Barter becomes increasingly difficult as a society becomes more complex. The use of a medium of exchange as a means to facilitate transactions was one the earlier financial inventions of humans. Its use is integral to a functional society. The term money, the common name for much of what is called medium of exchange, will not be used for this concept in this work because there is no clear meaning for it and the emphasis is on the fundamentals of economic transactions, not historical analysis. Also in current usage money includes some types of financial instruments
Medium of exchange evolved over time as a business practice. As far as can be determined, there was no particular individual who invented the use of medium of exchange. It arose naturally out of the market process because it facilitates the exchange of land, labor and production functions by allowing indirect exchange. It arises in a particular market area as an economy progresses.
Different physical items have been used as medium of exchange, the most common being a precious metal such as gold or silver. The medium of exchange that arose from the market as a commodity had the following basic characteristics:
The use of medium of exchange creates an indirect exchange process adding another step to the process of exchange.
It is important to realize that:
At any point in time in a market there is a fixed amount of medium of exchange and exchangeable items. During the market period items are traded for medium of exchange and medium of exchange is traded for items.
Because medium of exchange is divisible, each trade can be recorded as Q amount of the item and Mex amount of medium of exchange. Dividing the two gives a price P = Mex / Q such as $ per pound in terms of the medium of exchange and quantity units used in that market transaction.
If one market uses silver as its medium of exchange and another uses gold, there would arise over time an exchange rate between the two markets that would allow for trading between the two markets by going through an additional step of exchanging one medium of exchange for the other.
Looking at the fundamentals, each market participant goes to the market with a fixed amount of medium of exchange and a fixed number of items to be exchanged. The exchange period begins and the participants exchange less desired items for more desired items. When the market period is over, the participants have different numbers of items and medium of exchange. For the entire market consisting of all the participants, there has been no change in the amount of medium of exchange or items. Presumably each participant is happier with the ending distribution of items and medium of exchange than at the beginning or they would not have made the exchanges.
The market participants now engage in a consumption period and production period where some of the items are consumed and others are transformed. Some of the items could also be held for exchange during the next market period or for future use. The medium of exchange is held in a safe place to be used in the next market period.
During the production period it is possible that more medium of exchange could be found or some of it could be used for consumption or production purposes. The majority of the items used for medium of exchange would not be used in production or consumption because of its higher use value as medium of exchange. The fact that the commodity used for medium of exchange could be used in production or consumptions sets the quantity of the commodity used as medium of exchange to a proportion that has a relationship to the level of production and consumption in a market. Miners digging holes in the ground to find gold are providing a very useful service of keeping medium of exchange growth in proportion to economic growth.
Because the commodity used as medium of exchange has to be produced using the technology available at the time, the amount will grow as technology advances and more can be produced for a given effort. This will create a tendency for medium of exchange to grow along with the items available for exchange and exert a tendency for prices (the ratio of total amount of medium exchange to total items traded) to be more constant over time.
For a medium of exchange to be used easily, market participants need to know its quality and weight. Since most medium of exchange started out as precious metals, a jeweler would weigh and assay the metal. Over time the metal would be divided into coins and bars stamped by a recognized authority. This authority would in many cases be the ruler of the market area.
Transactions still could be made easier, if instead of taking precious metals and assaying, subdividing and making them into coins, the medium of exchange was stored in the safe of a jeweler and a paper receipt issued. The receipts could be for various denominations. These receipts can now be traded in place of the medium of exchange. If the owner of the receipt wanted the actual medium of exchange, the owner would go to the jeweler, who by now has become more specialized as a bank and would exchange the receipt for the medium of exchange. Both actual medium of exchange and receipts will trade in the market area based on the preferences of the market participants.
In the search for easier transactions there arose the demand deposit account. The medium of exchange would be placed in a bank and the bank, instead of issuing receipts in various denominations (bank notes), would give the depositor the ability to write a draft against the account. The written order tells the bank to give the person specified on the draft the amount of medium of exchange written on the draft from the writer's deposit account at the bank or transfer it to a different account.
In the market area where the banks and mints are recognized, the actual medium of exchange and the substitutes will be used interchangeably as if they were the physical medium of exchange itself. The original medium of exchange has a quality and a weight associated with it. Market practice made it easier to call it by a name such as dollar, pound, franc, lira, etc. These names would be used on the receipts instead of a certain fixed weight and quality of medium of exchange.
