8.1: Money and the functions of money

You can see the variety of things that have been used as money in Canada in James Powell's A History of the Canadian Dollar, available at the Bank of Canada's website: http://goo.gl/BnIgpK. Our money in the seventeenth and eighteenth centuries was silver and gold coins from many countries, and playing cards. The British pound sterling, the Spanish silver dollar, and the US dollar were the main moneys in Canada in the nineteenth century, followed by paper currencies issued by banks and by the government since the late nineteenth century.

It is not the commodity or token used as money that matters, but the social convention that it is accepted without question as a means of payment. Money makes it easier for everyone to buy and sell goods and services and economize on the use of scarce resources.

Money is defined by four important functions. It provides:

1. A means of payment as a medium of exchange
2. A unit of account
3. A store of value
4. A standard of deferred payments

As a means of payment money is involved in most exchanges. We use money to pay for the goods and services – from food and clothing to transportation, to rent, to fees and taxes. People receive wages and salaries and other types of income in money. Money is not consumed in these transactions. It is used as a medium of exchange.

Means of payment: a commodity or token generally accepted in payment for goods and services or the repayment of debt.

Exchange transactions without money are barter exchanges, a direct exchange of one good for another. These exchanges depend on a double coincidence of wants. Each party to the exchange has a good the other party wants and is willing to trade one good for another. This means exchange transactions are expensive as people must find others who have what they want and want what they have. Using a money as a medium of exchange dramatically lowers the cost and increases the ease and efficiency of trade.

Barter exchanges: direct exchanges of goods or services for goods or services without the use of money.

Money also serves as a unit of account. Prices in Canada are quoted in Canadian dollars. Similarly in other countries prices are quoted in domestic currency. In much of Europe prices are in euros, in the United States in US dollars and in Japan in yen. This reflects the convenience of using the same units for the means of payment and the unit of account. However, there are exceptions. Historically, in Canada, during the time of the fur trade, books were kept in "currency" but actual currency never changed hands in the barter of trade goods for furs.

Unit of account: the standard in which prices are quoted and accounts are kept.

To serve as a medium of exchange, money must also be a store of value. Money works as a time machine allowing people to separate the timing of their expenditures from the timing of their incomes. Money is accepted today with confidence that it can be used some time in the future to make payments when buying goods and services. You would not accept money today that you thought would be unacceptable when you offered it in payment at some later date.

Store of value: an asset that carries purchasing power forward in time for future purchases.

Money is not a unique store of value. Other assets including real estate, financial assets like corporate and government bonds, fine art and antiques all serve as stores of value. These may be better ways to store value, but people still choose to hold some of their wealth as money. This choice to hold money balances is very important to the effects money balances have on financial markets and aggregate expenditure. Chapter 9 examines it in detail.

Money provides a standard for deferred payments. If you take out a student loan the amounts you will repay in the future are measured in dollars. Similarly, servicing and retiring a mortgage on a property or a loan on a car calls for future payments specified in dollars. Domestic money is not essential for this function. Individuals, businesses and governments often borrow or lend in the money of other countries. In those cases the currency in which the loan transaction takes place is usually the standard for payments to settle the debt. The essential attribute of money is its general acceptance as a means of payment. For this money must also be a store of value. This works well when money is also a unit of account and a standard of deferred payments.

Standard of deferred payments: the units in which future financial obligations are measured.

The development of money

The money we use today is the product of a long and continuing evolution in the financial services industry. It is a testament to the ingenuity of people and society seeking to reduce the costs and increase the volume of trade in goods and services.

Historically, there were no banks. Money was a commodity. Gold and silver bullion are two commodities that came to be used extensively because of their relative scarcity and durability. Concerns about the purity of these metals and the inconvenience of weighing out small quantities to make payments led to coinage. The minting of gold and silver coins by heads of state offered a solution to these problems. The 'monarch' certified the purity and quantity of the metal in the coin by having his or her likeness stamped into the metal.

