Introduction to Money Fundamentals

Understanding markets requires understanding money.

Introduction

The introduction of money into the market opened the possibilities for exchange between parties in different locations at different times with different needs. In spite of its importance, people continually misrepresent money and its role in the economy. I will return to the subject of money and banking many times in this newsletter because of its importance.

As an introduction to money fundamentals, I will provide a precise definition of money and describe the components of that definition.

Definition

Money consists of any economic good, or any claim on such a good, that serves as a general medium of indirect exchange and that acts as a final means of payment.

Economic Good

The network of individuals that make up the market can choose to use any economic good as money. In small, isolated markets, people have used many different goods as money, but over time, gold and silver became the primary goods that individuals chose to use as money.

Over roughly the last hundred years, the use of commodity money has declined significantly. We can attribute a lot of that decline to the intervention of government. Government, however, does not determine what the market will use as money. Individuals in the market have accepted the dictates of government because they find it easier to follow the path of least resistance.

The primary substitute for money commodities has been claims on those commodities.

Claim on Economic Good

People have used banknotes, central banknotes, and bank checks, for example, as claims against money commodities. Money claims differ from other types of liabilities in that they are payable upon demand — not after a period of time.

I should make it clear at this point the claim does not represent a demand for “money.” Individuals use the claims themselves as money. The only time the good regains its status as money occurs when a bank honors the claim and transfers the money good to the claimant.

In national and international markets, commodity money has virtually disappeared replaced almost entirely by claims. These money claims now consist only of claims on claims.

The pyramid of claims becomes reasonably obvious when you consider that when you go to the bank and demand cash, you simply trade your checking claim for a note claim (generally a claim on a central bank). You can only exchange the new claim that you hold for yet another claim.

General Medium

In order for a good or claim to qualify as money, it must have general acceptance within the defined market. Some people who advocate for monetary reform suggest the use of local currencies. Those currencies become money only within a relatively small market.

The idea of general acceptance separates “dollars” created by the Federal Reserve from “dollars” created by banks. Only members of the Federal Reserve can exchange dollar-denominated claims created by the Federal Reserve. Members of the public cannot open accounts with the Fed. Dollar claims created by banks, however, have general acceptance throughout public markets.

Indirect Exchange

In an earlier post, I explained the concept of indirect exchange. A person accepts a good in order to exchange it for yet another good. They have no plans to consume a good they accept for indirect exchange.

The concept of indirect exchange becomes important to the definition of money. No one accepting money in an exchange anticipates consuming it. No need exists to increase or decrease the quantity of money. This point will become important in my next post when I discuss money prices.

Final Means of Payment

The idea of a final means of payment separates “money” from other means of payment. When a buyer pays with money, from his standpoint, he does not need to take any further action to complete the transaction.

This characteristic separates money payments from other forms of payment, for example, credit cards. When a buyer uses a credit card to acquire a product, he has not yet completed the transaction. He must, at some point in the future, make payment to the credit card company.

Conclusion

Many conversations about money continue without a clear definition. Some people have the mistaken impression that money consists of a form of debt. A clear distinction exists between a claim and a debt. Although financial accounting protocol lists both as liabilities, the two are distinctly different. A debt requires payment sometime in the future, even if that future time is only a day away. A claim, on the other hand, requires payment upon demand.

I offer this clear and precise definition of money as a reference for future discussions about money.