Money is primarily a medium of exchange or means of exchange. It is a way for a person to trade what he has for what he wants. Ideal money has three critical characteristics: it acts as a medium of exchange; it is an economic good; and it is a means of economic calculation.
To properly understand money as a medium of exchange one must first go back to the first methods of trade. Before money was invented one would have to engage in direct barter. A farmer who produced grain – but wanted shoes for his family – would have to find someone who, a) had shoes and, b) wanted grain. You can imagine the difficulty involved in finding that perfect someone who had what the farmer wanted and wanted what the farmer had.
Out of necessity, this gave rise to indirect barter. Continuing with our example above, let’s assume that the farmer found a shoemaker but discovered that the shoemaker did not want grain – he wanted candlesticks. While having a drink at the local pub he overheard the gentleman next to him lamenting that he needed grain in exchange for his candlesticks. Naturally, the farmer traded his grain for the candlesticks and went back to the shoemaker and traded the candlesticks for shoes. In this example, the farmer performed indirect barter when he used the candlesticks as a medium of exchange.
Over time, different commodities served as medium of exchange but the problem of marketability and durability came into play. A necessary and highly exchangeable commodity was food. The problem is that it was perishable. One had to either use it or trade it before it went bad. Over time, the most marketable and durable commodities came to be used as medium of exchange – commodities such as gold and silver. Since gold and silver did not rust nor rot they were ideal economic goods. Over time they became the preferred medium of exchange.
Before the development of a medium of exchange, people would barter
to obtain the goods and services they needed. This is basically how it
worked: two individuals each possessing a commodity the other wanted or
needed would enter into an agreement to trade their goods.
This early form of barter, however, does not provide the
transferability and divisibility that makes trading efficient. For
instance, if you have cows but need bananas, you must find someone who
not only has bananas but also the desire for meat. What if you find
someone who has the need for meat but no bananas and can only offer you
bunnies? To get your meat, he or she must find someone who has bananas
and wants bunnies ...
The lack of transferability of bartering for goods, as you can see,
is tiring, confusing and inefficient. But that is not where the problems
end: even if you find someone with whom to trade meat for bananas, you
may not think a bunch of them is worth a whole cow. You would then have
to devise a way to divide your cow (a messy business) and determine how
many bananas you are willing to take for certain parts of your cow. (It
can be hard to talk about money with your children, especially when
times are tough. Talking About Money When Times Are Tough has some tips to make it easy.)
To solve these problems came commodity money, which is a kind of currency
based on the value of an underlying commodity. Colonialists, for
example, used beaver pelts and dried corn as currency for transactions.
These kinds of commodities were chosen for a number of reasons. They
were widely desired and therefore valuable, but they were also durable,
portable and easily stored.
Another example of commodity money is the U.S. currency before 1971,
which was backed by gold. Foreign governments were able to take their
U.S. currency and exchange it for gold with the U.S. Federal Reserve. If
we think about this relationship between money and gold, we can gain
some insight into how money gains its value: like the beaver pelts and
dried corn, gold is valuable purely because people want it.
It is not necessarily useful - after all, you can't eat it, and it
won't keep you warm at night, but the majority of people think it is
beautiful, and they know others think it is beautiful. Gold is something
you can safely believe is valuable. Before 1971, gold therefore served as a physical token of what is valuable based on people's perception. (You don't need an MBA to learn how to save money and invest in your future
The second type of money is fiat money,
which does away with the need to represent a physical commodity and
takes on its worth the same way gold did: by means of people's
perception and faith. Fiat money was introduced because gold is a scarce
resource and economies growing quickly couldn't always mine enough gold
to back their money requirement. For a booming economy, the need for
gold to give money value is extremely inefficient, especially when, as
we already established, value is really created through people's perception.
Fiat money, then becomes the token of people's apprehension of worth -
the basis for why money is created. An economy that is growing is
apparently doing a good job of producing other things that are valuable
to itself and to other economies. Generally, the stronger the economy,
the stronger its money will be perceived (and sought after) and vice
versa. But, remember, this perception, although abstract, must somehow
be backed by how well the economy can produce concrete things and
services that people want.