Unfortunately, coinage did not completely solve the concerns about the quantity and quality of gold and silver money. The quantity of gold in a coin could be reduced by clipping its edges, or by rubbing the surfaces of the coin to wear some of the metal away. "Sweating" coins by placing them in a leather bag and shaking them was one technique used to remove some of their precious metal. The edge designs, millings, or facets that we still see on coins today were introduced to combat clipping, and wear on the heads and tails stamped into coins provided evidence of sweating. Coins that were worn or clipped were not accepted at full value in exchange for goods and services.

A second difficulty with precious metal coinage came from the sovereign who controlled the minting process. Adding a little base metal to the gold or silver being minted resulted in coins with less precious metal content than their face value certified. A little of the precious metal was withheld and could be used to mint more coin, which was, in effect, free money for the sovereign. This "debasing" of the coinage was a serious problem at times and, like clipping and sweating, reduced the acceptability of precious metal coinage as money.

The emergence of banks and paper money was a response to the problems with gold and silver commodity money. The first banks were goldsmiths who used gold in the production of jewelry and ornaments. They were accustomed to buying and selling gold bullion, and holding stocks of gold bullion. It was a natural extension of their business to offer to hold gold for safekeeping. Those who stored their gold with goldsmiths were given paper claims or receipts (IOUs), which were convertible back into gold on demand.

When people began to use gold receipts to make payments, gold receipts became a means of payment. They were token money, representing a fixed amount of the precious metal.

Token money: convertible claims on commodity money.

Goldsmiths became bankers when they realized that not all their customers would show up at the same time and want their gold back. The convertibility of gold receipts made them acceptable as a medium of exchange. Gold merchants could make loans by issuing more gold receipts than they had gold in their storage vaults. They only needed gold holdings equal to a fraction of the gold receipts they had issued, as long as people used the receipts as a medium of exchange.

Banks as we know them grew out of this acceptance by society of credit (IOU) money as a medium of exchange. Banks began to accept customer deposits of token money and to issue their own bank notes (credits) as receipts. People liked the convenience and safety of storing some of their wealth with banks. As society became more comfortable with banks and confident in the safety of banks, bank deposits, which could be transferred by cheque, became widely accepted as the medium of exchange. Bank notes and deposits were no longer convertible into gold or commodity money, but they were convertible into legal tender. Governments established central banks to control the supply of legal tender, bank notes, or cash. Bank notes now serve as both a medium of exchange and as the reserves banks hold to ensure the convertibility of their customers' deposits.

Legal tender: money that by law must be accepted as a means of payment.

Bank reserves: cash (legal tender) held by banks to meet possible withdrawals by depositors.

Unlike other financial institutions, such as pension funds and insurance companies, the key aspect of banks is that some of their liabilities are used as the medium of exchange; cheques and debit cards allow their deposits to be used as money to make payments. Bank deposits are credit money.

In Canada today, as in most industrial countries, we use a combination of fiat money and credit money. Fiat money, in contrast to commodity or token money is money that the government has declared to be legal tender. Coins and paper bank notes are fiat money in Canada. If you look carefully at a $5, $10, or $20 Bank of Canada bill you will find the statement: "This note is legal tender." By law it must be accepted as a means of payment for goods and services bought or debts repaid.

Fiat money: money the government has declared as legal tender.

Credit money: the debt of a private business or individual.

Our fiat money is supplemented by credit money. A bank deposit is credit money, and is redeemable in fiat money on demand, or in the case of some savings and time deposits, after a short waiting period. Furthermore, the bank is obliged to pay when your cheque is presented, or when you use your debit card. Bank deposits are a medium of exchange because they are generally accepted as a means of payment, even though they are not legal tender. The sum of bank deposits and fiat money in circulation outside the banks at any time is the stock of medium of exchange and the economy's money supply.

Money supply: the means of payment in the economy, namely currency (notes and coin) in circulation outside the banks and bank deposits.