A Short Course in Economics

1. Money

We have seen how individual self-motivated human exchanges in a free market lead to a productive ordering of society by developing a division of labor, resulting in a massive increase in productivity, which all individuals can enjoy the benefits of.

There is one more ingredient for a healthy, well-functioning free market.  This too develops naturally through individual exchanges.  It is the development of a money.

As soon as a society includes several individuals, problems begin to emerge with the process of direct exchange, or barter.  These problems include the following:

• The “Double Coincidence of Wants” – in order for an exchange to take place, the two parties must have reverse valuations of the units of goods being exchanged.  But suppose, for example, Jackson, the game-producer of the society, does not like berries.  How is Crusoe, the berry producer, going to obtain the game he desires?
• Indivisibility – Suppose Brown is a house-builder.  He wants to sell his product and with the proceeds buy berries, game, fish, eggs and milk for his consumption.  He cannot sell part of the house to Crusoe, another part to Jackson, and parts each to the fisherman, egg-producer and milk-producer, because a part of house is not highly valued.
• Accounting difficulties – in a barter economy, it is impossible to keep track of the value of goods being produced against the value of goods being purchased.  It is difficult to know whether capital is being consumed, maintained, or added to.  The businessman cannot accurately tell whether his business is successful or not.

These problems can be overcome only by using indirect exchange, where an individual buys a commodity in exchange, not as a consumers’ good for direct use, but simply to exchange again for another commodity that is desired as a consumers’ good for direct use.

Instead of exchanging his berries directly for Jackson’s game (impossible since Jackson does not like berries), Crusoe goes first to Smith, and exchanges his berries for fish, not because he wants to directly consume the fish, but in order to exchange the fish for Jackson’s game (assuming Jackson does desire fish).  Thus, the fish commodity has functioned as a medium of exchange in the trading of berries for game.  An important factor in Crusoe’s decision to go to Smith was that he knew Jackson desired fish.   

Brown, the house-builder, sells his house to Smith, in exchange for a large number of fish.  Some of these fish are for Brown’s own consumption, but most of them as to be exchanged again so that Brown can obtain what he really wants as well: berries, game, eggs and milk.  Here for Brown, the problem of the indivisibility of his product has been overcome by using a medium of exchange, in this case fish again.  Brown’s decision to use fish as a medium of exchanged was, again, because he knew the product was highly desired, and because it was easily divisible.

It can be seen that once a product starts being used as a medium of exchange, it will tend to be used for more and more exchanges, as more individuals come to recognize that product as being a useful medium for exchanges.  There will be a snowballing effect, until only a few commodities, perhaps only one, will become a general medium of exchange, or money.

In this example, fish may become the general medium of exchange.  Which commodity becomes money is a subject for economic history.  In the past, the following commodities have all functioned as monies: tobacco, sugar, salt, cattle, nails, copper, beads, tea, and shells.  Cigarettes function as money in modern prisons.  Throughout the centuries, two commodities have gradually evolved as the commodities most widely used as money: gold and silver. 

It is worth examining what are the qualities of a good money.  Today, most monies are specially-printed pieces of paper.  While gold and silver meet all the requirements of a good money, it can be seen that fiat (unbacked) paper money does not meet them all:

1. Marketability – it must be generally accepted in exchanges.
2. Intrinsic Value – it must be desired for its own sake; this helps with marketability and ensuring value is retained.
3. Divisibility – it must be easily broken down into small units.
4. Portability – it must be easily transportable, small and light.
5. Durability – it must not lose its value over time.
6. Recognizability – it must be easy to recognize and difficult to counterfeit.
7. Limited Supply – to retain value, the supply of the commodity should be relatively limited.  That is, it should be difficult to produce and unlikely to be subject to significant increases in supply.

Commodities are usually exchanged as units of weight.  With gold as money, prices and accounts are given in terms of ounces of gold.   Accounting becomes possible because income and expenditures can be counted in terms of the medium of exchange; businessmen will then be able to know if their business is successful or not. 

When a money develops, it is sought after because it can be used as money.  Individuals keep some of the money commodity on hand or saved somewhere, in anticipation of being able to exchange it for other goods at some later time.  We refer to an individual’s personal supply of the monetary commodity his cash balance.  The sum total of individuals’ cash balances is referred to as the money supply.  Note that there is no such thing as money “in circulation” – at any given time, all money is sitting “idle” in somebody’s cash balance.

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