throughout history. But there are problems with most commodity moneys,
including corn. First, corn must be properly stored or its quality will
deteriorate; even then, it will not maintain its quality for long. Second,
corn is bulky, so exchange becomes unwieldy for major purchases. For
example, suppose a new home cost 50,000 bushels of corn. Many truckloads of
corn would be involved in such a transaction. Third, if all corn is valued
equally in exchange, people will tend to keep the best corn and trade away
the lowest-quality corn. The quality of corn in circulation will therefore
decline, reducing the acceptability of this commodity money. Sir Thomas
Gresham, founder of the Royal Exchange of London, pointed out back in the
sixteenth century that "bad money drives out good money," and this has come
to be known as Gresham's Law". When moneys of different quality circulate
side .by side, people tend to trade away the inferior money and hoard the
best.
A final problem with corn as with other commodity moneys is that the
value of corn depends on its supply and demand, which may vary
unpredictably. On the supply side, if a bumper crop increases the supply of
corn, corn would likely become less valuable, so more corn would exchange
for all other goods. On the demand side, any change in the demand for corn
as food would alter the amount available as a medium of exchange, and this,
too, would influence the value of corn. Erratic fluctuations in the value
of corn limit its usefulness as money, particularly as a store of wealth.
If people cannot rely on the value of corn over time, they will be
reluctant to hold it as a store of wealth. More generally, since the value
of money depends on its supply being limited, anything that can be easily
produced by anyone would not serve well as commodity money. For example,
dirt would not serve well as commodity money.
Metallic Money and Coinage
Throughout history several metals were used as commodity moneys, including
iron and copper. More important, however, were the precious metals— silver
and gold—which have always been held in high regard. The division of
commodity money into units was often quite natural, as in a bushel of corn
or a head of cattle. When rock salt was used as money, it was cut into
uniform bricks. Since salt \vas usually of consistent quality, a trader
needed only to count the bricks to determine the amount of money. With
precious metals, however, both the quantity and quality became open to
question. Because precious metals could be debased with cheaper alloys, the
quantity and quality of the metal had to be ascertained with each exchange.
This quality-control problem was addressed by coinage. Coinage, when
fully developed, determined both the amount of metal and the quality of the
metal. The use of coins allowed payment by count rather than by weight.
Initially, coins were stamped only on one side, but undetectable amounts of
the metal could be "shaved" from the smooth side of the coin. To prevent
shaving, coins were stamped on both sides. But another problem arose.
Because the borders of coins remained blank, small amounts of the metal
could be "clipped" from the edges. To prevent this, coins were bordered
with a well-defined rim and were milled around the edges. If you have a
dime or quarter, notice the tiny serrations on the edge plus the words
along the border. These features, throwbacks from the time when these coins
were silver rather than a cheap alloy, prevented the recipient from
"getting clipped."
The power to coin money was viewed as an act of sovereignty, and
counterfeiting, an act of treason. In England the king extended his
sovereignty only to silver and gold coins. When the face value of the coin
exceeds the cost of coinage, the minting of coins becomes a source of
revenue to the sovereign. Seigniorage refers to the amount of precious
metal extracted by the sovereign, or the seignior, during coinage.
Debasement of the currency represented a source of profit for profligate
governments. Token money is the name given to coins whose face value
exceeds their metallic value.
Money and Banking
Early banks were little more than moneychangers, exchanging coins and
bullion (uncoined gold or silver bars) from one form to another for a fee.
Money was counted on a banque, the French word for "bench." Banking, as the
term is understood today, dates back to London goldsmiths of the
seventeenth century. Because goldsmiths had a safe in which to store gold,
others in the community came to rely on goldsmiths to hold their money and
other valuables for safekeeping. The goldsmith found that when money was
held for many customers, deposits and withdrawals tended to balance out, so
a pool of deposits remained in the safe at a fairly constant level. Loans
could be made from this pool of idle cash, and the goldsmith could thus
earn interest.
The system of keeping one's money on deposit with the goldsmith was
safer than leaving money where it could be easily stolen, but it was a bit
of a nuisance to have to visit the goldsmith each time money was needed.
For example, the farmer would visit the goldsmith to withdraw enough money
to buy a horse. The farmer then paid the horse trader, which promptly
deposited the receipts with the goldsmith. Thus, money took a round trip
from goldsmith to farmer to horse trader and back to goldsmith. Because
depositors grew tired of going to the goldsmith every time they needed to
make a purchase, the practice developed whereby a purchaser, such as the
farmer, wrote the goldsmith instructions to pay the horse trader so much
from the farmer's account. The payment amounted to having the goldsmith
move gold from one stack (the farmer's) to another (the horse trader's).
These written instructions to the goldsmith were the first checks.
By combining the idea of cash loans w4th checking, the goldsmith soon
discovered how to make loans by check. The check was a claim against the
goldsmith, but the borrower's promise to repay the loan became the
goldsmith's asset. The goldsmith could extend a loan by creating an account
against which the borrower could write checks. Goldsmiths, or banks, in
this way were able to "create moneys—that is, create claims against
themselves that were -generally accepted as a means of payment—as a medium
of exchange. This money, though based only on an entry in the goldsmith's
ledger, was accepted because of the public's confidence that these claims
would be honored. The total claims against the bank consisted of customer
deposits plus deposits created through loans. Because these claims against
the bank exceeded the bank's gold and other reserves, this was the first
fractional reserve banking system, a system in which only a portion, or
fraction, of deposits were backed up by reserves. The reserve ratio
measures reserves as a proportion of total deposits. For example, if the
goldsmith had reserves of $5000 but total deposits of $10,000, the reserve
ratio would be 50 percent.
