after by fashionable Europeans, the skins became important export items.
Iron Nails Even such important objects as nails occasionally served as substitutes for scarce coins.
Wampum American Indians traded with strings and belts of polished beads known as wampum. Colonies soon adopted wampum as a commodity currency.
A Money Economy How a money economy differs from a barter economy: at least one class of commodity continues to be used as a medium of exchange by practically everyone. That is, practically everyone is willing to trade his commodities for the same commodity. Some amount of the commodity used as money is also used as a good or resource.
Advantages of Gold Over Other Commodities As a Medium of Exchange 1. Its enduring market value as an ornament 2. Its physical durability. 3. Its high value in relation to its bulk. 4. Its divisibility. 5. Its capacity to be cheaply assayed. 6. Its high cost of production.
Second Type of Money: Representative Money Representative money: certificates of ownership to commodity money. The commodity money warehouse: a business that stores the money commodity. When a customer stores his commodity money, the warehouse manager gives her an ownership certificate. The certificate implies a promise by the warehouse manager to redeem the certificate. –Redeem: to exchange the certificate for the item that is stored.
Example of Representative Money Issued by Government Note that it is a promise to pay gold coin to the bearer.
Four Characteristics of Representative Money 1. It is issued by a commodity money warehouse. 2. It is a credible promise to turn over a given quantity of the commodity it represents. 3. The materials from which it is made have practically no value as commodities (e.g., paper). 4. There is a sufficient amount of the commodity in the warehouse vaults for the warehouse manager to keep all his promises to redeem the certificates for the promised commodity.
The Emergence of Representative Money Representative money has often been issued by a government. Sometimes, it has been issued by private commodity money warehouses, however. Question: how could representative money emerge in a society if a government did not issue it?
A Representative Money Scenario (1) 1. If people used gold coins as the only kind of money, they would keep some coins on hand in order to make future transactions and in order to save. 2. Storing coins is costly because: –1. They occupy space. –2. They can be stolen.
A Representative Money Scenario (2) 3. Costs of storage is lower for a warehouse that stores the gold of many people in the same place. 4. A warehouse business would be profitable because the price people would pay for storage of their savings is greater that the cost of providing the storage service. 5. Warehouses would issue deposit receipts, or gold certificates.
A Representative Money Scenario (3) 6. Warehouses agree to redeem the certificates for gold during the ordinary hours of business, regardless of who presents them. At this stage the certificates are not yet money because they are not generally acceptable in exchange. –Right to redeem representative money on demand: the right to withdraw the commodity that backs the money at any time during the normal hours of business simply by presenting the representative money.
A Representative Money Scenario (4) 7. But sellers would be willing to accept the certificates in exchange because they could redeem them. –They might charge a premium at first. But later they might prefer the certificates over gold coins. –The cost to a seller of redeeming a large number of certificates is practically the same as the cost of redeeming one. 8. As more and more sellers began to accept them, people would come to prefer the certificates to the gold because of the lower cost of using paper in exchange. –The representative money replaces the gold coins in exchange; but there is no increase in the total quantity of money.
Two Steps in the Emergence of Representative Money 1. A gold storage warehouse must emerge. –A. People must have a demand for gold storage. –B. The sum of costs of storing gold must be lower when owners join together and store it in a single place than when they store it separately. 2. Certificates issued by the gold storage warehouse must become acceptable in exchange. –This is more likely if the warehouse manager agrees to redeem them for gold to anyone who presents a certificate to him.
Third Type of Money: Paper Credit Money Definition: items similar to representative money but which are not certificates of ownership and cannot be redeemed for any commodities.
Characteristics of Credit Money May be identical in appearance to representative money. Issued by a banker, who creates money. Unlike a commodity warehouse, the banker does not have the commodities needed to redeem the certificates. Definition of a banker: a producer of credit money; a creator of money.
The Emergence of Credit Money (1) Assume at first that gold certificates are widely used in exchange. The commodity warehouse manager is not ordinarily required to redeem the certificates because people are happy to use representative money.
The Emergence of Credit Money (2) The warehouse manager issues certificates that are not backed by gold in the warehouse. –He may use them to buy goods for himself. –He may lend them out in order to earn interest. These certificates are credit money. The warehouse manager becomes partly a banker. Sellers accept the unbacked certificates in exchange because they expect other sellers to accept them.
