Money Matters

Something I’ve heard a lot of people talk about recently (and a general sentiment shared by people in times of financial difficulties) is how money is ‘evil’ and seems to be the root of everyone’s problems.

Unfortunately, it is quite easy to forget the role money plays in an economy, and also quite easy to forget the fact that money has come about due to a need for it to make life a whole lot easier.

The Roles of Money

There are 3 main functions that money serves in today’s world:

1. Unit of Account

In the way that we use metres for measuring lengths, we can give a value to something in terms of a universal unit. It means that you can go into a shop and know the exact value of a good by looking at the monetary price of it. We take this for granted, but imagine going to a shop to buy a jacket without the existence of money. There would be no price, so you would have to find something to exchange for the jacket.

Suppose you decided to spare some of your extra egg-laying hens (maybe there’s too much muck to clean out of the coop). But how would you know how many of your precious hens to trade for that jacket? You may think the jacket is worth 3 hens, but the shopkeeper may think it’s worth 5. Or you both agree that the jacket is worth 3.5 hens – what do you do then?

Also, if we can quantify things, then it enables us to compare different items objectively. So the old adage goes, you can’t compare apples to oranges. But if an apple costs 30p and an orange costs 40p, then you can objectively say that an orange is worth more than an apple in value (of course, it may not be worth more to you, but that is a subjective comparison which depends on individual preferences).

2. Store of Value

Even though money has no intrinsic value (although it once did), it is ‘worth’ something because of the status it is given by a government. That is to say that money is considered ‘legal tender’.

Also (ignoring inflation), you can be sure that your £5 stored away will still be £5 in a year’s time. You cannot, however, be sure that the hen you stored for purchasing purposes is worth the same in a year’s time. It may start producing fewer eggs next year, or may even be dead. Not a great way to store your life savings, clearly.

3. Medium of Exchange

Probably the most obvious role of having money is the fact that it can be exchanged for goods and services. In essence, money has no value of its own. You don’t work because you want money directly. You don’t gain anything from having a wad of paper in your hand. It is the property of that paper which is so valuable – that it is universally accepted as a medium of exchange for any good or service that you might want.

This obviously means that the person selling the good will accept the money as he/she can buy goods with that money as well. With hens, the seller may not accept them since they know that they don’t need them and can’t trade them for anything else.

It is this property in particular that I’d like to emphasise the importance of and go into more detail about.

Who needs money? Barter is the way forward!

There are quite a few good reasons as to why we don’t use barter any more. A few of those reasons came up in my hen examples earlier. Things like animals are useless and expensive to store for any length of time if the only reason you are keeping them is for a potential future trade. Inanimate objects might keep for longer, but you still cannot guarantee that someone else would want them. This problem is known as the ‘Double Coincidence of Wants’ (or lack of it). To find someone who wants your good and is offering a good that you want in return is actually quite difficult, and the probability of finding such a person is likely to be low.

Suppose there were 3 people in an economy with 3 goods A, B and C. If you wanted to create a market for trading those goods, you would need 3 stalls:

1. Trade A with B
2. Trade A with C
3. Trade B with C

But if there were 6 goods A, B, C, D, E, F you would need trading posts for each of these pairs:


That’s 15 stalls! (Those numerically inclined will notice that there is a pattern here, namely the one of triangle numbers)

This means that if there were n goods in an economy, the formula for trading posts needed would be 0.5n(n-1)! Even with 100 goods (which is a considerably small amount if you think about how many millions or billions of goods are in our economy today), this means that you’d need a market with 4950 posts. A physical market would certainly not be able to cope with this many goods, and if you think about the number of goods in our economy, even a virtual market would struggle to cope with that much data.

If one of those goods was used as a universal trading currency, however, it would cut down the number of stalls required to just n for n goods (including the currency good). Each stall would accept the same good in exchange for the good that they were selling – which is the role money fills today. This makes it a hell of a lot more efficient to trade.

Fine… what about indirect barter then?

You might make the case that if you cannot obtain a double coincidence of wants, you could instead try to make an intermediate trade. This is known as indirect barter.

For example, say you had a fish that you wanted to trade for some wine. You don’t mind the fish, but really like wine. You also think eggs are the scourge of the earth.

You know 2 people – Alice and Bill. Alice has eggs and wants some fish, whereas Bill has the precious wine you want but will only take eggs. Obviously, you can’t get the wine directly because Bill doesn’t care for your smelly aquatic treat. However, you can make an intermediate trade and trade your fish for some eggs with Alice. Alice is happy since she has the fish, and you can now trade the eggs with Bill for the wine. Drink responsibly.

So you can see that in this case, indirect barter can lead to everyone getting what they want even when you cannot find a person that is directly willing to exchange your good for theirs. This solves something known as the ‘Wicksell Problem’, which occurs in situations like this when direct barter wouldn’t have worked.

Unfortunately, it may not be this simple in reality. These trades wouldn’t occur instantaneously, and so you might be holding the good that you don’t want (in this case eggs) for quite a while. During this period, you are incurring a storage cost for something you are not using and not gaining any utility from holding. And when goods are perishable like this, the eggs might go off before you find someone to trade them with – so you may end up with nothing when you could have still eaten the fish had you not traded.

Money rules!

Historically, people saw these problems and so decided to have a universally accepted medium of exchange that you wouldn’t have to worry about storing for a while.

Initially, these would take the form of precious metals. However, precious metals have an intrinsic value – by using them as currency, you sacrifice them being used for other things such as jewellery, scientific equipment and engineering – especially when they are limited in supply. Also, I’m not sure if you’ve tried taking a couple of bars of solid gold with you to the shopping centre/mall but they’d be just a little bit heavy.

Eventually, money has evolved into the notes and coins that we use today (known as Fiat Money). This solves all the problems that we face with barter, and because the paper our notes are made of has practically zero value, we solve the problem of using another ‘useful’ good as currency.

Thus, in light of the current situation, let’s not be rash in blaming ‘money’ for causing problems. Its value and usefulness is often taken for granted, as I have shown. Unfortunately, bad things tend to happen when you try to take advantage of the system…

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