Lesson 1 of0
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Money

This chapter discusses money conceptually. Part IV of the book is dedicated to analyzing monetary economics with more depth and breadth.

The problem money solves

As the benefits of trade become apparent to people who engage in them, the incentive increases for people to engage in more trade. But the main impediment to the expansion of trade between people is the problem of lack of coincidence of wants. As humans try to find solutions to this problem, their actions naturally lead to the emergence of money, which is defined as a generalized medium of exchange. By understanding the problem of coincidence of wants that is solved by money, we can discern the properties that matter for money to operate successfully, and as a result, understand the properties that make for good money that emerges freely on the market. 

Coincidence of wants

At the scale of a family or small tribe in which everyone knows everyone else, and in which the degree of specialization in production is very low, leading to a very small number of goods and services being present, trade is likely to be very straight-forward and direct. In such a primitive setting, there is not much need for the emergence of money. With only a few goods available, individuals can trade these goods with one another directly. The hunter can just exchange their extra rabbits for fish from the fisherman at whatever exchange rate the two find agreeable, in a transaction called barter. With strong bonds between the small group of people, there is not even a need for direct exchange of present goods for one another. Individuals do not even need to provide present goods for immediate exchange; it is possible to exchange a present good for a promise for a future good. The hunter can give a farmer rabbits today in exchange for the farmer giving the hunter some of his grain crop in harvest season in a few months, in a transaction called debt.

Barter and debt are two ways of conducting trade, but they are only practical in specific circumstances. Barter requires a society of a very small number of goods where two parties both want to exchange two objects for one another. The fisherman needs to find a hunter who is looking for fish, and the hunter needs to find a fisherman looking for rabbits. Only if they manage to find each other, and have similar quantities to exchange at an agreeable price will the trade happen. The more the number of people in a society, and the larger the number of possible goods and products, the less likely it is for these two people to find one another for the trade to take place. In an economy in which there are only 100 people and 10 goods in total, everyone will be employed in the production of one of these goods, and everyone will need to obtain a supply of these goods. The odds of finding a trading partner whose wants coincide with yours decline drastically as the number of people in an economy, as well as the number of goods and services available, increases. 

In the modern world where there is a large variety of goods and services, barter is practically nonexistent. Siblings and friends might, by virtue of their proximity, identify occasions for direct exchange, and engage in it. But nobody in their right mind wakes up thinking of how to find a way to exchange goods and services for one another directly. The search costs would likely exceed the gains from the exchange. Beyond the scale of a small tribe exchanging a very small number of primitive goods, it’s impossible to have direct exchange. Nothing larger than a small tribe with very few goods can ever have an economy built on barter. 

As the number of individuals trading, and the number of goods and services, begins to increase, the problem of lack coincidence of wants becomes more pronounced. Human reason can find a solution to the problem of lack of coincidence of wants by engaging in indirect exchange: an individual will acquire a good not because they want it, but because they want to exchange it for something which they actually want. When the fisherman finds out that the hunter whose rabbit he desires is not interested in fish, but would like to obtain grains, the fisherman can exchange his fish for grain, and give the grain to the hunter in exchange for rabbits. Grains, to the fisherman, are not a consumer good, they are a medium of exchange: they are a good not acquired for its own sake, but for the sake of being exchanged with the good the holder actually desires. 

Man’s ability to reason makes it is inevitable that these indirect exchange transactions would emerge to solve the problem of coincidence of wants. Man’s actions, however, have consequences that extend beyond the aims of their direct reason. As humans begin to increasingly resort to indirect exchange, it is only natural that some goods will perform that function better than others, with important consequences to the parties involved. 

Understanding the function of medium of exchange allows us to understand the properties that make a specific type of money desirable. 

But extrapolating this further 

Money’s uniqueness among goods

Money as a good is distinct from other goods in several ways. The first distinction is that money is neither a consumption good nor a capital good. Consumption goods are acquired to be consumed, because they serve to satisfy human needs. Capital goods, on the other hand, do not satisfy human needs directly, but they are acquired because they can be used to produce goods that satisfy human needs. Money, however, is neither of those things. It is not acquired because it satisfies human needs, nor can it be used for the production of other goods; it is acquired purely to be exchanged in the future for other goods, be they consumption or capital goods. 

Being a medium of exchange is the quintessential function of money, and it means there is no direct utility from money for humans to value it. The utility of money is derived from the utility of the goods it can be exchanged for. Money, like all goods, will have a diminishing marginal utility, but its marginal utility declines less than the marginal utility of all other goods, since each successive unit of money can be used to buy a unit from the next most valuable unit of any good, and not just the next most valuable unit of the same good. For example, in an economy with money and only three goods, the utility of money will decline less than the utility of apples, oranges, and bananas declines. Being liquid and easily exchangeable for the other goods makes money a more useful thing to hold than other goods, because it can be easily exchanged for whichever one of them the individual happens to value most at any particular point in time. This salability is why people prefer to get paid in money than in objects of limited salability. The high salability gives money the utility of whichever good happens to be most valuable to the holder of money at any time.

Salability

This numerical example can help us understand the salability of money. For simplicity, it will be assumed that the market price of each apple, orange, and banana is the same.