The Emergence of Credit Money (3) An example: The warehouse manager issues 1000 kilograms worth of gold certificates. These are backed by gold and are commodity money. He later issues 100 kilograms worth of certificates. These are not backed by gold and are not commodity money. By issuing the unbacked certificates, he becomes partly a banker.
Question 1 Why does the warehouse manager issue credit money (and, therefore, become a banker)? Two answers: 1. To get money for his personal use. 2. To earn money by making loans.
Question 2 How does the banker's action of creating money affect people? People who receive the new money compete with holders of the existing money for goods and resources. They bid up the prices higher than they otherwise would be. Thus, the creation of credit money harms the holders of existing money, although they might not realize it, especially in a growing economy.
Question 3 What if someone accumulated a large number of gold certificates and demanded that the issuer redeem them for commodity money? The banker could not redeem all of the certificates. Answer depends largely on: –1. the organization of the money producing industry. –2. the law.
Fourth Type of Money: Government Money Definition: money produced by a government. It may be commodity, representative, or credit money.
The Government Advantage (1) A government has an advantage in getting its paper money accepted in exchange. A government can achieve acceptability of its money in exchange by: –Outlawing or taxing privately issued money (restricting competition). –Demanding that taxes be paid in government money.
The Government Advantage (2) In commodity money: –Debaser: a person who reduces the amount of metal in a coin by shaving off the edges. –The government has an advantage over a private issuer because it can punish debasers. In representative and credit money: –Counterfeiter: someone who produces paper that looks like representative money. –The government has an advantage in punishing counterfeiters
Commodity Money and Security (1) History teaches that the use of commodity money provides greater security against unexpected increases in money’s quantity than the use of credit money. Why? Because additional credit money can be created so easily and cheaply. Anybody who holds the credit money loses purchasing power compared with what they would have if the bankers or government did not print so much.
Commodity Money and Security (2) Sometimes both have been used in exchange. Some financial institutions issued representative money only. They were gold money warehouses. Others became banks and issued credit money. In such cases, people tended to find out about the difference and to prefer the representative money. They realized that credit money may suddenly lose value if the bank creates too much of it. At that stage, the representative money retained its value because gold and silver could be melted down and sold in markets for the metals. When the two are used together in a competitive situation, commodity money has ordinarily provides greater security than paper money.
Commodity Money and Security (3) Governments have often interfered with free competition or given favorable treatment to financial institutions that have issued credit money. By doing so, the government has promoted inflation. Sometimes it has even caused hyperinflation.
Commodity Money and Security (4) Inflation: An increase in the total price of a basket of typical consumer goods. Hyperinflation: a situation in which the government prints so much money that average prices rise very fast. Hyperinflation usually occurred during a war or prior to a revolution, when government leaders became desperate for resources.
Commodity Money and Security (5) The history of commodity shows that the quantity of commodity money does not increase unless new deposits of metal are discovered, mined and minted. Even when new gold is discovered, the new gold is such a small proportion of the total gold in existence that prices only rise by a small per cent.
Why the Dollar Replaced Gold and Silver in the U.S. Economic reason: Gold is less convenient (i.e., more costly) to use than paper money. Political reason: Lawmakers in the U.S. made it unprofitable and, at times, even illegal to use representative money based on gold as a medium of exchange.
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New Topic: Money in Modern Times Two types of modern money: 1. Currency. –Central bank notes plus token coins. –Token coin: a coin for which the value in exchange is gar greater than its value in use. The copper penny is an example. 2. The transferable deposit. Both of these are credit money. There is no representative money in modern times.
The Central Bank Central bank: a government agency that has three duties: –1. To issue paper money and coins. –2. To regulate banks. –3. To control the quantity of money. Central banks are sometimes an arm of the government and sometimes largely independent, like the judiciary of the major constitutional democracies.
The Central Bank Note Central bank note: government credit money, usually issued in several denominations, made of paper.
Transferable Deposit Definition: a legal right given by a private bank to a depositor of currency to transfer the ownership rights to the currency from one bank to another or to withdraw the currency. They are accepted in exchange: A.If sellers believe that the bank will redeem them for currency on demand or B.If sellers’ banks are willing to accept them in the same way as currency.
