FINISH What is Money?

What is Money

What is money?

There seem to be as many definitions of money as persons asked and it can kinda make one's head spin. To put some clarity on things, let's break the overall question down into a few parts:

1) What is money?

Ludwig von Mises, after extensive analysis of money in his work The Theory of Money and Credit logically concludes that (paraphrased) money is a common medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods on the market. In his time we could leave the definition right there, however, Mises predates the wide use of computers in our society. Since the advent of this machine and its prevalence in our monetary and financial systems, it's reasonable to assign information system to the definition of monetary system.

Putting a further refinement on things:
  • currency (bills, coins, etc.) as a physical representation of the idea of money (the medium of exchange), in some cases classified as money substitutes
  • your account book, statement, bank web page, computer record etc. as a historical trail of the idea of money (information system)
2) What is the function of money?
  • information system plays a dual role as it could also be considered a function of money
  • a unit of account
  • a store of value
3) What are the characteristics of money?
  • a commodity in universally high demand
  • highly and (relatively) easily divisible without losing value
  • easily portable
  • highly durable

Money allows all other commodities to be priced in the market at uniform and easier terms. Take a nice tray of pepperoni, mushroom, bacon and double cheese for example. Without money, a common medium of exchange, both sides of the exchange would need to know the pizza's price in goats, salt, fish, eggs or whatever other commodities are being used for trading. 24 slice tray is 1/8th of a goat, 3kgs of salt, 1kg of fish (but what about different kinds of fish?) and so on. This obviously has some major drawbacks to say the least. With money, the pizza is $X.xx or X weight (ie. gold, silver), easy peasy.

The commodities used as a medium of exchange have a long and varied history, but time and again gold and silver have emerged as the dominant ones jockeying for position. Mises notes this:

Ludwig von Mises said

This stage of development in the use of media of exchange, the exclusive employment of a single economic good, is not yet completely attained. In quite early times, sooner in some places than in others, the extension of indirect exchange led to the employment of the two precious metals gold and silver as common media of exchange. But then there was a long interruption in the steady contraction of the group of goods employed for that purpose. For hundreds, even thousands, of years the choice of mankind has wavered undecided between gold and silver. The chief cause of this remarkable phenomenon is to be found in the natural qualities of the two metals. Being physically and chemically very similar, they are almost equally serviceable for the satisfaction of human wants. For the manufacture of ornaments and jewellery of all kinds the one has proved as good as the other. (It is only in recent times that technological discoveries have been made which have considerably extended the range of uses of the precious metals and may have differentiated their utility more sharply). In isolated communities, the employment of one or other metal as sole common medium of exchange has occasionally been achieved, but this short lived unity has always been lost again as soon as the isolation of the community has succumbed to participation in international trade.

Copper has also bubbled up from time to time as well.

Looking at our required characteristics, these three metals fit the bill well:
  • commodities in universally high demand
  • rare enough supply that their commodity value will be reasonably stable
  • high value per unit of weight
  • durable so that they can virtually last forever (gold and silver at least)
  • divisible so that they can be divided into small pieces without losing their value (compare this to a tractor for example)
Let's wrap up this section with some more Mises as we put a definition to medium of exchange itself:

Ludwig von Mises said

A medium of exchange is a good which people acquire neither for their own consumption nor for employment in their own production activities, but with the intention of exchanging it at a later date against those goods which they want to use either for consumption or for production.

Money is a medium of exchange. It is the most marketable good which people acquire because they want to offer it in later acts of interpersonal exchange. Money is the thing which serves as the generally accepted and commonly used medium of exchange. This is its only function. All the other functions which people ascribe to money are merely particular aspects of its primary and sole function, that of a medium of exchange.

Media of exchange are economic goods. They are scarce; there is a demand for them. There are on the market people who desire to acquire them and are ready to exchange goods and services against them. Media of exchange have value in exchange. People make sacrifices for their acquisition; they pay "prices" for them. The peculiarity of these prices lies merely in the fact that they cannot be expressed in terms of money. In reference to the vendible goods and services we speak of prices or of money prices. In reference to money we speak of its purchasing power with regard to various vendible goods.

There exists a demand for media of exchange because people want to keep a store of them. Every member of a market society wants to have a definite amount of money in his pocket or box, a cash holding or cash balance of a definite height.

Why a commodity in universally high demand?

In order to effectively and easily move past the problems with direct exchange, it's important that the medium used is highly valued by a majority of those in the marketplace or we end up somewhat back where we started. A commodity in high demand means that folks will give up other goods and services in exchange for it - they want it - and the result of this high demand is a uniformity across the market reducing the possible mediums of exchange from gazillions to a workable few.  If the commodity is as universally valued in the market as possible, then goods and services can be traded with ease.

Suppose feathers, rocks, shells, tobacco and Bee Gees CD's were all used as a medium of exchange and each valued by 20% of the market respectively. We can see then the struggle in matching up desired goods with a vendor willing to accept the medium we possess, ugh, hurtin' head! If however, personally autographed Gordon Ramsey cookbooks were valued by large majority in the market, now we have a somewhat rare common medium that is universally accepted and will be a store of value. Voila! goods and services once again exchanged easily.

Types of money

Fiat Money

While some folks may make arguments one way or another, the reality is, any of those arguments would be outliers really: as of this point in our societal evolution, gold, silver and platinum are the only real money with the first two obviously far and away being the most prevalent and popular.

