Robert J. Stonebraker, Winthrop University
The Joy of
Economics: Making Sense out of Life
Robert J. Stonebraker, Winthrop
University
Money: What and Why
I have enough money to last me the rest of my life.
Unless I buy something.
...comedian Jackie Mason
It’s about time we got to money. Isn’t that what economics is supposed to be about?
No. Economics is about scarcity and choice, not money. In a very simple economy, there would be no need for money. Think about that for a minute. In a one-person “Robinson Crusoe” economy, would money exist? What is money, anyway?
What is money?
Economists define money as a medium of exchange. More simply, money is what we use to buy goods and services; it is the “medium” we use to “exchange” for things we want. We exchange money for hot dogs at Food Lion, we exchange money for CD’s at Wal-Mart, and we exchange money for admission passes at Disney World. In short, money is what we spend.
Be careful not to confuse money with income; it’s an easy mistake to make. Income is the flow of dollars we earn over a period of time; money is the amount of spendable assets we hold at a point in time. For example, a wealthy executive might earn an income of $200,000 a year, but she may have only a few thousand dollars of money. She may own an expensive house in a ritzy gated community, but a house is not money. She may own a new Mercedes and have a closet crammed with designer dresses, but cars and clothes are not money. Houses, cars and clothes are valuable assets, but they are not spendable assets.
To an economist, assets vary in terms of liquidity which is a measure of how easily something can be spent or traded for other assets. Since money is defined as the medium of exchange, only the most liquid assets can be categorized as money.
For the most part, only two assets can be directly spent. Cash is the most obvious. Most suppliers happily accept cash in return for goods and services. Checking deposits are the other. We can write a check or, with a swipe of our debit card, can transfer funds electronically from our checking deposits to the merchant as payment. What about credit? Can’t we buy things with our credit cards? Not really. I’ve tried it many times. Every time I do the same thing happens: about a month later I receive a bill that I’m expected to pay. Credit merely allows us to postpone payment. Eventually we must pony up the real thing: cash or a checking deposit.
The official government measures of money must account for a variety of obscure possibilities and can be quite complex. For example, how should we handle U.S. cash that is being held by people in other countries? How should we treat a deposit that can be used to write checks under some circumstances but not others? However, at this level it is easiest to think of money as being cash plus checking deposits. In most cases, other assets such as cars, clothes, bonds, stocks, and certificates of deposit must be converted to either cash or checking deposits before they can be spent.
Evolution of money
Money only has value in an economy in which we trade with others. Suppose that you were the sole inhabitant of an economy (what economists often call a Robinson Crusoe economy). Would you need money? What would you do with money? There are no stores from which to buy and no potential trading partners. Money would be worthless.
Even in rudimentary multi-person economies money may be unnecessary. If people live in self-sufficient clans, there would be no trade and, therefore, no need for money. If trade with other groups occurs on limited scale, bartering commodities directly will probably suffice. For example, my clan could trade two cows to yours in return for a dozen axes and three beaver pelts.
As trade grows, direct barter becomes more difficult. Barter butts heads against the problem we call double coincidence of wants. Not only must we find someone who has what we want, that person also must want what we have. For example, suppose I grow blueberries but want to supplement my diet with the potato chips produced by my neighbor. If my neighbor enjoys blueberries, we can deal. Unfortunately, if blueberries create an allergic reaction for my neighbor, I’m in trouble. She’s got the potato chips that I want, but does not want the blueberries that I have to trade. Not only must I find someone with potato chips, I must find someone who has potato chips and also wants my blueberries. Bartering cannot support an increasingly complex and specialized world. Imagine Tiger Woods wandering the streets offering to hit a few golf shots in return for new shoes. Imagine Brad Pitt knocking on doors offering to recite a few lines of Shakespeare in return for a bowl of macaroni and cheese.
As economies grew, and as specialization and trade became more entrenched, the need for money also grew. With money, a Tiger Woods could charge spectators money to watch him play, and then exchange money to others for shoes and other products.
Societies initially chose already existing commodities as means of payments. Animals were an early example. Some societies would price goods in terms of cows or chickens. A product might cost five chickens or a new plot of land might cost four cows. However, some commodity monies proved to be more successful than others. Specifically, the following characteristics were essential:
1. Portable
Oak trees make dreadful money. How do you get them to the store to spend? Portability was an advantage for animals, most are self-propelled.
2. Durable
Because we need the option of saving money for the future, money must long-lasting. That was a drawback of animal money. Animals die. Savers always ran the risk of having their money destroyed by disease or old age.
3. Divisible
We must be able to make change. Suppose a product costs 1/5 of a cow. How do we divide it up? What happens to the other 4/5?