Three Ways to Use Transferable Deposits 1. Write a check. 2. Use a debit card. 3. Authorize an electronic transfer.
Check Clearing System A system through which the checks written against one private bank but deposited in a second bank are cleared by transferring the rights to currency from the first to the second bank. The central bank may act as the banker's bank. It may accept deposits from banks and other financial institutions. The deposits are used to clear checks drawn against them. The bank depositor’s notion that when he writes a check, he “transfers funds.” In fact, central bank notes are more often not transferred. Only the accounting entries are changed.
Debit Card Definition: an electronic checkbook that allows a depositor of currency to transfer rights to the currency from his account to another person by passing a personal identification card through a recording machine that is linked to the computers of the banks of both the giver and receiver of the rights.
Electronic Transfer Rights Definition: an electronic payments system in which the owner of a bank deposit can directly and instantaneously transfer rights to currency from her account at one institution to someone else's account at another institution.
Central Bank Regulation and Money Creation To understand how money is created in a modern market economy, we must first understand the role of the central bank. We discuss this in chapter 11. Here we only want to show the difference between the freedom of a warehouse manager-turned-banker to create money and the restrictions on a modern bank.
Transferable Deposit Vs. Gold Certificate (1) A warehouse manager may issue more certificates than he can redeem in gold. He can issue them for personal use or to make loans. If he cannot meet demands to redeem the certificates, he must either go bankrupt or purchase gold. A modern banker may issue more transferable deposits than she can redeem in currency. But her uses of them are limited by central bank regulation. She can only make loans that do not appear to risky to the central bank’s auditors.
Transferable Deposit Vs. Gold Certificate (2) If a modern banker cannot meet demands to transfer deposits of currency, she can borrow from other banks and ask the central bank to print more and to lend them to her. Since her loans are likely to be sound, due to central bank regulation, borrowing is easy.
Money in International Exchange The U.S. dollar is the most prominent medium of international trade today because: –1. The U.S. is the largest buyer and seller of goods. –2. Since 1980, the U.S. has not permitted increases in the quantity of its credit money to substantially reduce the dollar's buying power. But this can change.
The Evolution of Money Money almost certainly came into being step by step over a long period of time. From no trade to gift exchange. From gift exchange to barter. From a barter to a commodity money economy. –Metallurgy and minting. From a commodity money economy to a credit money economy. –First paper money, then transferable deposits.
Learning to Use Money is Easy Think about how you first learned to use money. We know that learning to use money is easy because social scientists have observed primitive peoples who previously only used barter. Such people can learn how to use transferable deposits in a short time.
Inventing Money What actions would a person have to take to introduce money quickly into a society in which it had never been used. Because you have studied the history of money, you know that the developed trading societies do not use barter. They use paper money and transferrable deposits. Could you profit by introducing paper money? How could you actually introduce it?
Persuading Sellers To Accept Your Money You must persuade sellers of goods that they can use your paper (“dollars”) to buy something or to pay a debt. Ways to succeed: –Align yourself with a well known trader of goods – a multi-good trader. –Use your dollars to buy goods from the farmers and artisans in the community. Then give the goods they produce to the multi-good trader, who “sells” them for dollars to the farmers, artisans and others who happen to acquire money. In this way, each good acquires a dollar price.
Endorsement and Guaranty The whole process could proceed more smoothly if you also aligned with a wealthy and trustworthy citizen who agrees to endorse your dollars. Such an endorser of notes is called a guarantor. Guarantor: a person who agrees to convert what would otherwise be credit money into a commodity.
Monetization Monetization: the use of promises of goods, or debts, as a basis for producing money.
The Case of Scrip Credit money can easily be created by producers who are isolated from other parts of the economy. Consider an isolated mining town. Whether a particular form of money is accepted in exchange depends on expectations that it can be exchanged for something else. These expectations can often be reinforced by promises if the promisor is trustworthy. Thus the acceptance of an item as money is based on expectations and trust.
The Advantage of Government A government typically has an advantage in issuing credit money because it can declare that the money can be used to pay taxes and institute a legal tender system.
Counterfeiting and Over-issue Counterfeiting and over-issue may lead people to stop using a particular item as money.