Remember one of our money concepts/definitions: "a commodity in universally high demand". I doubt that there are (m)any folks who would, once recognized as gold or silver, leave a piece of either of these metals lying around if just happened upon. Can the same be said for paper, plastic, or, with the possible exception of copper, the metals that make up coinage today? Simple observation determines that people discard these three commodities at high rates.  

What we commonly refer to today as money, the paper and (non gold/silver) coins, are exactly what they look and feel like: paper, plastic and metal alloys, generally steel, copper and nickel here in Canada. There is no medium of exchange value outside of government decree. This is called fiat money:

Fiat Money

Term: Fiat Money Definition: Fiat money is a currency without intrinsic value that has been established as money, often by government regulation. Fiat money does not have use value, and has value only because a government maintains its value, or because parties engaging in exchange agree on its value. It was introduced as an alternative to commodity money and representative money. Commodity money is created from a good, often a precious metal such as gold or silver, which has uses other than as a medium of exchange (such a good is called a commodity). Representative money is similar to fiat money, but it represents a claim on a commodity (which can be redeemed to a greater or lesser extent).

Government issued banknotes began to be used in 11th century China. Since then, they have been used by various countries, usually concurrently with commodity currencies. Fiat money started to dominate in the 20th century. Since the decoupling of the US dollar from gold by Richard Nixon in 1971, a system of national fiat currencies has been used globally.

Fiat money has been defined variously as:
  • Any money declared by a government to be legal tender.
  • State-issued money which is neither convertible by law to any other thing, nor fixed in value in terms of any objective standard.
  • Intrinsically valueless money used as money because of government decree.
  • An intrinsically useless object that serves as a medium of exchange (also known as fiduciary money.)
The term fiat derives from the Latin fiat ("let it be done") used in the sense of an order, decree or resolution.
Source Reference: Fiat money - Wikipedia

The main risk of this money substitute is the possibility of a complete loss of value.

In the concept of money, fiat money is not real money but rather what's referred to as a money substitute. In order to keep this point clear, I try to use 'currency' to refer to our fiat money system as often as I can remember to instead of 'money'.

Further examplage: if someone at the Bank of Canada, or representing the government of Canada, were to say about paper/plastic/metal currency: "this is no longer considered a legal tender and is nothing more than paper/plastic/metal (steel, copper, nickel)", aside from a few being put away for posterity and historical purposes, this form of money would be quickly discarded or re-purposed for something entirely different, a doodle pad or fixing a wobbly chair leg for example.

If the same person were to say about gold or silver: "this is no longer considered a legal tender and is nothing more than gold & silver", would the same happen? Not on your life, specifically the discard part. Why? Most humans place a value on these two metal commodities and each of us who has lived above ground or with other humans for even a short period recognizes this. In turn, we each know then that any amount of these metals that we possess will most likely be reasonably easy to exchange for other goods and services with other humans. Can we say this about a piece of paper or plastic with some numbers on it? Not likely. Further, adding labour to a specific weight of either of the two metals and turning them into something else, jewellery and silverware for example, can not only increase its psychic value but also increase the market value of that same weight of the metal beyond the base commodity price. Can fiat say the same? Pretty sure that turning scraps of paper/plastic with numbers on it into Origami will not increase its value by nearly the same degree

If you still are interested in just discarding it, drop me a note, I'll be happy to arrange to take it off your hands! Now you are thinking "hmm, he's willing to go out of his way to take this gold and silver from me, perhaps there is some value somewhere here, perhaps I should be thinking of selling it to him and not just giving it away". Welcome to Economics101 ;)


Credit money

Credit money is created when financial instruments are used in indirect exchange. It is only a derived kind of money: it receives its value from an expected future redemption. For example, an IOU can be accepted by others, if they trust the reputation of the issuer of debt. This risk of default also limits its application.

"Not surprisingly, therefore, credit money has reached wider circulation only when the credit was denominated in terms of some commodity money, when the reputation of the issuer was beyond doubt, and when it was the only way to quickly provide the government with the funds needed to conduct large-scale war."[12]

Money Substitutes

Or money certificates, are placeholders for actual money, that is stored in a bank and can be redeemed at any time by the present owner of the note. Instead of trading e.g. silver, people would trade with notes representing the silver. Apart from paper notes, the main types of such substitutes are token coins, certificates of deposit, checking accounts, credit cards, and electronic bank accounts on the Internet. The advantage are lower transaction costs, the downside is a greater potential for abuse (and historically, this lure appeared to be irresistible).

Commodity money

As the more marketable commodities in any society begin to be picked by individuals as media of exchange, their choices will quickly focus on the few most marketable commodities available. The demand for these commodities has now an additional component - not only for their direct use, but also for their use as a medium of exchange. This increase in the demand greatly increases their marketability. If e.g. butter begins as one of the most marketable commodities and is therefore more and more chosen as a medium, this increase in the demand for butter greatly increases the very market­ability that makes it useful as a medium in the first place. The process is cumulative, with the most marketable commodities becoming enormously more marketable and with this increase spurring their use as media of exchange. The process continues, with an ever-widening gap between the marketability of the medium and the other commodities, until finally one or two commodities are far more marketable than any others and are in general use as media of exchange.[3]

Electronic money

The information technologies have been able to develop very efficient and beneficial new instruments to access and transfer. But no purely electronic money has been produced so far, except for government money, which is free from competition.[14] A possible candidate for a purely electronic money, which is currently in the experimental stage, is bitcoin which is limited in amount through a process called mining which cryptographically requires proof of work.

What money is not

an end unto itself. Money is a means to an end only.

What is inflation?

Technically speaking, an increase in the money supply.