What is Money?

0:00What is money? It seems to be a simple question. It's even a very simplistic question. Obviously, we all know what money is. It's the stuff we carry around in our wallets every day. It's the stuff that you get paid in when you cash in your paycheck, right? But it's a little more complicated than that when you look at it from the point of view of economics. So as economists, what we want to answer is how come these paper bills, these green paper bills that we carry around in our wallets, how come they are worth so much, right? Because the paper in itself is not worth anything, right? It's probably worth a few cents, but how come on the market, if you go out, how come you can take this paper and exchange it for something really valuable? You can buy a car, you can buy things which are worth So much more than what is in that paper, right?

0:54This is the question that we want to try and answer. And to do that, what we do first is we distinguish between what we call direct exchange and indirect exchange. So direct exchange is basically a stage of border, right? A place where there is no money, where a stage of civilization, where goods exchange for other goods. So people exchange with each other and they exchange goods for goods. So that's my, so this is the case of barter and I'll read it out, it's not that clear. There's no money in the society, it's a very primitive society. There's a Mr. Smith and there's a Mr. Jones, okay. And Mr. Smith has, is a farmer, he has a lot of corn.

1:41And Mr. Jones owns an apple orchard, so he has a lot of apples, okay. and Mr. Smith has corn but he would like to acquire some apples and Mr. Jones has apples and would like to acquire some corn. So now here, I mean, you can see that conditions are kind of perfect for these two people to profitably exchange with one another, to trade, okay. They could, Mr. Smith and Mr. Jones could come up with some kind of ratio which is agreeable to both of them Where they would exchange corn and apples with each other and they would both be better off at the end of that exchange. And this would be called direct exchange where they're exchanging goods for goods and there is no money in this society.

2:31But this is a very simple society. It's very quickly that you will see that problems start to kind of come up. So it's very easy to see that problems quickly arise in a very simple society in which there is no money. So here we have a case where we have a Mr. Smith and Mr. Jones again. But Mr. Smith, who has the corn, now wants to acquire some salt in exchange for that corn. And Mr. Jones still has the apples and still wants corn. Mr. Jones would love to exchange with Mr. Smith, but Mr. Smith right now does not want what Mr. Jones is selling, he wants something that Mr. Jones does not have.

3:21So this would be called that it is a lack of a double coincidence of wants. In order for direct exchange to take place, both parties of the exchange must actually want exactly what the other person has at the same time. This is the only way trade can take place when there is no money. But in a case like this, in scenario number two, between Mr. Smith and Mr. Jones, we have a problem. We have a lack of a double coincidence of wants. Each of them wants different things. They have something, but Mr. Smith does not want what Mr. Jones is selling, so this is a problem. Society would not get very far in a scenario like this. Now, what can happen is that if Mr. Jones, so Mr. Jones is a smart guy, okay, so he's going to kind of go around and he's going to find somebody.

4:17We have Mr. White there. If he's a smart guy, he's going to go and find Mr. White. And Mr. White has salt, he owns a bunch of salt and would love to buy some apples in exchange for them. What Mr. Jones can do is buy salt from Mr. White in exchange for his apples. He's going to buy the salt and now he has the salt, he wants Mr. Smith's corn, he can go back to Mr. Smith, hey I have your salt, now let's trade. So what did Mr. Jones just do here? He went and bought something, in this case it was salt, he went and exchanged something which he did not want directly. He had no demand for this good directly. He did not want to consume the salt for himself. The only reason he went and bought the salt was because he wanted to further exchange it with Mr. Smith and then get what he actually wanted.

5:15This would be an example of indirect exchange where somebody, so Mr. Jones in this case, And bought something which was not of direct utility to him. There was no way that he wanted it. He did not want to consume it. The only reason he went and bought it was because he wanted to further exchange it because he knew by doing so he could then further exchange and then get what he wants. Okay, so this is what we call indirect exchange and obviously this is a great way to get over the problems of barter. In a barter economy, you have people who have a lack of double coincidence of wants, but people like Mr. Jones who are smart can go and start to buy things, which they can then further exchange, right?

