Why is Money Accepted as a Medium of Exchange?

  • A widely accepted medium of exchange is critical to the efficient economic functioning of any society. Money, in all of its forms, has performed this role for thousands of year. Indeed, acting as a medium of exchange is, without doubt, the most important of money’s “three functions” and, for many, defines what is money and what is not.
  • However, while economics textbook overflow with discussions regarding the role of money as a medium of exchange and the importance of that role, most textbooks are mute on much more important topic: “Why is money accepted as a medium of exchange?”
  • There is little controversy around the fact that money is useful as a medium of exchange, a store of value and unit of account. However, merely making this simple observation doesn’t expand our understanding of why money is able to perform these vital functions.
  • In this week’s post, we will attempt to explain why money can perform its functions and, more specifically, why it is accepted as a medium of exchange. In order to do this, it is important that we go back in history and think about why early money, “commodity money”, was able to perform these roles. Once this exercise is completed, we can think about how money has evolved and why it is still able to perform these functions today.
  • The view of The Money Enigma is that in order for any item to act as a medium of exchange, that item must be “valuable”. More specifically, it must possess the property of “market value” or what Adam Smith might have called “value in exchange”.
  • In the context of an ancient economy, it is relatively easy to understand why “commodity money”, such as gold and silver, had value and was, therefore, accepted as a medium of exchange. The much harder question, and a question that economics generally fails to provide sensible answers for, is why does the money that we use today, i.e. “fiat money” or “paper money”, possess value.

Avoiding the Difficult Question

If you open a typical economics textbook and flip to the section about “money”, you will find a whole list of standard questions about money accompanied by a familiar list of answers. Near the top of this list of questions you will find the question “What are the functions of money?”

Economists feel very comfortable answering this question because all of us have some have first-hand experience with the “functions of money”. All of us have some familiarity with money’s role as a medium of exchange, a store of value and a unit of account.

Economists also feel very comfortable talking about why these roles are important. For example, money allows us to avoid the inefficiencies created by a pure barter system.

So far, so good. The problem is that these are easy questions: questions that require a basic modicum of common sense to answer, not a PhD in economics.

The much more difficult question, a question that is avoided by most introductory economics textbooks, is “why can money perform its function?” More specifically, why is money accepted as a medium of exchange, why is money able to function as a unit of account and why is money a store of value?

If you think that I am being unfair, try a quick Google search on “what are the functions of money?” No doubt you will find thousands of responses returned. Now, do a Google search on the phrase “why can money perform its functions?” or the phrase “why is money accepted as a medium of exchange?” Good luck finding a clear answer to these questions that doesn’t just repeat what the functions of money are.

The view of The Money Enigma is that there is little point discussing what are the functions of money if you can’t explain why money can perform those functions. The “why” is a much more difficult question than the “what”, but the “why” is a question that is fundamental to the science of economics.

Avoiding the Temptation of Circular Logic

It is very easy when answering the question “why is money accepted as a medium of exchange?” to inadvertently fall into a logical fallacy.

At the most basic level, most people recognise that in order for money to perform its functions, money must have value.

For example, you would not accept money from me in exchange for your goods or services unless you believe it is valuable. If I offered you Monopoly dollars for your services, you would refuse my offer. Why? You would refuse because Monopoly dollars have no value (except in the context of the game itself). On the other hand, if I offered you US Dollars, you would probably be more than happy to accept them because they are recognized as something “of value”.

In more technical terms, we can say that an economic good can only act as a medium of exchange if it possesses the property of “market value”. Money is only accepted in exchange because it has value. In the words of Adam Smith, we might say that money can only perform its role as a medium of exchange if it has “value in exchange”.

Again, so far, so good. The problem comes when we ask the next obvious question, “why does money have value?” More specifically, why does fiat money, paper money with no “intrinsic” worth, have value?

One of the more common answers to this question is “money has value because it is widely accepted as a medium of exchange”.

