Medium of exchange

A medium of exchange solves the coincidence of wants problem by decoupling the direct exchange requirement that is inherent in barter systems. By introducing a generally accepted medium of exchange as an intermediate step between the exchange of specific goods & services, the wants of each individual no longer need to coincide. Now, each individual can sell their specific goods or services for the medium of exchange, which can then be used to buy whatever they want in exchange. It is not necessary that they find someone who both has what they want and wants what they have. With a medium of exchange, Alice can sell his apples for money and then use that money to buy whatever he wants with it. Likewise for Bob and her milk and Charlie with his eggs. The elimination of the coincidence of wants constraint vastly expands the potential scale and scope of mutually beneficial exchange.

However it is important to note one crucial difference between barter and monetary exchange. In barter, selling and buying are parts of the same action. It is not possible to sell without buying in a barter economy. Furthermore, buying and selling are always exactly balanced in barter transactions. In economics, this principle is known as Say’s Law. The simplest formulation of Say’s Law is that “supply creates its own demand”. In other words, by producing goods & services for purposes of exchange, one also creates an equivalent amount of purchasing power with which to buy those goods & services. The introduction of a medium of exchange changes this aspect of the exchange system. When a medium of exchange is used as an intermediate step between selling and buying, it separates selling and buying into two separate actions. This makes it possible to sell without buying and creates conditions under which Say’s Law may not apply. In a monetary economy it is not necessarily the case that demand exists for all of the goods & services produced. By introducing the intermediate step of money, it is now possible to refrain from purchasing an equivalent quantity of goods & services that one sells from one’s own productive activities. This is also known as saving. This point will have important consequences as this analysis proceeds.

Other functions of money

Money’s primary function is to overcome the coincidence of wants problem by introducing a generally accepted instrument that serves as an intermediate step between buying and selling. But this is not the only function of money. Money has also adopted other functions such as being a unit of account and a store of value.

Unit of account

A unit of account is a standard measure which can be used to express the prices of all of the different goods and services that make up an economy. A unit of account could be considered as implicit in the medium of exchange function. The unit of account is simply whatever increment is used to measure or count the quantity of the instrument that is used as a medium of exchange. If the medium of exchange is gold, the unit of account is an ounce or a gram of gold. If the medium of exchange is corn, the unit of account is a pound or a bushel of corn.

It is difficult to imagine a suitable medium of exchange that would not also perform the unit of account function. So the medium of exchange and unit of account functions could be considered as the same function. This would mean that the medium of exchange and the store of value properties would represent the two commonly adopted functions of money.

Store of value

Money has historically helped individuals and businesses with preserving value over time. It enables people to save their earnings and spend them in the future, helping them to maintain most or all of their purchasing power.

Commodity money

Commodity money is money that has intrinsic value, often made from precious metals or from other valuable commodities. Common historical examples include gold, silver, copper, shells and salt.

Creating commodity money, especially using precious metals, will often mean that the resources need to be mined and extracted before they are then processed so that the commodity can be used as money.

Problems

• Hoarding - Commodity money, particularly precious metals like gold and silver, can be easily hoarded. Hoarding can lead to a reduction in money circulation, causing deflation and slowing down economic activity.

• Rigidity of supply - The supply of commodity money is tied to the physical availability and extraction of the commodity. This can lead to economic instability if the supply cannot be easily adjusted to meet the changing needs of a growing economy.

• Imbalance of power - ****Hard money, like gold or silver, give the buyer more power in the exchange process as they often have less urgency to make a purchase. Buyers have money that does not erode or degrade over time. Sellers often do have goods that get less valuable over time. This gives buyers an advantage in the exchange process as there is no cost for them to pause or delay the exchange.

• High production costs - Mining, refining and minting commodities like gold or silver can involve significant costs, which can be economically inefficient.

• Storage and transport - Physical commodities can be bulky and heavy, making them difficult and costly to store and transport.

• Market fluctuations - The value of commodity money can fluctuate with changes in market conditions for the underlying commodity.

Representative money

Representative money is money that represents a claim on a commodity or asset, redeemable for a fixed amount of the commodity. Common historical examples include gold or silver certificates.

Creating representative money will often involve the same process of extracting or mining the resources required for the commodity or asset that is going to be used as money before then processing it. The commodity or asset can then be stored in a reserve and a certificate claim can be created to represent that money.

Problems

• Inherits the same problems as commodity money - Representative money is a claim for a commodity or asset. Due to this it can inherit the same problems that exist with commodity money.

• Backing vulnerability - Representative money relies on the value of the reserves backing it, which can be subject to misrepresentation or insecurity.

• Trust and confidence - The system requires trust in the institutions managing the reserves, and any loss of confidence can destabilise the currency.

• Manipulation risks - The pegging or backing ratio can be altered, affecting the value of the currency and causing economic uncertainty.

• Complexity of management - Maintaining adequate reserves and ensuring their security can be complex and costly.

• Limited supply control - The supply of representative money is tied to the backing commodity, which can limit the ability to adjust money supply in response to economic needs.

Fiat money

Unlike commodity or representative money, fiat money does not have intrinsic value and isn’t backed by a physical commodity. Its value is derived from the trust and acceptance of the people who use it, enforced by government decree. Examples include modern paper currencies, coins and digital currencies.

In modern fiat systems, money is primarily created through the actions of central banks and the banking system. Central banks, such as the Federal Reserve in the United States, create money by issuing currency and through open market operations, where they buy government securities, adding reserves to the banking system. Commercial banks also create money through the process of fractional reserve banking. When banks lend out a portion of the deposits they receive, they essentially create new money in the form of bank credit. This process expands the total money supply in the economy, as the same initial deposit can be used to generate multiple loans and deposits across the banking system.

Problems

• Inflation risks - Fiat money is not backed by a physical commodity which makes it susceptible to over issuance by governments and the banking system. This can then lead to inflation or even hyperinflation. The value of these currencies can erode over time due to an ever increasing supply.

• Lack of intrinsic value - Fiat money has no intrinsic value. It relies entirely on public trust and government decree, which can be fragile.

• Interest and debt cycles - Fiat money systems often facilitate debt accumulation and interest, a system where money is able to earn interest passively, which incentivises hoarding and allows wealth accumulation without productive effort. This system can create economic instability and result in higher concentrations of wealth that exacerbate inequality.

• Potential for abuse - The ability to print unlimited quantities of money can lead to irresponsible fiscal and monetary policies. These policies could have unintended consequences and create economic instability.

What defines money?

Historically there are two characteristics which have defined money. The first is the general acceptance of money as a means of payment for goods & services. The second is the status of legal tender, as designated by the government. These two characteristics often coincide, but this isn’t always the case.

Presently, new forms of money are being experimented with in a variety of different contexts, including the Web3 industry, alternative/community exchange systems and complementary currencies. Many of these new experimental forms of money do not have legal tender status, but that does not preclude the possibility that they could achieve the first characteristic of money, i.e. general acceptance. As a consensus grows that national governments have mismanaged and abused their roles as creators of money, more and more people are concluding that this function should be performed by entities other than governments. The future will likely be one in which people are free to choose from a variety of different forms of money, regardless of whether they have legal tender status or not.