6:02So in this economy, we can see that something like salt, right, salt, which is actually a marketable good, a more marketable good than maybe apples, everybody would like to have some salt, a commodity like salt will start to emerge, everybody will start to kind and want to hold salt in order to exchange it further, in order to engage in indirect exchange with it. So this is basically how money starts to emerge. A commodity like salt, which is valued for itself, but then also because it is so marketable, people start to acquire it to engage in indirect exchange with it. This is what is called a medium of of Exchange, and as more and more people start to catch on, since a lot of people will now accept salt in exchange for their goods, there's going to be all these other people who are going to start to demand salt, not because they wanted to consume it in any way, but because it's starting to emerge as this medium of exchange.

7:10So it's kind of like a self-perpetuating process once it gets started. All you need is a few smart people to kind of figure this out, that if we actually did this we could get over this problem of barter. But then once a few people have figured it out, it's the self-perpetuating process where the demand for a commodity like salt kind of really jumps because everybody knows that other people are going to accept it and this is how a medium of exchange comes into being. So this is really kind of at the heart of when we talk about what money is, how we define money, it isn't what it is, it's not defined by the thing that it is, but it's defined by what it does, by its function.

7:56And the main function of money is that it is a medium of exchange. It enables people to buy things that they would not otherwise be able to buy. And the main characteristic of this medium of exchange is that people acquire it, people want to hold on to it only for the reason of further selling it, not because they want to consume it. So if you think about money, the money in our pockets, we don't get direct utility from it. There's no way we can consume it like you can when you go out to lunch and you eat a burger. You can't consume the money. The only reason you're holding onto the money is because you can then further exchange it. So at the heart of it, what money is, is that it is a medium of exchange and it enables indirect exchange to take place. So obviously, as you can see, in a case like this, this is a very simple case obviously, but as money starts to emerge in a society, it enables trade and exchange.

8:51Where you have no money, where there's only barter, you can have a very low level of trade, a very low level of specialization, because there is going to be all these problems. But with money, you start to get over these problems and trade, exchange and the market start to develop because of the existence of money in the market. I'd like to give you an example of the problems of barter. So this is a real world example and it was written by a 19th century economist, William Stanley Jevons in his book and he, the book is called Money and the Mechanism of Exchange And it's a true story, and he tells the story of a French singer who went to a Tahitian island.

9:38She would tour the world, and she was on this island, and she agreed to give a concert to sing for the island people. And the person, the manager who kind of organized this concert, agreed to give her one-third of the ticket sales in return for her doing the concert. and when she got paid, what she found was, when she counted her share, her share was found to consist of three pigs, 23 turkeys, 44 chickens, 5,000 coconuts, besides considerable quantities of bananas, lemons and oranges. And this was because there was no money on this island. So people wanted to come and watch this concert, right? They want to hear this famous singer sing, but there's no money on this island.

10:26The only way they pay for the ticket was with commodities. This was bought or they were giving commodities. And the only way she got paid was in those commodities. And he said that in Paris at the time, if you took all those commodities, they would have actually sold for 4,000 francs. It was a lot of goods. It would have sold for 4,000 francs, which is a great price, which is a great price for a concert. It's great money to make. There was no way that she could now transport all these things back to Paris. So basically she had to leave it behind. She had to lose her money. She had to lose the payment that she had got. She'd done this concept, but there was no way she could actually use things that she'd got paid with. So this would be an example of how barter discourages trade and exchange.

11:15So the next time she's not going to go and give a concert where people don't have money. If there was a money, if there was something that was acceptable as a medium of exchange, it would be great. It would encourage other people to come in and do things like give concerts. So this is the basic point, that in the presence of money, trade is facilitated. So trade would exist without money, but with it, it expands, it grows. Another important function that money plays in society is that it is a unit of account. And by unit of account, it means that all prices are quoted in terms of money. So when we go out and you buy something, prices are in terms of money. They're not in terms of amounts of other goods.

