Introduction to Economic Reasoning - Chapter 9: Money, Part 2

In the last chapter Dr. Gordon showed that actors converge on the use of a few goods to use as a medium exchange. He defines money as a good almost universally accepted in a market for purposes of exchange.

Various goods have served as money throughout history (sugar, sea shells, cattle), but certain commodities like gold and silver became almost universally acceptable. History shows goods with certain qualities tend to become money.

The most popular monies tend to be durable, divisible, and widely acceptable commodities. For these reasons people have tended to adopt gold and silver as money.

Gold, because it was widely accepted, not only expanded the space over which goods could be exchanged, but also the time. Because it is durable, gold can be stored for use later to purchase other goods. Money, then, also serves as a store of value.

Once a good, like gold, becomes the preferred medium of exchange, other goods that served as competing media of exchange will fall in value. They will retain their ‘use’ value, but their exchange value will fall to zero. The preferred media of exchange will be valued according to its general acceptability.

Where did money come from? The money regression theorem explains the origin of money. Government edicts or explicit agreements do not create money. Money arises spontaneously in the market place. Gold began as a good desired for its use in creating jewelry and other goods. It then gained in value because people realized it could be traded for other gods they wanted. Gold did not begin as a media of exchange, it developed into one. Carl Menger was the first economist to develop this account of the development of money. Before him, economists like John Locke theorized that money originated through an explicit agreement to accept a certain substance as money.

We learned earlier that the supply and demand for a good determine its value. Demand and supply, in turn, depend on the utility of the demanders and suppliers. A question then arises, what determines the utility of gold? People want gold because they can use it to buy other things. In explaining the value of gold in this way, however, we are using circular reasoning. We are explaining the utility of gold in terms of its value; that is that the utility of gold is determined by the value of gold in being able to purchase other goods. Its value is in turn determined by its utility.

Mises found a way out of this circular explanation for the value of gold using utility theory. He began by stating that people determined the value of gold today according to its value yesterday. (This is not the same thing as saying people valued it the same as they did the day before). The value of gold going back in time depended on its value the previous day. Going back far enough in time there will be a day in which gold was not valued as a media of exchange at all, but as a commodity used to directly satisfy a human need or want. Mises thus showed that utility theory did apply to money just as it did to other goods. The value of the good the day before it started being used as money was based on its direct utility. People thus had a basis upon which to value the good before it became a media of exchange. A good without such a value could not begin as money.

Note that Mises’ theory does not state that fiat money (paper money not redeemable for a commodity) is not possible. Mises’ theory does explain that fiat money could not have first come about unless it had been based on a commodity that had arisen as a media of exchange.