Understanding Money: Forms, Value, and History
Money is any item generally accepted by a society as a medium of exchange to pay for goods or services. For a good to be well qualified as money, it must fulfill the following functions:
- Medium of exchange: It should be interchangeable. This happens when it is readily traded for other goods and services.
- Unit of account: It must be an accounting unit. This occurs when the value of a good is used to express the value of other goods and services.
- Store of value: It must be a store of value. This occurs when the value of the item is stable enough to conserve and use it for trade later.
- Standard of deferred payment: Related to the above, the good considered money should allow the establishment of payment agreements and income.
For a good to be considered valid as money, it should be durable, portable, divisible, homogeneous, and of limited supply.
Opportunity Cost and Interest Rates
Keeping money liquid has an opportunity cost because this money could be used for investments, loans to banks, or other institutions in exchange for a given interest rate. The opportunity cost of holding money is the interest sacrificed that could have been earned if invested otherwise. The interest rate is the cost of money, expressed in monetary units per year, for each currency unit borrowed.
Historical Evolution of Money
The most commonly used goods throughout history as money have been gold, silver, and other metals. The first coins appeared in the 7th century BC in what is now Turkey, made with an alloy of gold and silver. It was in the Roman Empire when, for the first time in the history of the Western monetary system, a unified currency was recognized, becoming equal in size, weight, and value to existing currencies. In the last days of the Roman Empire, gold and silver coins were produced, which were replaced by other cheaper metals like bronze.
China’s Role in Paper Money
China played a crucial role in the development of currency as certificates of possession of a quantity of gold. Paper money had several advantages over common currency: its fabrication was cheaper, it was transported more easily, and it prevented the movement of large amounts of metal. In Europe, paper currency was introduced by banker Johan Palmstruch in 1661. In Spain, the emission was centralized at the Bank of Spain in 1874.
Different Forms of Money
- Commodity money: This mode of payment is a physical good valued for itself and occasionally used for final consumption.
- Cash: This is a particular type of commodity money that has intrinsic value. The physical good used is a metal, usually gold, silver, or bronze, in the form of coins.
- Convertible paper currency: This arises as a document that gives the right to claim a commodity, such as gold or silver, as a means of payment. Its use became widespread when money changers issued receipts in exchange for deposited metal in their safes.
- Fiat money: This is a commodity with little to no intrinsic value that serves the functions of money because an official order is issued.
- Bank money/Demand Deposits: This implies a loan provider’s commitment to repay the notes and coins in circulation. We find it in checking accounts.
The Value of Money and Inflation
The value of money is measured by the number of goods that can be acquired with it now or may be acquired in the future; that is, its purchasing power. Inflation is a measure that indicates the change in the value of money.
Inflation Rate
The inflation rate is the percentage increase in the price level. The most widely used index for measuring inflation is the Consumer Price Index (CPI), which indicates the percentage change in the price of goods and services that a consumer acquires, using a reference known as the “shopping basket.”
Hyperinflation
If there is hyperinflation, which occurs when monthly inflation exceeds 50%, money ceases to operate as a medium of exchange, and due to the loss of its purchasing power, people avoid keeping their money and spend their income as soon as they receive it.
Money Supply
In the current economic system, true commodity money and barter have disappeared, and the most commonly used means of payment are cash (notes and coins in circulation in the hands of the public) and bank deposits. All the money in circulation constitutes the money supply.