Now, can you see the problem with this answer? We have just argued that money is accepted as a medium of exchange because it has value. Therefore, we can’t also argue that money has value because it is accepted as a medium of exchange. One of these answers can be right, but they can’t both be right. Maintaining that both of these answers are right creates a circular argument, a form of logical fallacy.

Where does that leave us? Well, we need to pick one answer that we believe must be correct and then find another solution for the second question.

The view of The Money Enigma is that our answer to the first question is correct: money can only act as a medium of exchange, unit of account and store of value because money has value. Therefore, the question for which we need a new answer is “why does money have value?”

A sensible answer this question needs to achieve two objectives. First, it needs to avoid invoking money’s role as a medium of exchange to explain why money has value. Second, it should provide us with a model that can explain why money has had value in all the various forms that it has taken over time.

Bearing this second point in mind, let’s consider how money evolved over time and why money, in its earliest forms, had value and was able to act as a medium of exchange.

Commodity Money as a Medium of Exchange

It is not hard to imagine how in early barter-based societies, one particular commodity, such as grain or cattle, emerged as the favorite among traders of goods. Indeed, historical records indicate that these basic commodities were used as money as early as 9,000 BC.

It seems likely that, in early societies, goods that were widely used by most people, could be stored for a reasonable period of time and that weren’t prone to wild fluctuations in their value would have become favored as “trading goods” within and between small communities.

All of these basic goods derived their “value in exchange” from their natural or physical properties. Grains and cattle could be eaten, while other materials such as copper and silver could be used to make tools or household equipment.

In modern-day parlance, all of these items had value because they were “real assets”, i.e. they derived their value from their physical properties. Similarly, each of these early forms of “commodity money” had value because they were real assets.

Over time, precious metals emerged as the most popular form of commodity money. There are many reasons for this, but the primary reason for their popularity was the relative invariability in the stock of these commodities. Gold is rare, it’s hard to find and it doesn’t get consumed. Therefore, its stock is relatively constant over time. Why would this make it attractive as a medium of exchange? Well, in simple terms, gold would have acted as constant in a sea of economic variables. While other commodities were subject to vast fluctuations in stock due to natural variations in supply and disease, a trader knew that there was not going to be a lot more nor a lot less gold available in the world one year from now than there was today. (Those who would like to read more about this subject should read an earlier post titled “What Determines the Price of Gold?”)

Whatever the reasons, gold and silver became the preferred forms of commodity money and remained so for many centuries. Importantly, both gold and silver are real assets that derive their value from their natural or physical properties.

Paper Money and the “Real Asset/Financial Instrument” Paradigm

Whether it is cattle or grain or gold, it is easy to understand why something that derives an intrinsic value from its physical properties should be accepted as a medium of exchange. What is more difficult to comprehend is why “paper money”, money that is literally made of paper of little intrinsic worth, should have value.

However, it is easier to understand why paper money has value if we think about the evolution of money over time.

The first form of paper money, “representative money”, was nothing more than contract, written on a piece of paper, that promised some amount of gold or silver coin on request. Issuing these pieces of paper allowed the early kings and emperors to pay for wars and major public works without emptying the royal treasury of all its gold.

In effect, representative money was an early form of “creative financing”: it allowed the rulers and governments of the day to stretch their spending beyond the limits of what would have otherwise been imposed on them if they had to rely solely on using gold and/or silver to pay the workers and soldiers.

Interestingly, the issuers of this paper money didn’t need to have gold in the vault for every piece of paper that they issued. Rather, they just need to make sure that they had just enough that the promised of “gold on request” remained credible.

The reason that I mention the term “creative financing” is not to imply that paper money is somehow of poorer quality than commodity money. Rather, it is to highlight the point that the real function of paper money is to act as a financing tool. The early kings and emperors didn’t create paper money because their societies needed a new or better medium of exchange: gold and silver were doing just fine in that regard. Paper money was created to finance the expenditures of these early rules.

The fact that paper money was invented primarily as a financing tool should give us a big clue regarding why paper money has value. If paper money was created as a financing tool, then, by definition, it is a “financial instrument”.

