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Unit 6 The financial sector: Debt, money, and financial markets
6.5 Introducing money
Our model so far was highly simplified. Grain was the only good in the economy, and there was no money—nothing like banknotes and coins, for example. In the model, grain acted as both a store of value and a unit of account. Each of these functions is also fulfilled by something we call ‘money’ in a modern economy. But we also use bank deposits, notes, and coins as a means of exchange: that is, for buying and selling things. This function becomes essential once we move on to consider a model with multiple goods.
To see why, imagine a world with many different goods, but without any form of money. Think about how you would be paid for work and get hold of a range of goods and services in a world without money—a barter economy. What you could buy today would depend on what you have available to sell. Perhaps you have grown some vegetables in your garden, and would like to exchange them for cheese, or fish. Perhaps you want to buy some tomatoes, and can offer your skills as a hairdresser in return. Whatever exchange you would like to make, your immediate problem is to find someone else who wants to make the opposite exchange. If you can find a tomato grower in need of a haircut, you will also need to agree how many kilograms of tomatoes it is worth. If you end up with more tomatoes than you wanted, maybe you can trade them later for some pasta.
A barter economy is impractical except in highly restricted circumstances; and there is a lot of evidence that it has barely ever been the primary method by which trade takes place.1 If we found ourselves in such an alternate reality, it would not be long before we wanted something that would provide:
Graeber, D. 2011. Debt: The First 5,000 Years. Brooklyn, NY: Melville House, p. 40. Close footnote
- a means of exchangemeans of exchange One of the characteristics of money is that it serves as a means of exchange: something that buyers and sellers are willing to exchange for goods and services.: something (preferably not too heavy) that you can accept in return for what you have to sell, knowing that it will be accepted in future by others when you want to buy other goods or services
- a store of valuestore of value One of the characteristics of money is that it can be used as a store of value: people can store their wealth in this form until they want to use it to buy goods and services.: the problem with accepting tomatoes in return for your work is that they won’t last long—you want something that will remain valuable until you are ready to buy something else
- a unit of account: to facilitate the exchange of goods and services by enabling everyone to use the same units for valuing them—a system of prices.
In other words, we would want to invent moneymoney Money is something that acts as a store of value and is widely accepted as a means of exchange. Typically it is also used as the unit of account, for measuring the value of goods and services, and assets and liabilities. Some commodities can be used as money, but in a modern economy money in the hands of the public consists of commercial bank deposits and currency (notes and coins) issued by the central bank. See also: means of exchange, store of value..
To explore this question, we extend our model to an economy with many goods and services.
Commodity money
One possibility is that grain could be a means of exchange as well as the unit of account and store of value. Julia and Marco could use their grain to pay for other goods, and the prices of those goods would be expressed in units of grain.
Grain used in this way would be an example of commodity moneycommodity money In an economy without a well-developed banking system, people may use a particular commodity such as gold, as money. The commodity is typically a basic good that is widely valued, but can also act as a means of exchange, a store of value, and a unit of account. See also: money.—a good that is valued for its own characteristics (grain can be consumed) but also performs the three functions of money. Many such forms of money have indeed existed in the past. But which commodity should be chosen?
At 2024 prices, for example, a ton of wheat costs around US$220, so a sack of wheat would not, in practice, buy you very much in an high-income industrial economy.
While there is some evidence that grain was used as commodity money in some societies, it has some very obvious disadvantages.2 Grain is perishable (its quality deteriorates over time) and it can be eaten by pests. Carrying a sack of grain around with you at all times to make purchases would be distinctly impractical, especially in a modern economy where basic foodstuffs are relatively cheap.
Graeber, D. 2011. Debt: The First 5,000 Years. Brooklyn, NY: Melville House, p. 21. Close footnote
Historically at least, there was a tendency to use precious metals—most notably silver and gold—for all three functions of money.
Precious metals had both advantages and disadvantages. Their rarity gave them a high value relative to other goods, so only small amounts needed to be carried around, making them more portable than basic commodities such as grain. They also did not deteriorate over time. But gold and silver could be stolen, and it was not always easy to verify the quality of the metal. And being relatively valuable, they were not at all suitable for small purchases. Additionally, and at times crucially, if there were changes in the value of gold or silver relative to other goods and services, this detracted from their role as a unit of account.
These shifts in the real value of silver or gold were often driven by shifts in supply. Probably the most famous example was the significant increase in the supply of gold and silver during the early stages of European colonial expansion in the Americas. This caused a fall in the real price of gold, but since gold was itself the unit of account, this fall required the prices of other goods to rise: that is, the increase in supply caused inflation. Shifts in the real prices of metals can also be driven by shifts in technology that make it cheaper or more expensive to extract and refine metals.