4. Limited in supply
Limited supply proved to be the most elusive and most critical element. The value of money, like that of other commodities, ultimately rests upon supply and demand. If we flood the markets with new supplies of bananas, the value of bananas will drop. The same will happen to money. If we flood the market with new supplies of money, the value of money will drop.
Do you want an example? In the early 1600’s several American colonies used tobacco as their primary medium of exchange. Tobacco was portable, durable and divisible, but was not limited in supply. Early colonists immediately understood that they could grow their own money. And so they did. Predictably, the number of acres planted in tobacco rose and, also predictably, the price of tobacco fell. Of course, if the price of tobacco is cut in half, then shoemakers will demand twice as much tobacco in return for a pair of shoes: the “price” of shoes will double. In other words, as the value of money falls, the amount of money needed to buy other goods (the “price” of those goods) will rise. That’s inflation! After a number of unsuccessful government attempts to restrain the supply of tobacco, colonies adopted other monies in its stead.
Over time metals proved to be the most successful candidates. They were portable, durable, divisible and limited in supply. Initially, buyers and sellers used scales to weigh out specific amounts of metals to make purchases. But scales were controversial. Even in the 21st century some scales assert that I weigh more than do others. Medieval technology was even less reliable and many merchants were eager to use scales that skewed payments in their favor. To ease disputes and increase convenience, governments soon began minting coins that contained specific quantities of metal.
Depending upon which ones were available in a particular region, countries adopted many different metallic metals. However, trading across borders was much easier when both countries used the same metal as money. To facilitate international trade, countries eventually began adopting similar metals. Gold and silver were the popular choices, primarily because they could be found in many different parts of the world and were easily worked into coins.
Although gold and silver worked well in many respects, carrying large sums required considerable effort. They were heavy; so heavy that countries began seeking lighter alternatives. They found it in paper. Toting $10,000 in gold was difficult, but $10,000 of paper currency could easily be carried in a few pockets. Paper was portable, paper was durable, and paper was divisible. Paper had only one problem: it was not necessarily limited in supply. However, governments easily could limit the supply of paper money if they tied it to the supply of something that was limited in supply: something like gold. That’s what they did. Governments bought up the available gold and then issued paper notes in its place: $1 of paper for each $1 of gold. Governments often allowed citizens to redeem the paper for gold on demand but, because the paper currency was so much more convenient, few ever did.
In this world, paper satisfied all the necessary criteria: portable, durable, divisible, and limited in supply. Alas, another “problem” arose. Economies grew. As economies grew and more people were making more transactions, the need for money grew as well. Unfortunately, the supply of gold did not keep pace and shortages of money soon appeared. Governments reacted by moving to fractional backing. By holding only $.90 of gold for each paper dollar issued, governments could issue additional sums of money to meet the needs of their growing economies. As economic growth continued over time, governments met the continued needs for more money by gradually lowering the fraction of gold held per dollar. The smaller was the fraction of gold governments needed to hold, the larger was the number of paper dollars governments could issue.
In the end, governments decided to eliminate all gold backing. They began issuing the amount of money they thought appropriate, regardless of the amount of gold available in government vaults. In modern economies, currency supplies are determined by government policy, not by the supply of gold. In modern economies, gold is no different from other metallic assets.1
What now “backs” the U.S. dollar? Nothing. Dollars are fiat money; they are money because the government declares them to be money. Is that dangerous? Not necessarily. Remember that the only reason we tied currency to gold was to limit the supply of currency. Too much money will cause money to lose value and create inflation. But too little money can crimp the needed transactions in a growing economy. We want the amount that is just right: enough to facilitate growth, but not so much that it creates inflation. The relevant question is which system is more likely to create that “just right” amount. Should we shackle monetary growth by tying it to the supply or gold, or should we allow government policy makers the discretion to create the amount of money they deem best.
If we trust government do a respectable job, gold backing is both unnecessary and potentially damaging to long-run growth. If governments are incompetent, gold backing can provide a useful check to power that might otherwise be abused. For the most part, government policy makers have performed admirably in the U.S. Our monetary system has accommodated sustained and steady real growth in real GDP. Regrettably, not all countries have fared as well.
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Notes:
1. The U.S. government still holds huge stores of gold in Fort Knox vaults, but it is no longer used to back currency. The gold simply represents a government asset, like forested land in Alaska, that the government could sell at any time. It does sell a few tons now and then, but if it tried to sell it all, the increased supply would swamp world markets, drive down the price, and destroy the value.
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Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:
1. Define money, list the assets we officially count as money, and explain.
2. Explain the concept of liquidity.
3. Explain why money would be useless in an economy in which all people or families were self-sufficient.
4. Explain why bartering works less and less effectively as an economy grows and specializes.
5. Describe the characteristics that a commodity to be used as money should possess.
6. Explain why gold was originally used to "back" money and why it is no longer used in this way.