12:00And we kind of take this for granted. But if you kind of think about it, it would be extremely difficult to get over a problem like this. So we can think of an example. So let's say you want to buy a washing machine. And you go to one store, and the washing machine, The price of the washing machine is 500 loaves of bread. So you have to give them 500 loaves of bread to buy the washing machine. You don't know if that's a good deal or not. So you're going to go to another store and see what their price is. So you go to the other store and their price is 30 pairs of shoes. And how do you compare? How do you compare whether it's a better deal to give up 500 loaves of bread or 30 pairs

13:14How do you, you're literally comparing oranges and apples. There's no way to really tell if you're actually getting a good deal or not. You would have to find a store which quoted prices of both those goods in everything else. So you would have to find a common denominator. You would have to find another store which maybe quoted those shoe prices in oranges as well. So maybe the shoe price is 2,500 oranges. This way now you have a common denominator, you can actually compare which one is the better deal and therefore you impute backwards and you say which washing machine is the better deal. In this case, it would be the first one. But this is extremely cumbersome. So money actually gets rid of all of these problems. If we did not have money serving as this unit of account, we would have these problems and these are extremely, these are very, very cumbersome problems.

14:06It takes a lot of time, it's very hard. A lot of trade that exists today would not take place because there's just such high costs to going around and figuring out which is the best deal. You'll be like, you know what, I'll just wash my clothes at home, I'll just do it by hand, right? And this is how we did it, this is how we did it in earlier times, you would wash your own clothes by hand. So this is basically the two most important functions of money and in the end I would like to talk about some of the implications of talking about money like this. Of course, we spoke about how money encourages trade, but it also encourages specialization. Specialization meaning that everybody has the incentive in a monetary economy to do what they do best, to specialize in what they are best at, because they know that if they produce a good which they are best at producing, that there is, because it's a monetary economy,

15:04that they are going to have a market for that good, that there is going to be other people who are going to want to buy that good, that it's very easy to sell your good if other people use money, right? If other people don't use money, you have to kind of be very tuned into what other people will really, really accept because there is no this one common medium of exchange. So in a monetary economy, it encourages not just trade, but specialization. And by engaging in a monetary economy, not only do we specialize, but we can also reap the benefits of other people specializing in what they are good at, in what they are best at. So this is, it's a great advantage of having a monetary economy. In fact, the amount of specialization that we see today or through the ages would not exist if we did not have money.

15:57And money has obviously taken many forms through the ages. So I mean, in older times, I mean, anything from cows, salt, shells, beads, more prominently the precious metals have been money, gold, silver, copper, copper for the smaller exchanges. It's only recently that we see paper money being so widely used. And till very recently, which would be 1971, even that paper money did have some backing in gold, in something valuable. It's only very recently that our money that we have in our pockets is a pure fiat money, meaning that there is no backing of a commodity behind it. It's only the government which says that, you know, we say that this is money and this is what it's worth.

16:46The money that we have today is fiat money, but it has evolved as a commodity through our history. And this sort of explanation that we went through today was first given by Carl Menger, who was Mises' teacher, and he's the founder of the Austrian School of Economics. And basically what he showed was that money actually evolves spontaneously in a market, in a Market. That you do not need to have a state or a government legislate and say this will be money. This is not how money evolves. Money can actually evolve spontaneously just through the actions of people. So just in this way with Mr. Jones kind of figuring out that if I go and engage in indirect exchange, that this is going to facilitate trade. That this is how money evolves. And this is actually historically this is what we see. And I didn't get to talk about this at all. But if anybody's interested about the evolution The foundation of our money through history, a great book is Murray Rothbard's What Has Government Done to Our Money, which will give you a great feel for how our money, especially in the United States, has evolved and come to be what it is today. Thank you.