The Definition of Money Explained

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Understanding how to survive and thrive through a dollar crisis first requires that one understand the definition of money. While at first glance, the definition of money might seem obvious, defining money is more complicated than most might think. Throughout history, many items have served as money, from gold to cattle to shells, to coins and as in the United States and virtually every other country in today’s world, paper created by a government or banking authority. Most Americans simply define money as the U.S. Dollar. It is true that an American can enter any retail establishment in the U.S. and leave with whatever goods for which he or she chooses to exchange for goods and services. But why is this the case?

When the typical citizen asked to define money, most will describe it as their national currency, others might say it’s gold or silver. The dictionary defines it as:

“any article or substance used as a medium of exchange, measure of wealth, or means of payment, as checks on demand deposit”. Economist Frederic Mishkin defines money as:

“any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country”.

These definitions would presumably define money as the currency in your wallet. But that currency is simply paper issued by the government. Why does this paper have value? Is it because we have such a strong belief in our government? Is it the special paper the U.S. Bureau of Engraving and Printing uses? Or is it something printed on the bills themselves? When one reads what’s on a one-dollar bill, that person will read: “This note is legal tender for all debts, public and private.” But what is “legal tender”? Well, legal tender is defined as:

“currency that may be lawfully tendered in payment of a debt, such as paper money, Federal Reserve notes, or coins”.

The Bureau of Engraving and Printing produces the paper money and coins for the Federal Reserve. However, chasing these definitions reveals nothing about why this currency has value. The cost of a loaf of bread in 2012 averages $2.20. But why is the price $2.20? Why not 22 cents or $22? For that matter, why not $22,000 or even $22,000,000? Basic economics can provide a partial answer. It teaches that from the interaction of supply and demand, $2.20 is the price where the buyer and the seller meet. In other words, the baker motivated by maximum profit feels an adequate profit will be made selling bread at $2.20, while the buyer, motivated by maximum savings, finds $2.20 to be a price that person is willing to pay. Hence, prices become a mutually beneficial agreement, between buyer and seller. However In Zimbabwe, a loaf of bread cost approximately one trillion Zimbabwe dollars in 2009, right before that currency was effectively abandoned.

Why does it take only slightly more than two dollars for the American consumer, and one trillion dollars for the Zimbabwean consumer to come to this agreement? We can infer from this historic phenomenon that a currency’s value is driven by scarcity. The supply of Zimbabwean dollars is considerably higher, has been subjected to government money printing and backed up by considerably less prestige than the USD. With every wave of money printing, the supply of Zimbabwean dollars increased. Increased printing decreased scarcity. Hence, these dollars had less value. And less value means more Zimbabwean dollars are required to purchase goods compared to before a given round of money printing.

The scarcity principle makes sense by other measures as well. One metal that’s been valued throughout time and across all different types of societies all across the world is gold. Only 166,600 tons of gold had been mined from the beginning of time to 2010. The price of gold reached a high of over $1,900/oz. in 2011. This compares to water. In spite of water’s importance for human survival, water covers 71% of the earth’s surface and can be easily found in most parts of the world. In spite of the fact that only 0.37% of the world’s water is drinkable, tap water costs slightly more than $2 per 1,000 gallons.

So how does scarcity affect people who use the USD? Officially the USD is backed by the “full faith and credit of the United States.” As mentioned before, the USD is a fiat currency, holding value merely because the government declares it as such. All governments in the world now use fiat currency. The scarcity of the USD is determined and maintained by the U.S. Federal Reserve. But why do investors in the U.S. and across the world place trust the Federal Reserve if the USD has value merely because the Fed declares it as such? Given what appears to be an insecure measure of value, why use money at all?

We use this money because civilizations need a portable and convertible store of value to exchange goods. From the beginning of time, people exchanged goods and services by barter, or trade. However, barter has substantial limitations. For example, a barber may need the services of a doctor. However, if the only nearby doctor is bald and in need of a plumber, neither the doctor nor the barber can get the services they might need by trade alone. For this reason, the world has gravitated to the use of money, a form of exchange universally accepted across a defined area. The barber can now pay the doctor to get whatever cure needed, while the doctor can take the money paid to him and use it to pay to pipes he relies on for his home’s water system. The gravitation to money has been apparent throughout history. Even before metal coins were invented in 1000 B.C., people used cattle, grain or shells as forms of exchange. Within the prison system, where cash is of little use, cigarettes were used before tobacco products were banned from federal penitentiaries in 2004. After the tobacco ban, prisoners gravitated toward valuable products that are used by most people and don’t spoil over time. Items such as vacuum-sealed fish, coffee, and postage stamps hence have become the “money of prison”. These forms of money might seem strange to people used to purchasing and earning dollars, but they can also perform the functions of money within a prison society. For example, postage stamps have an easily understood value (the mailing of one letter first class since the advent of the forever stamp), are easy to store and carry, and are used by everyone (access to e-mail is limited at best in prison). And because everyone uses them, most everyone will accept them in trade for other goods and services. If the day comes that other prisoners do not want to accept them, a prisoner can write a letter and use the stamp to get that letter sent, or they can sell stamps for the prevailing rate of mailing a letter. Additionally, the stamp will not spoil in the same manner as fish and coffee. And because it’s a “forever” stamp, backed by the full faith and credit of the United States Post Office (whatever that’s worth), it will not be subject to the depreciating power of inflation. Interestingly, the USD does not offer this level of stability, as no guarantee that $2.20 will forever buy a loaf of bread exists.

Money is simply a medium of exchange created by and backed by society in order for goods and services to be exchanged. Any number of items have been used throughout history, though the most durable mediums of exchange have a stable value, are easily carried, and not subject to spoilage. By understanding what money really is, people, groups and societies can better understand value and how one creates and preserves that value.



Source by Michael W Healy

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Forex

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