GoodAppleOrangeBananaMoney
1st unit utility1009085100 (1st apple)
2nd unit utility80706590 (1st orange)
3rd unit utility60504585 (1st banana)
4th unit utility40302580 (2nd apple)
5th unit utility2010570 (2nd orange)
6th unit utility00065 (2nd banana)

Being the most saleable good, money is the easiest good to exchange for consumption goods, and that’s what makes it more desirable as an option for people to accept payment with it. 

For this individual, accepting money as payment is a superior option to accepting apples, oranges, or bananas, because the money is easily exchangeable for whichever of these consumption goods the individual values the most at any particular point in time.

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Some economic goods are more suitable than others to fulfill the role of medium of exchange. The more suitable a good is to being exchanged, the more marketable or saleable it is. Understanding the problem money solves can help us identify the properties that make for good money. The lack of coincidence of wants is the problem money solves, and it manifests across several dimensions. There is the lack of coincidence of wants in the goods themselves, as discussed in the fish, rabbits, and grains example above. Beyond that, there is the lack of coincidence of timeframes for trading, when a person wants to sell an object today, or over a period of time, in order to obtain another good in the future. A person might want to sell apples over three years in order to buy a car. It is not possible to accumulate three years’ worth of apples to exchange for a car, as the apples will ruin. Far more convenient would be the exchange of apples for a medium of exchange which gets accumulated to then be exchanged for the car.

Thirdly, there is the lack of coincidence of scales, when individuals want to exchange goods of different sizes and value to one another, and partial exchange is not possible. The person who wants to sell apples cannot exchange each apple for a small part of a car which he then assembles after three years of small trades. 

Fourth is the lack of coincidence of wants across space, wherein a person might want to sell something in one location and obtain a good in exchange in another location.

What makes for a good medium of exchange is what makes for a good solution for the coincidence of wants problem.

Lack of coincidence of wants across:                 Solution:

Goods: Not the same good.             One

Time: I want to sell something today but I want to buy something in the future.         Durable

Scale: I want to sell something large and only buy something small.           Homogenous,       Divisible, and groupable

Space: I want to sell something in one location and buy something elsewhere. Transportable

Menger: “Tending to increase the marketability of a commodity are its demand for use by more people, its divisibility into small units without loss of value, its durability, and its transportability over large distances.”

Choices will quickly focus on the few most marketable commodities available.

Demand for goods as medium of exchange on top of use demand increases their marketability. Also increases its price.

As the more marketable commodities in any society begin to be picked by individuals as media of exchange, their choices will quickly focus on the few most marketable commodities available.

Rothbard: “A commodity that comes into general use as a medium of exchange is defined as being a money. It is evident that, whereas the concept of a “medium of exchange” is a precise one, and indirect exchange can be distinctly separated from direct exchange, the concept of “money” is a less precise one.”

Menger: “Money is not an invention of the state. It is not the product of a legislative act. Even the sanction of political authority is not necessary for its existence. Certain commodities came to be money quite naturally, as the result of economic relationships that were independent of the power of the state.”

Money existed long before governments. Governments did not make gold money. Governments had to use gold in their coins in order to get their coins accepted for trade. 

Significance of money

A money will reinforce all three drivers of economic growth and progress, increasing the quantity and value of our time:

1- Increase the extent of the market, increasing the division of labor:

The establishment of a money on the market enormously increases the scope for specialization and division of labor, immensely widens the market for every product, and makes possible a society on a civilized productive level.


2- Allow for complex economic calculation, increasing the time frame and technological sophistication of economic production.


Rothbard: “Not only are the problems of coincidence of wants and indivisibility of goods eliminated, but individuals can now construct an ever-expanding edifice of remote stages of production to arrive at desired goods because money allows for sophisticated calculation.”

Specialization today:  Engineer in a factory that sells all over the world, only produces highly specialized input into a very complex production process. His skills are useless for anything else. Relies on the market for everything else. Long chains of production only allowed through specialization and through money.

Humans search for solutions to these problems, and the most obvious solution is to buy something else and exchange it for the thing you want. Indirect exchange.

Humans will look for things to buy in order to exchange for the things that they want. 

An important implication of the use of money is that all prices are expressed in terms of one good. In an economy with money, money is one half of every transaction.

A barter economy with 10 goods would require 45 different prices, each expressing each good in terms of the other. But a money economy with 10 goods would require only 9 prices. (number of individual prices = n(n-1)/2).

A barter economy with 100 goods would require 4,450 different prices. But a money economy with 100 goods only has 99 prices. 

A barter economy with 1,000,000 goods would require 500 billion different prices. But a money economy with 1,000,000 goods would requires 999,999 prices.

3- Increase the ability to save for the future, incentivizing capital accumulation and lowering time preference

Money is needed because of uncertainty. Money is a tool we use to tame the uncertainty of the future. The better a money is at holding its value, the less uncertain the future is. 

With money, human labor, capital accumulated, technological innovations, and trade take place in a large extended system of impersonal exchange. People who do not know each other and do not coordinate with one another directly, nonetheless manage to collaborate to produce highly sophisticated products over very complex production structures.