Despite all of these problems, over long historical periods and in many societies, different forms of commodity money were used as a means of exchange, essentially because the gains in efficiency, compared to barter, easily outweighed the disadvantages.
Bank deposits as a means of exchange
To extend the model, think again about Julia, Marco, and the bank. Suppose that they live in a much wealthier economy, in which there are now many goods, which can be bought at a supermarket.
To simplify the analysis, we again just examine a small slice of the economy—we do not ask where the goods in the supermarket come from.
For now, we shall continue to assume that there are no notes or coins. So even in this extended model, we shall assume that grain is used as a commodity money and as the unit of account.
At this stage, ‘grain’ could represent any form of commodity money.
We assume as before that Marco starts with 100 units of grain; he saves half of it for period 2 by depositing it in (loaning it to) the bank, and keeps the other 50 units for consumption in period 1. Julia borrows 50 units of grain from the bank, keeping 20 units for first-period consumption and investing the other 30 in grain production.
The difference is that we assume that Marco and Julia could now use their grain as commodity money to buy goods and services at the supermarket instead of consuming grain directly. If Marco wanted to buy a selection of groceries worth five units of grain, we assume that he could take a sack of grain to the supermarket, which would accept five units in exchange for his shopping.
But, for reasons we have noted above, using grain as a medium of exchange would be very inconvenient. Is there an alternative?
Since we have not yet introduced a central bank or a government into our model, Julia and Marco cannot pay using the pieces of paper and metal that we refer to as ‘legal tender’ or currency (banknotes and coins).
But even without currency, there is a simpler way than paying with grain. The bank can provide another intermediary service, this time between its customers and the supermarket.
Suppose that, instead of carrying grain when he goes shopping, Marco deposits all of his grain at the bank. You could imagine that he deposits 50 units into a savings account for his consumption next period, and 50 units into a current account for his consumption now. Assume also that he has a bank app on his phone that records the amount in his accounts, and allows him to make transfers from his current account to another account holder.
Then, rather than handing over five units of grain in exchange for groceries, Marco can simply use his bank app to transfer five units of the bank’s liability from himself to the supermarket. The bank will now owe five units to the supermarket instead, while still owing 95 units—the remainder of its liability—to Marco. So, assuming for now that the supermarket has an account at the same bank, the bank will increase the supermarket’s deposit by five units. Since it still owes the same total amount, its balance sheet is entirely unaffected.
If this sounds familiar, it is more or less exactly what actually happens when you go into a supermarket today and pay using your phone.
One obvious difference, however, is that, unlike in the model, today’s banks do not hold grain in their strongrooms. Instead, they hold bank reserves in accounts at the central bank. This will become clear in the next section where we introduce the central bank. It is also likely that the supermarket banks with a different bank from Marco’s. We will explain how banks settle balances with one another using their reserve accounts.
For a deep dive into central bank reserve accounts, read this article.
Paying for goods and services by transferring bank deposits from your account to someone else’s is using bank moneybank money Money in the form of deposits in commercial banks. The bank allows bank deposits, created for example when the bank makes a loan, to be used as a means of exchange, debiting the buyer’s deposit and crediting the seller with a new deposit. (also called bank deposit money or simply, bank deposits) as the means for exchange. Buyers can pay sellers using bank deposits by transferring part of the bank’s liability to the seller. The buyer receives goods; the seller receives money. Marco and Julia now have two alternative means of exchange: commodity money and bank money, both of which are the liabilities of a commercial bank.
Remember that grain remains the unit of account: bank money and prices are all expressed in units of grain.
Bank deposits or bank money make up the vast majority of money in a contemporary economy. The other—much smaller—component of money in today’s economy is not grain, or gold, or any form of commodity money, but currency, which we introduce later in this unit.
Bank money emerged as a means of circumventing the practical difficulties of commodity money. For example, gold merchants would issue certificates, defined in terms of gold, but which could be used to make payments without any actual gold changing hands.
How does this work for Julia, who previously had no deposits? The bank has lent her 50 units of grain. However, like Marco, she prefers not to have to carry it when she goes shopping. So instead of handing over grain to her directly, the bank credits 50 units of grain to her as a deposit. She can withdraw some to invest in grain production, and leave the rest as bank money in her current account to use as a means of exchange.
Exercise 6.5 Bank money and bank balance sheets
Draw the individual’s and the bank’s balance sheet to illustrate the situations described in this section:
- Marco deposits 50 units of grain and uses his phone app to pay five units of grain to the supermarket.
- Julia owes the bank 50 units of grain, which the bank credits to her as a deposit.
