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I will begin with a simple question. What is money? Are you thinking dollars? The currency in your pocket? You are partially correct – though not entirely. Money is the generally accepted medium of exchange that is also a store of value as a function of industrial demand. Money is an asset, a tool, that allows you to transport value through time in exchange for goods and services. Before, getting into the details relating to the role of money in society, it is important to understand how the evolution of money took place.
A World Without Money
Money is an evolution of the barter system – an old method of exchange wherein people trade goods and services in return for other goods and services. Sounds like a simple process? However, it is not. Let me explain further with an example. Imagine, money does not exist, and everything else is the same. Supposedly, you want to buy a loaf of bread, and you have the skill of a painter. So, you go to the supermarket; shopkeeper asks you to paint a wall for the loaf of bread. The transaction is completed, but it is idealistically in nature. Now, let’s take this example a notch higher. What if, the supermarket had a fresh coat of paint and you offer to provide services of a painter in return for the loaf? The shopkeeper will refuse your offer, no loaf for you, the transaction is not completed, and the barter system has failed.
The phenomenon where you and the shopkeeper are willing to exchange services of a painter for the loaf of bread is known as double coincidence of wants – a situation where the parties involved in the exchange of goods or services desire the exact quantity and nature of good or services from each other. You might be thinking, in the backdrop of the illustration, this situation is not practical and will only come to fruition in rare instances. True that.
The barter system is riddled with fundamental problems that inhibited the expansion of this medium of exchange. The problems are:
- Finding Exchange Partners – Let me ask you a question; what are your chances to find a shopkeeper that requires a fresh coat of paint in your neighborhood? Pretty slim, I tell you. This brings us to the first fundamental flaw in the barter system. The ability to find exchange partners that want the same good or service that we possess or are willing to provide is restrictive in today’s economy. In other words, the double coincidence of wants is like winning the Powerball. Exciting, but the odds are not in your favor.
- Timing – Relating to the illustration of bread, arises another flaw in the barter system – timing. The timing refers to the exact moment where you find the shopkeeper interested to take up your offer as a painter while providing you with a loaf of bread in return. The spontaneity, in the example, is a matter of coincidence and often, harder to accomplish.
- Quantity – Another flaw in the barter system is the assumption where quantity you can offer is the quantity the other party requires. This assumption rarely holds true and, in fact, in the economics of markets, the more the buyers of bread, the more walls you should paint to earn that loaf of bread. Tiring, certainly.
As you can understand, the barter system had serious flaws that led to its downfall and the emergence of a more practical means of exchange. Hence, the rise of money as an intermediary to the barter system was inevitable.
Role Of Money In History
To counter the flaws of the barter system, gold and silver, for a long period throughout history, have been considered as money. But why these precious metals? Why not any other commodity? The reason is simpler than you think. There are certain characteristics that gold and silver possess that have contributed to their rise as money as well as their existence as an asset. The characteristics are as follows:
- Scarcity – Precious metals are scarce commodities. The demand for precious metals in industrial needs is ever-increasing as the uses of it in new technologies expand, while the supply of precious metals is limited. Interestingly, existing gold and silver are humongous to newly produced metal. This means that the previous quantities of gold can be used as money without the need to mine for more gold.
- Storage Value – You wouldn’t want your money to be rotten or decay in anway such that it losses value over time – that would be counter purpose. Precious metals, barring any supply shocks and as long as they posses their continued demand for industrial purposes, will retain their relatively stable value throughout time. As such, on average, if you can purchase a certain basket of goods with one gold coin (1 oz) today, more or less you will be able to purchase that same basket of goods in the future for the same quantity of gold.
- Highly Liquid – Liquid, in the economic sense, refers to the asset’s high desirability leading to sufficient demand to always meet supply. Gold, being widely accepted worldwide, is highly liquid and hence, acted as a medium of exchange for centuries.
- Low Transportation and Storage Costs – Gold is subject to lower costs as it has high value to weight ratio. In other words, even a small quantity of gold is worth a lot and as such can be stored as well as transported more cheaply. On the other hand consider if a bushel of wheat weighing 60 pounds was our money. Each bushel, as of March 2017, has a value of approximately $4.57. Imagine carrying 600 pounds (10 bushels) just to buy something at the grocery store. On the other hand, you can simply carry precious metals in your pocket such that their value significantly exceeds storage costs.
- Divisible – Gold can be divided into smaller fragments, each holding its value as a factor of the bigger piece. In simpler words, every gram of gold can be used as money without losing any of its value during the process of divisibility. This is not the case with a federal reserve note however. Image tearing in half a $1 dollar note? Try getting someone to accept that.
Due to its above characteristics, gold and silver rose in prominence as money and the world, for better, prospered.
To conclude, contrary to popular notion, money is the reason for all that we take for granted in the society.
But keep in mind, there is a clear and dangerous distinction between currency and money. Are you confusing the two? Do you own currency or money?
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