Financial instruments are interesting because they derive their value in a completely different manner to real assets. As discussed earlier, real assets derive their value from their intrinsic or physical properties. In contrast, financial instruments derive little or no value from their physical properties. Rather, financial instruments derive their value from their contractual properties.

Every financial instrument is both an asset and a liability. By creating a liability against itself, the issuer of the financial instrument creates an asset for another party. In other words, a financial instrument is only valuable to the holder of that instrument because it creates a contractual obligation upon its issuer to deliver something of value.

Now, let’s think about this in the context of representative money.

Clearly, representative money, the first form of paper money, was a financial instrument. Representative money is, quite literally, a written contract that creates an obligation upon its issuer, normally the royal treasury, to deliver a certain amount of gold or silver on request.

Early paper money only had value because it represented an explicit contractual obligation between its issuer and the holder of that money. Paper money was an asset to its holder, because it was a liability to its issuer.

The key point is that the “real asset/financial instrument” paradigm allows us to explain why commodity money had value and was accepted as a medium of exchange and why representative money, the earliest form of paper money, had value and was accepted as a medium of exchange.

Fiat Money as a Financial Instrument

Given how easily both commodity money and representative money fit within the “real asset/financial instrument” paradigm, you would think that economists would have spent much time and effort attempting to extend this paradigm to fiat money.

Unfortunately, you would be wrong.

As soon as “fiat money” enters the room, most economists rush to throw out this basic and important paradigm regarding how assets derive their value. Rather, they spend enormous time and energy trying to invent an entirely new paradigm, a paradigm that can explain why one asset, “fiat money”, is so unique that it must derive its value in a completely different way from every other asset ever known.

The view of The Money Enigma is that fiat money is a financial instrument and, in common with all financial instruments, derives its value from its contractual properties.

In simple terms, when the gold standard was abandoned and the explicit contract that previously governed representative money was rendered null and void, it was replaced by a new implied-in-fact contract. This new implied contract, or what some might term a “social contract”, is what gives fiat money its value.

While it may be difficult to determine the exact nature of the implied contract that fiat money represents, the view of The Money Enigma is that, prima facie, this represents a far more productive line of theoretical enquiry than trying to create a new entirely paradigm solely to explain how one asset, an asset of relatively recent invention, derives its value.

Moreover, if we can unravel the terms of the implied-in-fact contract that governs fiat money, then not only will we have a sensible answer for why fiat money has value and, therefore, can act as a medium of exchange, but we will also have a better understanding regarding what determines the value of fiat money, i.e. what factors cause the value of fiat money to rise and fall.

So, what are the terms of the implied fiat money agreement?

Those who are regular readers of The Money Enigma will know that we have dedicated a significant amount of time to this issue in recent posts including “A New Theory of Fiat Money”, “What Factors Influence the Value of Money?” and an earlier post titled “Money as the Equity of Society” that reviews the parallels between fiat money and shares of common stock.

However, in simple terms, the view of The Money Enigma is that fiat money is a liability of society and represents a proportional claim on the future output of society. In other words, fiat money has value because we recognize it as a claim against our collective future output.

The amount of output that any unit of money can claim at a given time depends on a complicated set of factors, but the term “proportional” implies that it varies in proportion to the long-term expected size of the outstanding monetary base. All else remaining equal, the greater the expected size of the monetary base, the less valuable each unit of money is today. Conversely, the greater the expected growth in future real output, the more valuable each unit of money is today.

In summary, money, in all of its forms, can only perform its role as medium of exchange if it possesses the property of “market value” or “value in exchange”. The view of The Money Enigma is that assets can only derive their value from their physical properties (“real assets”) or their contractual properties (“financial instruments”).

Commodity money, the earliest form of money, derived its value from its physical or intrinsic properties. In contrast, paper money, whether it be asset-backed or fiat, derives its value from its contractual properties. Fiat money derives its value in exchange from its implied contractual properties and it this recognized value that allows fiat money to perform its primary role as a medium of exchange.