Human nature being what it is, some people are not able to resist temptation as much as others. Since opening a precious metal mine, refining its output and assaying it is difficult and time consuming work, and writing a number with some fancy printing is much less work, there were always those who counterfeited medium of exchange substitutes or tried to shave some of the medium of exchange off the minted coins. Counterfeiting has the further benefit of avoiding producing something to exchange for medium of exchange and then using the medium of exchange to trade for the consumption goods that were the ultimate desire. Counterfeiting medium of exchange substitutes is illegal because of the obvious fact that it is fraud. However, the owners of a mint or a bank have powers that an individual counterfeiter doesn't have.
The issuers of the medium of exchange substitutes were generally either the rulers of the area or others who had close connections with the rulers. Since they were people with political power, they could influence or make laws and enforce them with police powers.
When precious metal used as medium of exchange is brought to a mint, it is weighed, assayed and made into a coin with a name for the medium of exchange used in the trading area, or a bar is made that is stamped with weight and quality and the mint name. The issuers of the coins or bars can add base material to them so they look the same and weigh the same. The issuer can then use the precious metal left over to make new coins for themselves.
There is a long history of rulers who controlled the mint doing this to finance wars, pay for palaces, etc. The rulers debased the coins as a seemingly painless way to obtain items in the market. The debasement continues until market participants realize what is going on and either refuse to accept the coins or increase prices to compensate for the reduced medium of exchange content. The rulers usually fight back by making it illegal to refuse to accept the debased coins at face value through legal tender laws or more draconian acts such as making it illegal to own medium of exchange and confiscating the medium of exchange from the citizens. This was done by Executive Order Of The President dated April 5, 1933 in the United States during the Great Depression. Diocletian, a Roman Emperor, did it in 300 AD as well.
It is even easier to issue bank notes which are receipts for medium of exchange, so most modern rulers make it illegal to own medium of exchange, issuing bank notes in its place. They make the bank notes legal tender in the nominal amounts printed on them. It is then easy to issue as many as the ruling group wants.
Market participants now have to deal with capricious ruling classes who think they no longer have to raise taxes to finance their activities or produce something of value to trade for medium of exchange. Over time this flood of receipts for medium of exchange into the market, which we call money (to distinguish it from medium of exchange), cause the market participants to either refuse to accept the money or to raise prices at a rapid rate, trying to keep ahead of the ruling class's money creation.
The ruling classes respond by enacting wage and price controls. Before long the economy has extremely high inflation with people going around with an armful of money just to buy basic necessities. Economic activity declines. Society goes into a crisis with the result sometimes being war and revolution. This happened in the 1920s in Germany and contributed to the rise of Hitler and World War II.
These types of events also happen regularly in nations today. Ruling groups then lose power. Money supply is again brought under control and economic activity usually begins to resume. The power to issue money and make it illegal for citizens to use medium of exchange in their economic transactions is a closely guarded prerogative of the ruling groups.
Most ruling groups especially, if they have to face elections, know that economic growth under their rule is a better way to maintain power so they generally keep outright creation of money under some sort of restraint. For example the US Federal Reserve buys assets from banks or US Treasury Bonds from the government giving them newly created money rather than just issuing money for the government to spend.
The effects of serious inflation are clear and devastating so more subtle techniques are required to obtain items and services in the market by the creation of money. One of the ways which was mentioned earlier is to make it illegal for citizens to own medium of exchange or use it untaxed for market transactions. This can be done by making contracts with payment in medium of exchange unenforceable. It is possible to tax each transaction using medium of exchange as if it were a commodity instead of medium of exchange. These techniques are in use in the United States at this writing.
In general, simply making it illegal to hold medium of exchange and issuing banknotes or similar instruments to finance the ruling groups' endeavors doesn't work too well as market participants anticipate the increase in money supply and increase their prices, making it difficult for the ruling classes to extract more resources from the population without resorting to other means such as taxes or borrowing. They sometimes try to enact wage and price controls but market participants withdraw their goods and services and that doesn't work either.
