Study Guide to the Theory of Money and Credit

Summary

Money is necessary in a society based on private property and the division of labor. The function of money is to facilitate these trades: Money is a commonly used medium of exchange.

In a direct exchange, people accept goods in trade that they intend to personally use, whether for consumption or production. There is no medium of exchange involved in the transaction.

In an indirect exchange, at least one person in the transaction accepts a good that he intends to trade away in the future for something else. The item that is accepted in the first trade is a medium of exchange.

Even before the use of money, traders would have quickly discovered the benefits of indirect exchanges, and the use of media of exchange to facilitate them. Some goods would have had a far broader market than others. A trader who came to market with an unmarketable good would place himself in a more advantageous bargaining position if he engaged in an indirect exchange, by trading his good for something that was more marketable.

Because every trader would act in this fashion, those goods that were initially more marketable, would see their marketability enhanced even further. Over time, a community would gravitate to one or a few commodities that would be acceptable to everyone in trade. This is how money emerged from an initial state of barter. Historically the market has often chosen gold and silver as money.

Although other writers outline other “functions” of money—such as a standard of deferred payments or a store of value—these all flow from its definition: money is a commonly accepted medium of exchange.

Chapter Outline

1.   The General Economic Conditions for the Use of Money

A person living by himself on a tropical island would not need money. Several people living in the same household would not need money either, so long as they produced everything they needed within the household. Even an entire community—consisting of thousands or millions of households, each of which specialized in producing different goods and services—could get by without the use of money, assuming there were a central group or person who acted as a “planner” and told everyone what to make, and decided which portion of the total output each person would get to consume.

However, in a society based on the division of labor, and where private individuals own both consumption goods (TVs, radios, Big Macs) and producer goods (tractors, factories, copper mines), money is essential. In such a society, there is no one person or group who decides how scarce resources will be deployed. Each individual must make his or her own plans, which usually require exchanging property for other people’s property. The function of money is to facilitate these trades: Money is a commonly used medium of exchange.

2.   The Origin of Money

In a direct exchange, people accept goods in trade that they intend to personally use, whether for consumption or production. For example, suppose Alan has a muffin but he is really hungry for fish. Bill, on the other hand, has a net (which can be used to catch fish) that he doesn’t really want, but he thinks Alan’s muffin looks delicious. If Alan trades his muffin for Bill’s net, this is a direct exchange. There is no medium of exchange involved in the transaction.

In an indirect exchange, at least one person in the transaction accepts a good that he doesn’t intend to consume or use himself in production. Rather, the person accepts a good because he plans on trading it away again in the future. For example, suppose there is a woman who has knitted a quilt, and she wants to exchange it for a certain parakeet. Unfortunately, the man who owns the parakeet doesn’t want a quilt, but is instead interested in obtaining a new radio. The owner of the radio, however, hates birds, but is very cold at night. The woman with the quilt, unfortunately, is very hard of hearing and has no use for a radio.

In this scenario, no direct exchange is possible. However, the woman could trade away her quilt for the radio—even though she personally has no use for it—and then trade the radio in turn for the parakeet. These two successive trades would make all three people happier. In this example, the radio would be a medium of exchange.

Logically, there must have been a time when people had goods and traded with each other, but before money had arisen. Even before the use of money, traders would have quickly discovered the benefits of indirect exchanges—and the use of media of exchange to facilitate them.

Some goods (eggs, milk, leather) would have had a far broader market than others (telescopes, philosophy books, machinery). A trader who came to market with an unmarketable good such as a telescope probably wouldn’t be able to quickly find someone who (a) had the items that the first trader hoped to acquire and (b) wanted a telescope. In this case, the trader could improve his bargaining position by trading away his telescope for something more marketable, such as eggs, even if the trader had no desire to eat the eggs.

Because every trader would act in this fashion, those goods that were initially more marketable, would see their marketability enhanced even further: They would be demanded not only by people intending to use them directly, but also by people intending to use them as media of exchange. In any particular indirect exchange, a trader would naturally prefer to sell his own wares in exchange for the most marketable medium of exchange, because this would place him in the most advantageous position as he continued looking for the goods he ultimately desired. Over time, a community would gravitate to one or a few commodities that would be acceptable to everyone in trade. A commonly accepted medium of exchange is money.

Historically, gold and silver have been the two commodities most frequently employed as money. They have very similar properties and are both excellent media of exchange.

3.   The “Secondary” Functions of Money

Money is, by definition, a common medium of exchange, which therefore serves to facilitate the exchange of goods and services. In a market economy, this is a crucial “function” and we see money’s importance by focusing on it. Although other writers outline other “functions” of money—such as a standard of deferred payments, or a facilitator of credit transactions, or a store of value through time—these all flow from its use as a common medium of exchange.

Important Contributions

•   Mises references Carl Menger, whose 1871 Grundsätze (translated as Principles of Economics) is the founding work of what is called “Austrian” economics. Among his other contributions, Menger is credited in the annals of the history of economic thought with giving the first satisfactory explanation of the origin of money. Rather than assuming that money must have been created by an edict issued by a powerful king or wise tribal leader, Menger showed that step-by-step evolution from an initial state of barter to a monetary economy, where each person only seeks to improve his own position at each step in the process.

•   Even in modern textbooks, writers will list several “functions” of money. This can be confusing, because it makes it hard to pin down exactly what money is and why it so important. Menger’s approach—followed by Mises—is refreshingly clear: Money is defined as a commonly accepted medium of exchange, and this characteristic enables all of the other “functions” attributed to it.

New Terminology

Direct exchange: An exchange in which both parties intend to directly use the received good, either in consumption or production.

Indirect exchange: An exchange in which at least one party intends to hold the received good, in order to trade it away in the future for something else.

Division of labor: The situation in which people specialize in particular occupations, producing far more than they personally can consume, and trade away their surplus to receive some of the surplus created by others.

Medium of exchange: A good that is accepted in exchange, with the intention of trading it away to acquire something else in the future.

Money: A medium of exchange that is generally accepted in the community. Money typically stands on one side of virtually every exchange.

Study Questions

1.   Would a society based on total central planning in both production and consumption need money? Why or why not? (p. 29)

2.   Why doesn’t a direct exchange involve the use of a medium of exchange? (p.30)

3.   Can you think of reasons that traders eventually gravitated toward gold and silver as money, as opposed to other items such as cattle or aluminum?

4.   Did media of exchange exist before the existence of money? (pp. 30–32)

5.   For the various secondary functions of money listed by Mises, explain how each is related to money’s role as a commonly accepted medium of exchange. (pp. 34–36)