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Money

Money is an intermediary that serves as a medium of exchange, unit of account, standard of deferred payment and a store of value. Money is one of the central topics studied in economics. There have been many historical arguments regarding the combination of these four functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. These arguments are covered in financial capital which is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender.

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Before Money

Prior to the introduction of money, barter was the only way to exchange goods. Bartering has several problems, most notably timing constraints. If you wish to trade pigs for wheat, you can only do this when the pigs and wheat are both available at the same time and place - and without proper storage that may be a very brief time. With a trade standard like gold, you can sell your pigs at the "best time" and take the coins. You can then use that gold to buy wheat when the harvest comes in. Thus the use of money makes all commodities become more liquid.

Early systems, Commodity Money

The first instances of money were objects which were useful for their intrinsic value. This was known as commodity money and included any commonly-available commodity that has intrinsic value; historical examples include pigs, rare seashells, whale's teeth, and (often) cattle.

Even in the industrialised world, in absence of other types of money, people have occasionally used commodities like tobacco as money. This last happened last on a wide scale after World War II when cigarettes became used unofficially in Europe, in parallel with other currencies, for a short time.

Another example of "commodity money" is shell money in the Solomon Islands. Shells are painstakingly chipped into rough circles, filed down, and threaded onto large necklaces, which are then used during marriage proposals; for instance, a father may charge twenty shell money necklaces for his daughter's hand in marriage.

Once a commodity becomes used as money, it takes on a value that is often a bit different from what the commodity is intrinsically worth or useful for. Being able to use something as money in a society adds an extra use to it, and so adds value to it. This extra use is a convention of society, and how extensive the use of money is within the society will affect the value of the monetary commodity. So although commodity money is real, it should not be seen as having a fixed value in absolute terms. Its value is still socially determined to a large extent. A prime example is gold, which has been valued differently by many different societies, but perhaps none valued it more than those who used it as money. Fluctuations in the value of commodity money can be strongly influenced by supply and demand whether current or predicted (i.e. if you know the local gold mine is about to run out of ore, the price of gold will go up in anticipation of a shortage).

Money can be anything that the parties agree is tradable, but the usability of a particular sort of money varies widely. Desirable features of a good basis for money include being able to be stored for long periods of time, dense so it can be carried around easily, and difficult to find on its own so that it is actually worth something. Again, supply and demand play a key role in determining value. When governments print more banknotes, they are increasing the supply of money without any underlying increase in value. Therefore, the money becomes worth less than before the new banknotes were issued.

For these reasons metals like gold and silver have often been used for a commodity money. However these metals are also easily alloyed with a less expensive metal, making their value somewhat suspect.

Standardized Coinage

It was the discovery of the touchstone that paved the way for metal-based commodity money and coinage. Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. For these reasons gold as a money spread very quickly from Asia Minor where it first gained wide use, to the entire world.

Using such a system still required several steps and some math. The touchstone allowed you to estimate the amount of gold in an alloy, which was then multiplied by the weight to find the amount of gold alone in a lump.

To make this process easier, the concept of standard coinage was introduced. Coins were pre-weighed and pre-alloyed, so as long as you were aware of the origin of the coin, no use of the touchstone was required. Coins were typically minted by governments in a carefully protected process, and then stamped with an emblem that guaranteed the weight and value of the metal.

Although gold and silver were commonly used to mint coins, other metals could be used -- in the early seventeenth century Sweden lacked more precious metal and so produced "plate money" which were large slabs of copper approximately 50cm or more in length and width, appropriately stamped with indications of their value. The unwieldiness of this plate money no doubt contributed to Sweden becoming the first European country to issue paper currency, in 1661.

Representative Money

The system of commodity money in many instances evolved into a system of representative money. In this system, the money itself had no intrinsic value, but could be converted into commodities with intrinsic values.

Paper currency and non-precious coinage was backed by a government or bank's promise to redeem it for a given weight of precious metal, such as silver. This is the origin of the term "British Pound" for instance, it was a unit of money backed by a pound of sterling silver.

For much of the nineteenth and twenieth centuries, many currencies were based on representative money through the use of the gold standard.

Fiat Money

Fiat money refers to money that is not backed by reserves of another commodity. The money itself is given value due to an authority such as a government acting like it has value. If a large enough organisation issues, uses, and accepts something as payment for bills or taxes, that in itself gives the money some value because certain payments can be made with it. Perhaps the value it has is not the same as the large organisation might like, but there is some value nevertheless.

Governments through history have often switched to forms of fiat money in times of need such as war, sometimes by suspending the service they provided of exchanging their money for gold, and other times by simply printing the money that they needed. It was seen over time that suspending the exchange of a currency for gold (or whatever the currency represented) had less effect on what could be bought with it than many people expected. Occasionally, governments also by simple decree changed the amount of gold they would supply in exchange for their notes, and this also often had less effect on what could be bought with the money than the change in the amount of gold should have implied.

In 1971 the US finally switched to fiat money indefinitely. At this point in time many of the economically developed country's currencies were fixed to the US dollar, and so this single step meant that much of the western world's currencies became fiat money based.

Credit Money

Credit money often exists in parallel with other money such as fiat money or commodity money, and from the users point of view is indistinguishable from it. Most of the western world's money is credit money derived from national fiat money currencies. Credit money tends to arise as a byproduct of lending and borrowing money. The following example illustrates this.

Imagine you have deposited some gold coins in a bank vault. The bank might lend the coins to a second person based on a promise to pay equivalent coins back with a few extra at a time in the future. The second person can in the meantime use the coins normally as money. But you still own the coins, and you also could still use them - you could transfer their ownership to another person to pay for something you have bought by telling the bank to transfer them from your account to the other persons. You might do this by writing a check. So in this simple example there are two people using the same coins as money at the same time. It's as if new money has been created by the act of lending. Taking it another step, if the second person spends the coins at a shop, and they end up being deposited back into the bank by the shopkeeper, the bank can lend them again. Now you and the shopkeeper can use the coins in the same way, by writing checks or the equivalent in this example, and whoever borrows the coins a second time can use the coins directly as money. So there are three people with financial use of the coins. This can go on with many people ending up simultaneously using the same coins financially, but for each extra user there is a promise to pay equivalent coins back. These arrangements where many people use the same money simultaneously is in many respects the same as if there was extra money. The extra money that there appears to be is known as credit money. The credible promises to repay in a reasonable time give the extra money its value. It tends to exist in parallel with another form of money such as fiat money or commodity money, wherever banking style loans are used, and occurs as a byproduct of lending. It could occur without banks, but banks provide a degree of stability to the whole process by taking and evaluating the risk involved in each loan.

During the Crusades in Europe, precious goods would be entrusted to the Catholic Church's Knights Templar, who effectively created a system of modern credit accounts. Over time this system grew into the credit money that we know today, where banks create money by approving loans - although the risk and reserve policies of each national central bank sets a limit on this, requiring banks to keep reserves of fiat money to back their deposits. Sometimes, as in the U.S.A. during the Great Depression or the Savings and Loan Scandal[?], trust in bank policies drops very low and government must intervene to keep the industry of credit in operation.

See also: globalization, currency market[?], Local Exchange Trading Systems, Electronic money

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