It's something that most people think they don't have enough of, and yet it's only a piece of linen and cotton material just 6.14 inches by 2.61 inches or a disc of non-precious metal. It lasts from one year to 30 years, depending on whether it's currency or coin. What is it? It's money! But why do we need money? What function does it serve? Is the economy better because we have it?
The purpose of money is to facilitate the exchanges of goods and services. When we think of payment options, there are only three possible methods of effecting exchange: barter, credit and money. Individuals—who are sometimes referred to as economic agents—have an incentive to choose the least costly method of effecting exchange. The choice is illustrated by the parable of the trader.
There was a producer named Jake who once a week loaded some of his produce on a wagon and went to town where he and other producers would meet to trade their wares. One day Jake noticed that there was one particular item, grammies,1 that nearly everyone wanted and that they would exchange goods for grammies. Realizing that he can buy virtually any good he desired using grammies, he offers to take grammies for the goods he was trying to trade. Initially, Jake does this only when there was no opportunity for barter. He soon discovers, however, that trading in grammies is much faster and easier than searching out barter opportunities and his barter transactions become increasingly infrequent. By trading his wares for grammies, and grammies for the goods that he desires, Jake discovers that he can accomplish the desired trading in a fraction of the time that he had previously spent. Thus, Jake had more time to produce more goods or just have fun.
Jake realized that his trading time could be shortened further if the other producers also trade in grammies. If grammies generally were accepted by everyone in exchange, they would be money. The more widespread the use of money and the lower the exchange cost, the more likely it is that people will trade. The use of money causes markets to flourish. Increased trade promotes greater specialization, greater dependence on trade, and a greater need for and use of money. The phrase "Money makes the world go 'round" may be an apt description of how money facilitates economic exchange.
The parable of the trader may explain why money is an efficient method of effecting transactions, but it does not explain why money is held. Money is held for only one reason—by its very nature the process of exchange takes time so that anything that functions as a medium of exchange must be held. Although money is continuously changing hands, it always is being held by someone—it is never consumed. This is true of all assets, so what distinguishes money from other assets? The important criterion for separating money from other assets is that money is an asset that is generally acceptable as a means of trading goods—other assets are not. Generally speaking, assets are held for the myriad of reasons that individuals accumulate wealth. In contrast, money is primarily held because of its low cost in effecting transactions.
In earlier periods in history, commodity money such as salt or gold was used to transact exchange. In modern monetary economies, however, money is typically paper currency with no intrinsic value.2 Intrinsically useless money is called fiat money. Because fiat money requires fewer of society's scarce resources for its production and maintenance, its use results in a higher standard of living. Despite its advantages over resource-using money, fiat money evolved slowly over a considerable period of time.
Our money is called the dollar. Congress adopted the dollar (and the decimal system) as our unit of currency in 1785. Alexander Hamilton's coinage recommendation, which established the U.S. dollar as 270 grains (11/12 fine of gold) or 416 grains (0.89242 fine of silver), was not adopted until April 1792. Because of the inconvenience of carrying gold or silver, sight drafts were issued in convenient denominations. These claims on U.S. stocks of gold and silver circulated in lieu of the commodities themselves. Over the years the dollar has been redefined. Currently, U.S. currency is just a claim on the same quantity of U.S. currency. That is, we now have a pure paper currency (fiat money) standard. People are willing to hold intrinsically useless pieces of paper and claims that are denominated in intrinsically useless pieces of paper because they are certain that other individuals will accept the same.
Although the world is dominated by monetary economies, this does not mean that transactions are never carried out using barter or credit. In monetary economies, all three methods of effecting exchange are used. Because of its obvious limitations, relatively few transactions are carried out via bartering. In contrast, a large and increasing percentage of transactions initially are carried out with credit. The rise in the use of credit has caused some to speculate whether there could be a pure credit economy, with no money. This is unlikely for two reasons. First, to be efficient, credit needs to be denominated in a universally accepted unit of account. Second, credit instruments must be redeemable in some good that people desire. Both of these will tend to give rise to the development of money. While it is less obvious, it is important to note that money facilitates the use of credit just as it facilitates the trade of consumable commodities and tangible assets.
Money is a social arrangement resulting from a complicated evolutionary process. It exists because it facilitates exchange by reducing the cost of trade. By reducing the cost of exchange, it encourages more trade and greater specialization. Because of their strategic complementary, it is not surprising that money, trade and specialization have tended to evolve simultaneously.
This article was adapted from "Money in a Theory of Exchange" which was written by Daniel L. Thornton and appeared in the January/February 2000 issue of Review, a St. Louis Fed publication.