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Cray column: The economy and the role of money

11:57 PM, Mar. 15, 2014  |  Comments
Randy Cray
Randy Cray
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In February's column, I discussed the items that make up the U.S. money supply. This month, I would like to talk about the unique properties of money. It is these properties that make money indispensable for the operation of a modern economy.

In terms of human history, money is a fairly new invention. According to archeologists, modern humans have been around for about 200,000 years. However, the record seems to indicate that it was not until about 12,000 years ago that rudimentary forms of money developed. This means that for approximately 94 percent of the time that modern humans have been on earth, money as we know it today was not used.

Money functions as a medium of exchange in a modern economy. It allows a person to readily purchase goods and services. To the extent that money helps facilitates a greater amount of trade, more jobs and income can be created. Without modern money, an economy would have to rely on a barter system. The problem with barter is that a person A has to find person B who has the good that person A wants. For the transaction to happen, person B must also want what person A has to trade. In economics, we say that money eliminates the problem of the "double coincidence of wants."

You can imagine how much time and energy would be wasted using a barter system. Countries that engage in large amounts of barter are generally ones where the population has little confidence in the ability of the state to maintain purchasing power of the money supply. Further, nations that have a large amount of barter taking place tend to have low standards of living when compared to the rest of the world.

Money also serves as a unit of account in the advanced world. In a modern economy, goods and services are priced in terms of the local currency. Without money, we would have a bewildering set of trade ratios. For example, how many bananas does it take to equate to a pineapple? How many pineapples equates to a visit to the doctor's office? How many visits to the doctor equate to a new car? The number of trade ratios for products and services would rise exponentially, and the ability to trade would suffer. This would greatly limit how many transactions would occur each day in an economy because people would spend a tremendous amount of their time and energy trying to figure out the value of things. With money, we know how much products costs, the value of our debt, the amount of taxes we owe, etc.

Money also is a store of value. It allows people to conveniently store purchasing power. A person who does not spend all of their income can store purchasing power in the form of money and use it when needed. Money is not the only asset that a person can use to store purchasing power. Stocks, bonds, real estate and other assets can do this as well. The thing that makes money special is its high degree of liquidity. Liquidity refers to an assets ability to be quickly converted into the local medium of exchange without the loss of purchasing power. Money by definition is the most liquid of all assets and thus is well suited to being a store of value.

In sum, sound money plays an important role in facilitating trade and economic activity. Money allows for specialization, and this leads to a greater output of goods and services, higher employment levels and increased income in a society.

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