In modern economies the outright creation of money to finance the ruling class's expenditures is not as prevalent as it once was. Developing countries still have the problem, leading to periodic crises in specific countries. As long as there is free discussion and the threat of being voted out of office, other methods of finance are used such as borrowing.
There is a flaw in the banking system that has not been well understood. It causes serious economic dislocations, recessions and depressions as well as periods of feverish economic activity that is not sustainable. The flaw has been part of deposit banking since the first people deposited their medium of exchange in a bank and were issued a receipt. The original idea was that there was a one to one correspondence of receipts with the medium of exchange in the bank. This is because the receipt would state that the issuer would return the medium of exchange on demand to a holder of the receipts. This evolved into the demand deposit account which in modern practice is called a checking account.
Since a bank is not a charity, it needs to charge the owner of the demand deposit account a fee to maintain the account. Charging a fee, however, was not the way to make large amounts of money by providing demand deposit accounts. Over time bankers realized two key things about these accounts that would be more lucrative than charging fees:
Creative bankers then came up with the practice of loaning out the balances in the depositors' checking accounts as well as the bank's capital and the amounts in time deposit accounts. It was called fractional reserve banking. This practice sets up subtle problems that continue to plague the economy. The problems are:
Since banks knew what they were doing, they always demanded the actual medium of exchange when presented with a check drawn on another bank. To make this process easier. they set up clearing houses where they would present the drafts drawn on the other banks and only the balance of medium of exchange would be transferred. As long as the banks in a clearing house increased the amount of medium of exchange substitutes at a uniform rate, no balances would need to be transferred.
The bankers have to honor their drafts and hope that they have an adequate supply of medium of exchange on hand for those who want it. The bankers run the constant risk that enough depositors would want their medium of exchange so that there would no longer be enough available to meet their demand. Once depositors fear that they will not get their medium of exchange on demand, a bank run would ensue and some depositors would be disappointed. The bank would go out of business. The disappointed depositors would no longer have the medium of exchange they thought they had and they would cut back on their expenditures resulting in a depression or recession.
The bankers not admitting what they had done would say there is a shortage of medium of exchange and blame the use of medium of exchange for their problems. As a solution, they came up with the idea of a central bank which would monopolize the issuance of medium of exchange substitutes and prohibit the use of a commodity as medium of exchange. This enables the central bank to provide as much medium of exchange substitutes as required to stop any bank runs.
The central bank did not solve the problems as is evident by more severe and long lasting depressions and recessions since 1913 when the Federal Reserve System was created in the United States. There was the 1929 crash and the 2008 great recession, with smaller recessions recurring intermittently. Growth of the economy declined in the thirties and again after the great recession. Bubbles and the subsequent collapse are characteristic of the fractional reserve flaw. This flaw has not been recognized by the banking community who still insist that the cause of it is the gold standard (commodity medium of exchange) or poor quality loans the government forced them to make or some other cause. They neglect the fact that President Nixon took the United States off the gold standard in the 1970s. A commodity medium of exchange is not the root cause of the business cycle. Fractional reserve banking is the root cause. The use of a commodity medium of exchange is a tool that would maintain a stable medium of exchange as long as fractional reserve banking was prohibited.
Medium of exchange has another important use in economic action. It is used as a unit of account. Since all transactions use medium of exchange in a non-barter economy, the transaction can be recorded in terms of units of medium of exchange. This makes it possible to create accounts using units of medium of exchange as a common measurement unit.
The unit of account concept allowed for the invention of double entry book keeping and the scientific management of economic enterprises by performing economic calculations of the potential profit and loss entailed by pursuing specific actions. Economic calculation will be discussed in more detail later in this work.
Medium of exchange facilitates economic action by making an exchange economy possible. Barter is impractical for any large scale organized economic activity and needed to be replaced for economic growth to occur. Medium of exchange started as a commodity and over time institutions arose to facilitate its use. They evolved into the current banking systems.
The banking system is still evolving and the business cycle has not been tamed even with the creation of central banking. This is because of the fundamental flaw of fractional reserve banking which sets up conditions in which more than one person has a claim on the same item.
Medium of exchange is used as the unit of account which makes possible scientific management of economic enterprises through the use of economic calculation.
Copyright 2014-2019 Richard A. Cornell, PE