The Emergence and Functions of Money 2.0

To the lay observer, the existence of money appears to be a given, and this is if they even notice money’s peculiarity. Money is a good, but unlike other goods, its primary use is as a medium of exchange. In the pre-modern era, money was typically linked to a commodity, but in the modern financial system, this is no longer true – at least not for base money. So how does money become an object of its own, delinked from any use value? How does money arise at all?

Given that humans preexisted money, there must have been a time where money did not exist. This is consistent with the framework that we have built over the last several weeks. Remember that analysis starts with agents. These agents have preferences that are revealed as they engage in exchange. Implicit in this exchange is the existence property rights. Every agent has opportunities to engage in entrepreneurial action. Our agent acts to attain profit. She imagines that she can transform the world from its present state into one that she prefers more greatly. She forms an expectation that she will use to frame and guide her action. The agent may prove successful and attain the profit or may break even or even incur a loss. In typical fashion, we can extend this concept to exchange. Two agents, both looking to improve the state of their existence, notice that each has a good desired by the other. It so happens that each wants the good that the other holds so they exchange the goods. Each has improved his or her lot, although we cannot be sure by how much exactly as there is no such thing as a cardinal utility measure – not even for a single agent. We must take agent action at face value and accept the action as a contextually constrained expression of the agent’s preference.

Barter is easy to accommodate in the model when the agents lacks geography. Action, however, always occurs at a particular time and place. The agent interested in a trade, let’s call him agent A, must find another agent, agent B, who owns the object of desire and who is interested in trading it for something owned by agent A. Often, this double coincidence of wants fails to arise. The agent can continue looking for a single trading partner, or he can partition his work. Instead of finding only a single agent, he can find a good that is demanded by agent B and trade that intermediate good for the desired good. Over time, the agent might realize that there are one or several goods that most easily accommodate this indirect exchange. First several other agents notice this wise idea and begin to copy the innovation. A small number of goods come to be recognized as having value in exchange in addition to value in use. These goods are different forms of money.

As we have seen, money does not arise by the plan of a single individual. It arises without intention. The goal of agent A was simply to find a good desired by agent B. There is no need for agent A to expect that other agents will adopt his strategy. His goal was simple. As the innovation is copied, the commodity becomes a network good. It gains value because other agents are willing to use it in indirect exchange, and therefore, charge prices in terms of the intermediate good. The good that becomes money comes to serve as a numeraire in which prices are denominated.

What makes for a good money? History provides an answer. Societies have tended to select money that meets 5 criteria. Money must be

1. durable
2. easily divisible
3. relatively scarce
4. highly saleable
5. portable.

These qualities promote the function of money. With these criteria more or less present, money can serve as:

1. a medium of exchange
2. a store of value
3. a unit of account
4. a standard of deferred payment.

Notice that the criteria for money relate to its functions. Saleability and portability allows money to function as a medium of exchange in the first place. What good is a money that is difficult to carry? Increased portability makes a money more easily saleable and more broadly acceptable. Durability and scarcity promote money’s function as a store of value. Divisibility is closely linked to money’s role as a unit of account. Prices, denominated in the unit of account, are more easily accommodated if money can be divided into homogeneous units. Given a common unit of account, agents can also lend money to one another. This allows an agent to attain a good that she otherwise could not afford or would be unable to borrow. Thus, money becomes a standard of deferred payment.

The development of money represents an innovation in accounting. A common standard or standards of measure allow for an approximation of the socially determined value of a good. Since prices are denominated in a common unit of account, the value of different goods, as determined in light of the demand of consumers and cost of supply, can be compared objectively. These prices represent the quantity of money a good can fetch if it is sold on the market. This allows producers to compare costs and revenues so that they can be certain of the magnitudes of their gain or loss.

These prices fluctuate according to changes in the quantity demanded at a given price (shifts in the demand curve) or as quantities available at given prices fluctuate (shift in the supply curve). They also change if either of these factors are expected to change. Thus, prices reflect not only present conditions but also expected changes in these factors. Since prices reflect information about agent valuations, they increase the accuracy with which agents can account for the value of their goods. This promotes an allocation of goods that reflect needs of all agents the preferences and budget constraints of those agents. With the addition of money, our model contains the building blocks requisite for economic calculation and widespread patterns of exchange.

Market regulation of the quantity of money

Just as money emerges from within a market dependent upon barter exchange, the quantity of money is also determined by market forces. Imagine that in some market, oats become the commonly accepted medium of exchange overnight. This change means that any person who buys or sells goods is willing to let money represent the other half of the exchange. A farmer who sells an apple use negotiates a price in terms of some weight of oats. He buys other goods using these same oats. 

Suppose that a community recognizes, overnight, that oats can now be used as money. Instantly demand for oats will increase as agents understand that oats can be exchanged for other goods. That is, oast not only have a use value – they can be eaten – but they also have an exchange value – they can be used to acquire other goods. The new price of oats, p1 (Figure 1) represent the combined use and exchange values. The original price, p0, represent the use value of oats. The difference between these two (p0 – p1), represent value derived from exchange. Note that if the supply curve was perfectly inelastic at q0, that the exchange value would be reflected by price implied at the intersection of Q0 and D1. For this example, the exchange value of oats in the short-run will be higher than the price reached in the long-run equilibrium.

The higher price sustained by the use of oats as medium of exchange incentivize greater production of oats. If the price is pushed high enough, it can also incentivize the development of technology that reduces the cost of oat production. Something similar occurred at the end of the 19th century when a relatively high price of gold incentivized the development of cyanide extraction process. For oats, this may include the development of new irrigation techniques or systematic use and breeding of the most productive strains of oats, among other possibilities. If the technology successfully reduces the cost of producing a unit of oats, the cost of supply falls. We represent this by shifting the supply curve to the right (Figure 2). Suppose that oat farmers suffer a drought one year. What will happen to the price of oats? In the case of a drought, the cost of supply increases. The supply curve for oats will shift left and the value of oats will increase.

Figure 1

Figure 2

The price of money
You may ask yourself, if oats are money, how do we determine their price. For any money, its price is what it exchanges for. If a quart of oats trades for 2 apples in equilibrium, then the price of a quart of oats is two apples. Likewise, if the same quart trades for 3 oranges, then the price of a quart of oats is also 3 oranges. Likewise, the price of an apple is 1/2 quart of oats and the price of an orange is 1/3 quart of oats. Money has an array of prices. Thus, the price of money is whatever it can exchange for. What we usually mean by the price of money, however, is the average price of money. This is often referred to as its purchasing power. Typically, we refer to the price level, which is the inverse of the purchasing power of money. A price index considers all exchanges for each type of good. Ideally, the price of each category of good sold is weighted according to the total number of goods exchanged. In reality, the basket of goods and weights of these goods change overtime, so there exists no perfect estimation of the price level and, by implication, the purchasing power of money.



[1] Another term commonly used is the purchasing power of money.

*Expanded from The Emergence and Functions of Money