The Basics of Money

The following is a contribution from a friend of the site, Art Carden. Art is an Economics Professor at Samford University's Brock School of Business, a research fellow at multiple research and public policy institutes, and a regular contributor to Forbes.com and the Washington Examiner. This article is the first in a series examining the theory, development, and history of money and what lessons can be learned (or repeatedly forgotten) by looking through the longer-term lens of monetary history.

What is money, why is it important, and why do we have it? If you ask some people, money is an unnecessary distraction. If you ask others, money is a social abstraction that represents a person's alienation from the product of his labor and from other people. Aristotle argued that to try to get money (as opposed to the necessities of life) is unnatural, and hence he disdained retail trade. 1 Timothy 6:10 tells us that "the love of money is a root of all kinds of evils." What is money, what does it do, and where does it come from?

Money has four functions. It serves as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. As a medium of exchange, it makes trade much easier than it would be under a system of pure barter. As a unit of account, money allows us to compare apples to oranges: we can add up the money values of a lot of disparate things and learn the value of an individual's or a business's assets and liabilities. As a unit of account, money also allows us to compare the cost of different ways of producing things. Monetary calculation allows us to calculate revenues and costs, and as the twentieth-century economist Ludwig von Mises pointed out, it allows us to determine whether our actions are creating value for others.

Money also serves as a store of value, or wealth. Beauty is in the eye of the beholder, and so are value and wealth. If money has a stable value, though, monetary measurements can tell us how other "beholders" assess the value of one's assets at a given point in time. The crucial advantage of money as a store of value comes from the fact that money is durable. Historically, durable precious metals like gold and silver served as money. Under a fiat money system, entries in a computer are durable, as well (the differences between fiat money and commodity money will be explored in a future article; for now, it suffices to know that durable money can be a reliable store of value).

Imagine a dairy farmer who produces more milk than she cares to drink and who wants to store her excess wealth. How should she do it? While she could use the milk to make (far more durable) cheese, that's a cumbersome process that still leaves her with a large inventory of bulky, relatively low-value stuff. It would be far easier for her to sell the milk and store her wealth using money.

Money also serves as a standard of deferred payment. People don't value money for its own sake; rather, people value money because they can use it to buy goods and services. Money represents a promise: if you accept this money, you can redeem it for goods and services that you value (In Ayn Rand's novel "Atlas Shrugged," her character Francisco d'Anconia explains this eloquently). Unless we are compelled to accept it by force, we accept money based on our faith in others to accept the money in exchange for future goods and services.

Money emerges naturally; it is an inevitable consequence of what Adam Smith called our "propensity to truck and barter." As a social phenomenon, money emerges because it helps people with different preferences, abilities, and beliefs cooperate. Consider Robinson Crusoe shipwrecked on an island. He just so happens to have fishing equipment and therefore is able to eke out a meager living catching fish. He covets the coconuts that he sees at the tops of the coconut trees on the other side of the island, but he isn't a good enough climber to actually reach the coconuts.

One night, there is a terrible storm. While walking about, Crusoe discovers that the storm has deposited another shipwreck victim (Friday) on the side of the island where the coconut trees are. Unlike the slow and plodding Crusoe, Friday is an expert climber who is able to get the coconuts out of the trees with ease.

Crusoe senses an opportunity. He offers to trade Friday some of the fish he has caught for some of the coconuts Friday has gathered. Friday politely declines, though, saying that he is a vegan (and showing that he is willing to stick to his principles even in these dire circumstances).

Crusoe is out of luck- for now. A week later, a plane crashes onto the island. The plane is piloted by Sawyer, and it carries a large supply of vegan peanut butter. Crusoe finds a new way to get the coconuts he wants. He trades fish to Sawyer for peanut butter, and then he trades the peanut butter to Friday for coconuts.

We have just witnessed the emergence of a monetary economy with, in this case, peanut butter serving as the monetary commodity. Peanut butter is valuable because it's tasty and nourishing, but in this case, it also takes on value as a medium of exchange. Peanut butter emerged as money in this case because it solved a problem called the problem of "the mutual coincidence of wants" (sometimes called "the double coincidence of wants"). Without something to serve as money, Crusoe and Friday would not have been able to cooperate because while Friday had what Crusoe wanted, Crusoe didn't have what Friday wanted. Since Crusoe was able to get vegan peanut butter, he was able to trade with Friday.

Foodstuffs don't make good monetary commodities because they eventually go bad, they might be hard to transport, and they might not be homogeneous. Over time, metals like gold and silver emerged as monetary commodities because they were durable, homogeneous, and divisible; they were also in high demand and limited supply for other uses (like ornamentation). Hence, gold and silver tended to emerge as money.

Eventually, commodity money (gold and silver) was replaced in circulation by money substitutes, which were bank certificates that could be redeemed for gold and silver. Even further along, competitive issue of banknotes backed by gold and silver was replaced by government monopolies on note issue and, eventually, a decoupling of commodities and media of exchange altogether. We will explore these phenomena and their implications and challenges in greater detail in the next article.

This article is also based on textbook discussions of money as well as conversations in my Principles of Macroeconomics class at Samford University's Brock School of Business.