Money 2 Essay, Research Paper

The use of money began in the sixth century B.C. in what is now western Turkey, when lumps of gold found in rivers were melted and turned into pieces of uniform size imprinted with a stamp. For almost all of the time since then, the common monetary system has been commodity money, whereby a valuable commodity (typically a metal) is used as a widely accepted medium of exchange. Furthermore, the quantity of money was not under anyone s control; private agents, following price incentives, took actions that determined the money supply.

Today, the prevalent monetary system is that of fiat money, in which the medium of exchange consists of unbacked government liabilities, which are claims to nothing at all. Moreover, governments have usually established a monopoly on the provision of fiat money, and control, or potentially control, its quantity.

Fiat money is a very recent development in monetary history; it has only been in use for a few decades at most. Why did this evolution from commodity money to fiat money take place? Is fiat money better suited to the modern economy or was it desirable but impractical in earlier times? Were there forces that naturally and inevitably led to the present system?

Fiat money did not appear spontaneously, since government plays a central role in the management of fiat currency. How did govern-ments learn about the possibility and desirability of a fiat currency? Did monetary theorizing play any role in this evolution? In this article, I will argue that the evolution from commodity to fiat money was the result of a long process of evolution and learning. Commodity money systems have certain advantages, in particular in providing a natural anchor for the price level. But they also have certain disadvantages, manifested in particular in the difficulty of providing multiple denominations concurrently.

These problems arose early on, in the fourteenth century, in the form of money shortages. Societies tried to overcome these disadvantages, and this led them progressively closer to fiat money, not only in terms of the actual value of the object used as currency, but also in terms of the theoretical understanding of what fiat money is and how to manage it properly. In the process, societies came to envisage the use of coins that were worth less than their market value to replace the smaller denominations that were often in short supply. These coins are very similar to bank notes; they are printed on base metal, rather than paper, but the economics behind their value is the same. What governments learned over time about the provision of small change is thus directly applicable to our modern system of currency.

In his A Program for Monetary Stability (1960), Milton Friedman begins with the question: Why should government intervene in monetary and banking questions? He answers by providing a quick history of money, which he describes as a process inevitably leading to a system of fiat money monopolized by the government (p. 8): These, then, are the features of money that justify government intervention: the resource cost of a pure commodity currency and hence its tendency to become partly fiduciary; the peculiar difficulty of enforcing contracts involving promises to pay that serve as medium of exchange and of preventing fraud in respect to them; the technical monopoly character of a pure fiduciary currency which makes essential the setting of some external limit on its amount; and finally, the pervasive character of money which means that the issuance of money has important effect on parties other than those directly involved and gives special importance to the preceding features. …

The central tasks for government are also clear: to set an external limit to the amount of money and to prevent counterfeiting, broadly conceived.

This article will find much to validate this view. It turns out that the problem of counter-feiting, identified as central by Friedman, provided obstacles that were overcome only when the appropriate technology became available. As technology changed and offered the possibility of implementing a form of fiduciary currency, various incomplete forms of currency systems were tried, with significant effects on the price level. These experiments led to the recognition that quantity limitation was crucial to maintaining the value of the currency. The need for a government monopoly, however, does not emerge from our reading of the historical record, and we will see that the private sector also came up with its own solutions to the problem of small change, thereby presenting alternatives to the monetary arrangements we have adopted.1

Commodity money and price stability

Among the desirable features of a monetary system, price stability has long been a priority, as far back as Aristotle s discussion of money in Ethics. In the words of the seventeenth century Italian monetary theorist Gasparo Antonio Tesauro (1609), money must be “the measure of all things” (rerum omnium mensura) (p. 633). Aristotle also noted that commodity money, specifically money made of precious metals, was well suited to reach that goal: “Money, it is true, is liable to the same fluctuation of demand as other commodities, for its purchasing power varies at different times; but it tends to be comparatively constant” (Aristotle, Ethics, 1943 translation).

The commodity money system delivers a nominal anchor for the price level. The mechanism by which this takes place can be described in the context of a profit-maximizing mint, which was how coins were produced in the Middle Ages and later.2 Suppose there is a way to convert goods into silver and silver into goods at a constant cost (in ounces of silver per unit of goods), which can be thought of as either the extraction cost of silver and the industrial uses of the metal or the “world price” of silver in a small country interpretation. Silver is turned into coins by the mint; the mint (which really represents the private sector) also decides when to melt down existing coins.

The government s role is limited to two actions. It specifies how much silver goes into a coin, and it collects a seigniorage tax 3 on all new minting.

When the mint is minting new coins, its costs are the cost of the silver content, the seigniorage tax, and the production cost;4 its revenues are the market value of the coins, which is the inverse of the price level. Similarly, when the mint is melting down coins, its costs are the market value of the coins, and its revenues are the value of the silver contained in them.

Whether the mint will produce new coins or melt down existing coins will thus depend on how the price level relates to the parameters: silver content of the coins, production costs, and seigniorage rate. The price level cannot be too low (or the purchasing power of the coins too high) or the mint could make unbounded profits by minting new coins and spending them. Similarly, the price level cannot be too high (or the purchasing power of the coins too low), or the mint would make profits by melting down the coins. The absence of arbitrage for the mint places restrictions on the price level, which is contained in an interval determined by the minting point and the melting point