To understand money, we first need to understand something that existed before money. The Necessity that leads to the Invention of Money, the Barter System.
Before 3000 BC, barter was the only prominent way of exchange goods and services between strangers. Barter can be termed as an exchange of goods or services with other goods or services. It does not use any medium of exchange, such as money.
Even though it was the only mode of exchange at that time, barter had a number of problems such as:
- You need a double coincidence of wants where both the parties need what the other party is offering
- There is no measure of value. Like one burger should be equal to how many bananas?
- The exchange needs to be immediate and the payment cannot be deferred
- Difficulty in storing what you can offer
All the above problems are solved by money to a great extent.
Money is a medium of exchange. It can be any item or a verifiable record that is generally accepted as:
- Payment of goods or services, and
- Repayment of debts
Functions of Money
To qualify as money, a thing should perform the following 4 functions:
- It should be a medium of exchange
Money can be used to intermediate the exchange of goods and services. It resolves the problem of “coincidence of wants of a Barter System”
- It should have a common measure of value/unit of account
Money act as a standard measure and a common denomination of trade.
Example: 1 Litre of milk = USD 1
- It should be usable as a standard of deferred payment
Money can be used to settle debts because the money would hold the same value as it holds now (if we ignore the effects of inflation)
- It should be a Store of Value
Money retains its value over a period of time and is not perishable.
Types of Money
The use of money started somewhere around 5,000 BC as commodity money
- Commodity Money
- Commodity money is a type of good that functions as money. These goods have a value or use in themselves known as intrinsic value
- These goods are Durable, Portable and Easy to Store
- Example: Gold, Silver, Copper, Salt, Silk, Cocoa Beans Etc.
- The problem with the commodity money was that it was difficult to store, secure, and transact with.
- During the 10th Century (960 AD), with the development of trade and commerce, there was a need for a better solution – Representative Money.
- Representative Money
- Representative money is a paper or any other item that represents something of value. It is also known as “Commodity Backed Money”.
- Example: Gold and Silver Certificates.
- It has no intrinsic value but represents something of value such as Gold or Silver.
- This led to the establishment of the first monetary system called the Gold Standard in the late 19th Century (1870 AD), where a standard unit of currency was based on a fixed quantity of Gold.
- Representative money could be printed only to the extent to which it was backed up by the Gold Reserve.
- Therefore, the value of a currency was mostly fixed and it was not prone to inflation.
- The system was almost a perfect monetary system till it was disrupted by the First World War.
- By 1971, representative money was mostly replaced with a new form of money as US Government disassociated US Dollar from the value of Gold.
- This led to the inception of a new form of money – Fiat Money.
- Fiat Money
- Money that exists today in the form of currency notes, bank account balances, and wallet balances are Fiat Money.
- Fiat money is a medium of exchange that is established as money, often by Government Regulation.
- It does not represent anything of value. It has value only because it has been established as money by the government issuing it.
- Fiat Money can be any money declared by a government to be a legal tender.
- Like in 2016, the Indian Government decided to discontinue 500 Rupee notes as a legal tender. Thus, the 500 Rupee note was no longer money.
- Fiat money is prone to inflation and its value may fluctuate with time.
- Digital money is an extension of Fiat money such as Debit Cards, Credit Cards, PayPal wallets, etc.
Cryptocurrencies, such as Bitcoin are a new form of money or asset that is only a decade old. Though Bitcoin is a long way before it is globally accepted as money, it has almost all traits of gold, and hence we can say that it would form commodity money. Thus, Bitcoin will take our monetary system back to the basics.
So let us conclude what we understood about money:
- Money is nothing but a belief system. It has value because people believe it to be valuable.
- It is valuable because we want it, and we want it only because it gets us the desired product or service.
- Finally, money enables us to focus on the development of one skill that can be used to earn money, and subsequently, this earned money can be used to purchase anything we desire. Thus, forming the backbone of today’s a trade and economy.