You use money every day. From getting your morning coffee from the barista of your choice to paying for the new pair of shoes you want. You are paid in money, you use it to pay rent, buy gas and pretty much everything.
But what is money? Why do these paper or plastic based notes have value and how is it determined?
To understand all this, first we must look at how money existed in its earliest forms.
The Barter System
Before money (or any other form of standardized exchange asset) existed, people used the barter system. If a person wanted something from another, they had to exchange an asset they had. For example, a farmer could use his stored wheat for some food wares from a potter. They would need to settle on the exchange value, i.e. how much wheat should the farmer give for a pot or a pan.
Sounds simple and logical. However, if the potter already had enough wheat from a previous sale, he would either ask for a lot more wheat in exchange, or simply say that he had no need of more.
What would the farmer do then?
The farmer would ask what the potter needed and then try to find another person who had that item and try to negotiate a barter of wheat with the third person, obtain the said item and then exchange it for the pot.
This is situation is called the coincidence of wants
See how quickly it gets complicated?
The Scarcity Principle and Precious Items
Some assets are more valuable than others are and this is what led to the next stage of money. Precious items that were admired greatly became valuable and with the ability for people to acquire these, these started to become an intermediary – a medium of exchange. Pearls and rubies, gold and silver are a few examples.
But the value was not absolute across the world. The perceived value was dependent on the locality and how scarce the asset was there. You would not see limestone as being much expensive, but for the Micronesian nation of Yap, they were. Not local to the Yap Islands, the Rai stones (as they were called) came from neighboring Palau or Guam. Big, heavy, scarce and difficult to move, the stones were the perfect monetary system for the Yapese. The scarcity maintained a high stock to flow ratio*, making these the perfect monetary system.
But with Western contact, entrepreneurs like David O’Keefe used modern tools and explosives to speed up braking Rai stones and brought these to Yap in large quantities to trade for coconuts. This resulted in lower stock to flow ratio, increasing supply and overall making it easier for the Yapese to acquire the stones.
Eventually, this led to erosion of value and therefore, Rai stone monetary system collapsed.
Over the centuries, with trade and modern transportation improving, the scarcity of materials have changed. Seashells and limestone were eventually replaced with others, which in turn were replaced with other items.
*Stock to flow ratio: The ratio between current market circulation (stock) of an asset and its new supply (flow). A higher ratio means new supply is scarce, giving increased value to the asset, whereas a higher supply or flow means the market is flooded with the asset and its value decreases.
As modern industries and commodities grew, so did the demand of different metals. Iron, copper, zinc and other metals became demanded items. Rarer metals like gold and silver too.
Heavier, denser and easy to shape into smaller pieces, metal money was easier to transport than lighter seashells or the humongous Rai stones. Initially, metals were valued against their weight, but with developments, countries and nations started minting coins with different shapes and sizes. Standardized weights meant a proper unit of accounting could be developed. Instead of weighing, the amount of coins started being used. Stock to flow ratios still applied, with rare and difficult to procure gold meant gold coins were able to buy more than silver ones.
Modern Paper Money
Coins were much easier to carry than lightweight seashells or large stones and it made much sense. Nevertheless, transacting in large amount was still an issue.
Banks were already using checks, that allowed anyone to issue a paper note saying that the recipient could get the written amount of gold or silver (or the standardized metal) coin from the bank. Central banks formalized this into replacing coins altogether (though still having metals such as gold in reserve) into government issued paper money.
Thus the era of gold backed money started.
While a lot has happened to modern paper money, including breaking the gold backed standard, which is a discussion for another time.
About the Author
Jay Shaquile is a lifelong entrepreneur who is all about helping people build wealth by understanding the modern and digital money space. A Young Entrepreneur Nominee in 2016, Shaquile is known for his out of the box approach towards money, Bitcoin, trading and generating income.
He shares his passion with the world through his firm, Swave Agency.
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