Paper Money
Another way a bank could create claims against itself was to issue bank
notes. In London, goldsmith bankers introduced bank notes about the same as
they introduced checks. Bank notes were pieces of paper that promised to
pay the bearer a specific amount in gold when presented to the issuing bank
for redemption. Whereas only the individual to whom the deposit was
directed could redeem checks, notes could be redeemed by anyone who held
them. Notes redeemable for gold or another valuable commodity are called
fiduciary money. Fiduciary money was often "as good as gold" since the
bearer could, upon request, redeem the note for gold. In some ways
fiduciary money was better than gold because it took up less space and was
easier to carry.
The amount of fiduciary money issued depended on the bank's estimate
of the proportion of notes that would be redeemed for gold. The greater the
redemption rate, the fewer notes could be issued based on a given amount of
gold reserves. Initially, these promises to pay in gold were issued by
private individuals or banks, but over time governments developed a larger
role in their printing and circulation. The tendency to redeem notes for
gold depended on the note holder's confidence in the bank's willingness to
do so upon request.
Once fiduciary money became widely accepted, it was perhaps inevitable
that governments would begin issuing fiat money, which consists of notes
that derive their status as money by power of the state, of fiat. Fiat
money is money because the government says it is money. Fiat money is not
redeemable for anything other than more fiat money; it is not backed by a
promise to pay something of intrinsic value. You can think of fiat money as
mere paper money. It is acceptable not because it is intrinsically useful
or valuable but because the government requires that it be accepted as
payment. Fiat money is declared legal tender by the government, meaning
that creditors must accept it as payment for debts. Gradually, people came
to accept fiat money because of the belief that others would accept it as
well. The money issued in the United States today and, indeed, paper money
throughout most of the world is now largely fiat money.
The Value of Money
Why does money have value? As we have seen, various commodities served as
the earliest moneys. Commodities such as corn or tobacco had value in use
even if for some reason they became less acceptable in exchange. The
commodity feature of the money bolstered confidence in its acceptability.
When paper money came into use, acceptability was initially fostered by the
promise to redeem it for gold or silver. But since most paper money
throughout the world is now fiat money, there is no promise of redemption.
So why can a piece of paper bearing the image of Alexander Hamilton and a
10 in each corner be exchanged for a large pepperoni pizza or anything else
selling for $10. People accept these pieces of paper because they believe
others will do so. Fiat money has no value other than its ability to be
exchanged for goods and services now and in the future. Its value lies in
people's belief in its value.
The value of money is reflected by its purchasing power—the rate at
which money is exchanged for goods and services. The higher the price level
is, the fewer goods and services can be purchased with each dollar, so the
less each dollar is worth. The purchasing power of each dollar can be
compared over time by accounting for changes in the price level. To measure
the purchasing power of the dollar in a particular year, first compute the
price index for that year, then divide 100 by that price index. For
example, the consumer price index for 1986 was 328, using 1967 as the base
year. The value of a 1986 dollar is therefore 100/328, or about SO.30
measured in 1967 dollars. Thus, a 1986 dollar buys less than one-third the
goods and services purchased by a dollar in 1967.
Too Much and Too Little Money
Money serves as a medium of exchange, a standard of value, and a store of
wealth. One way to understand these functions of money is to look at
situations in which money did not perform these functions well. Money may
not function well as a medium of exchange because there is too little
money, too much money, or because the price system is not allowed to
operate. With prices growing by the hour, money no longer represented a
stable store of wealth, so people were unwilling to hold money. With
rapidly rising prices, relative prices also became distorted, so buyers and
sellers had difficulty knowing the appropriate price of each good. Thus,
money became less useful as a standard of value—that is, as a way of
comparing the price of one good relative to another. Money still served as
a medium of exchange, but as larger and larger amounts of money were needed
to carry out the simplest purchases, money became more cumbersome. Exchange
demanded more time and energy. In short, when there is too much money, the
economy becomes less productive than when there is an appropriate amount of
money.
On the other hand, if there is too little money in the economy or if
the price system is not allowed to function, the economy may be reduced to
barter, and, as we have seen, barter is inefficient. For example, just
after World War II money in Germany became -largely useless because,
despite tremendous inflationary pressure in the economy, occupation forces
imposed strict price controls. Since prices were set well below what people
thought they should be, sellers stopped accepting money, forcing people to
use barter. Experts estimate that because of the lack of a viable medium of
exchange, the German economy produced only half the output that it would
have produced with a smoothly functioning monetary system. The German
"economic miracle" that occurred after 1948 can be credited in large part
to that country's adoption of a reliable monetary system. It has been said
that no machine increases the economy's productivity like properly
functioning money. Indeed, it seems hard to overstate the value of a
reliable monetary system. Consider in the following case study a more
contemporary example of the official currency failing to serve well as a
medium of exchange.
Conclusion
Just as the division of labor creates the need for exchange, exchange
creates the need for money. With money, exchange need not rely on the
double coincidence of wants required with barter. People can sell their
labor in return for money to be used for future consumption.
1. Barter was the first form of exchange. As the degree of specialization
grew, it became more difficult to uncover the double coincidence of wants
required with barter. The time and inconvenience involved with barter led
even simple economies to introduce money.
2. Money serves three primary functions: a medium of exchange, a standard
of value, and a store of wealth. The first money was commodity money, where
a good such as corn served also as money. With fiduciary money, the second
type of money introduced what changed hands was a piece of paper that could
be redeemed for something of value, such as silver or gold. The third type
of money introduced was fiat money, which is paper money that can not be
redeemed for anything other than more paper money. Fiat money is given its
value as money by law. Most currencies throughout world today are fiat
money.
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