Thursday, April 6, 2006

Origins of Money

Money, everybody talks about it but no one understands it. Let me try to get to the basics of money.

To understand what money is, we need to know what is the importance of money, and, before we can do that, we have to understand how money arose.

Before money, there was barter. Goods were produced by those who were good at it, and their
surpluses were exchanged for other goods (produced by others good at it). Every product had its barter price in terms of all other products. And every person gained by exchanging something he needed less for a product he needed more.

Barter had severe limitations on the scope of exchange and therefore on production. In the
first place, in order to buy something one wanted, each person had to find a seller who wanted precisely what he had available in exchange. In short, if an bread maker wanted to buy stitch clothes, he had to find a tailor who at that very moment wanted to buy bread.

Or, sonside, I make a living as a software consultant. If I wanted to buy a newspaper in a world of barter, I would have to wander around and find a newsdealer who in exchange from me wanted, say, a software to solve his paper delivery issues . Now assuming I somehow manage to write a working software where will I find a newsdealer with the problem?

This crucial element in barter is what is called the double coincidence of wants. A second problem is one of indivisibilities. The above examples highlight the first problem. For second problem someone who owns a house, and would like to sell it and instead, buy a car, a washing machine, or an AC. How could he do so? He can not chop his house into 20 different segments and exchange each one for other products. Clearly, since houses are indivisible and lose all of their value if they get chopped up, we face an insoluble problem. If houses could not easily be bartered, not many would be produced in the first place.

Another problem with the barter system is what would happen to business calculation. In the barter system, profit or loss calculation would be a hopeless task and business firms willl be unable to calculate whether they are making or losing money in each of transaction.

Barter, therefore, could not possibly manage an advanced or modem industrial economy. Barter could not succeed beyond the needs of a primitive village.

Trying to overcome the limitations of barter, man arrived at one of most ingenious, important and productive inventions: money.

Take, for example, the bread maker who is trying desperately to get his clothes stitched. He thinks to himself: if the tailor has cup-boards full of bread and doesn’t want to buy them, what does he want to buy?. Bread maker needs to find what tailor would like to obtain. Suppose he finds out that it’s shoes. So the bread maker goes out and buys shoes, not because he wants to eat the fish himself (he might have several pairs), but because he wants it in order to resell
it to the shoemaker. In the world of barter, everyone’s purchases were purely for himself or for his family’s direct use. But now, for the first time, a new element of demand has entered: The bread maker is buying shoes not for his own sake, but instead to use it as an indispensable way of obtaining shoes. Shoe is now being used as a medium of exchange, as an instrument of indirect exchange, as well as being purchased directly for its own sake.

Once a commodity begins to be used as a medium of exchange, when the word gets out it generates even further use of the commodity as a medium. In short, when the word gets around that commodity X is being used as a medium more people will purchase that commodity, since they know that it is being used there as a medium of exchange. In this way not before long the commodity is in general use throughout the society or country as a medium of exchange. But when a commodity is used as a medium for most or all exchanges, that commodity is defined as being a money.

Money was a leap forward in the history of civilization and in man’s economic progress. Money—as an element in every exchange—permits man to overcome all the immense difficulties of barter. The bread maker does not need to find a shoe maker who wants bread and I don't need to find a news dealer who wants software. All we need do is exchange our goods or services for money; for the money commodity. Similarly, indivisibilities are overcome; a homeowner can sell his house for money, and then exchange that money for the various goods and services that he wishes to buy. Similarly, business firms can now calculate, can figure out when they are making, or losing, money. Their income and their expenditures for all transactions can be expressed in terms of money.

These are the basics of money. Next I will try to look at what are the qualities of money.

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