Medium of exchange

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Medium of exchange is one of the three fundamental functions of money in mainstream economics. [1] [2] [3] It is a widely accepted token which can be exchanged for goods and services. Because it can be exchanged for any good or service it acts as an intermediary instrument and avoids the limitations of barter; where what one wants has to be exactly matched with what the other has to offer. [4] [5]

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Most forms of money can act as mediums of exchange including commodity money, representative money and most commonly fiat money. Representative and fiat money often exist in digital form as well as physical tokens such as coins and notes.

Commodity money Money with value derived from composition from a commodity (such as silver or gold coins)

Commodity money is money whose value comes from a commodity of which it is made. Commodity money consists of objects that have value in themselves as well as value in their use as money.

Representative money any type of money that has face value greater than its value as material substance

Representative money is any medium of exchange that represents something of value, but has little or no value of its own. However, unlike some forms of fiat money, to be a genuine representative money, there must always be something valuable supporting the face value represented.

Fiat money currency established as money by government regulation or law.

Fiat money is a currency without intrinsic value that has been established as money, often by government regulation. Fiat money does not have use value, and has value only because a government maintains its value, or because parties engaging in exchange agree on its value. It was introduced as an alternative to commodity money and representative money. Commodity money is created from a good, often a precious metal such as gold or silver, which has uses other than as a medium of exchange. Representative money is similar to fiat money, but it represents a claim on a commodity.

Overcoming the limitations of barter

A barter transaction is the exchange of one valuable good for another of equivalent value. William Stanley Jevons described how a widely accepted medium allows each barter exchange to be split into three difficulties of barter. [6] A medium of exchange eliminates the need for a coincidence of wants.

William Stanley Jevons English economist and logician

William Stanley Jevons FRS was an English economist and logician.

The coincidence of wants lacking a medium of exchange, which have to rely on barter or other in-kind transactions. Double coincidence of wants means that both of the parties have to agree to sell and buy each commodity. The problem is caused by the improbability of the wants, needs, or events that cause or motivate a transaction occurring at the same time and the same place. One example is the bar musician who is "paid" with liquor or food, items which his landlord will not accept as rent payment, when the musician would rather have a month's shelter. If, instead, the musician's landlord were to throw a party and desire music for it, hiring the musician to play it by offering the month's rent in exchange, a coincidence of wants would exist.

Want of coincidence

A barter exchange requires finding a party who both has what you want and who wants what you have. A medium of exchange removes that requirement, allowing you to sell what you have and buy what you want from different parties via an intermediary instrument.

Want of a measure of value

A barter market would theoretically require an exchange rate for every possible pair of commodities, which is impractical to arrange, and impractical to maintain as the relative value of things changes all time. If all exchanges go 'through' a common medium, then all goods can be priced in terms of that one medium instead of with against other good. The medium of exchange thus makes it much easier to set and adjust the relative values of things in a marketplace.[ citation needed ]

Want of means of subdivision

A barter transaction requires that the held object and the wanted object be of equivalent value. A medium of exchange can typically and be subdivided to small enough units to approximate the value of any good or service.

Transactions over time

A barter transaction typically happens over a short period of time, or on the spot. A medium of exchange can be held for a period of time until what is wanted becomes available. This relates to another function of money, the store of value.

A store of value is the function of an asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved. More generally, a store of value is anything that retains purchasing power into the future.

Mutual impedance with Store of Value function

The ideal medium of exchange should be spread throughout the marketplace so that anyone with stuff to exchange can buy and sell. When money also serves the function of a store of value, as fiat money does, there are conflicting drivers of monetary policy, because a store of value can become more valuable if it is scarce in the marketplace. [7] When the medium of exchange is scarce, traders will pay to rent it (interest), which acts as an impedance to trade and a net transfer of wealth from poor to rich.

Interest A sum paid for the use of money

Interest, in finance and economics, is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum, at a particular rate. It is distinct from a fee which the borrower may pay the lender or some third party. It is also distinct from dividend which is paid by a company to its shareholders (owners) from its profit or reserve, but not at a particular rate decided beforehand, rather on a pro rata basis as a share in the reward gained by risk taking entrepreneurs when the revenue earned exceeds the total costs.

Medium of Exchange and Measure of Value

Fiat currencies' most important and essential function is to provide a 'measure of value'[ dubious ]... Hifzur Rab has shown that the market measures or sets the real value of various goods and services using the medium of exchange as unit of measure i.e., standard or the yard stick of measurement of wealth. There is no other alternative to the mechanism used by the market to set, determine, or measure the value of various goods and services. Determination of price is an essential condition for justice in exchange, efficient allocation of resources, economic growth, welfare and justice. The most important and essential function of a medium of exchange is to be widely acceptable and have relatively stable purchasing power (real value). Therefore, it should possess the following characteristics:

  1. Value common assets
  2. Common and accessible
  3. Constant utility
  4. Low cost of preservation
  5. Transportability
  6. Divisibility
  7. High market value in relation to volume and weight
  8. Recognisability
  9. Resistance to counterfeiting

To serve as a measure of value, a medium of exchange, be it a good or signal, needs to have constant inherent value of its own or it must be firmly linked to a definite basket of goods and services. It should have constant intrinsic value[ dubious ] and stable purchasing power. Gold was long popular as a medium of exchange[ dubious ]and store of value because it was inert, was convenient to move due to even small amounts of gold having considerable value, and had a constant value[ dubious ].

Some critics of the prevailing system of fiat money argue that fiat money is the root cause of the continuum of economic crises, since it leads to the dominance of fraud, corruption, and manipulation precisely because it does not satisfy the criteria for a medium of exchange cited above. Specifically, prevailing fiat money is free floating and depending upon its supply market finds or sets a value to it that continues to change as the supply of money is changed with respect to the economy's demand. Increasing free floating money supply with respect to needs of the economy reduces the quantity of the basket of the goods and services to which it is linked by the market and that provides it purchasing power. Thus it is not a unit or standard measure of wealth and its manipulation impedes the market mechanism by that it sets/determine just prices. That leads us to a situation where no value-related economic data is just or reliable. [8] [9] On the other hand, Chartalists claim that the ability to manipulate the value of fiat money is an advantage, in that fiscal stimulus is more easily available in times of economic crisis.

Requisites needed

Although the unit of account must be in some way related to the medium of exchange in use, e.g. coinage should be in denominations of that unit making accounting much easier to perform, it has often been the case that media of exchange have no natural relationship to that unit, and must be 'minted' or in some way marked as having that value. Also there may be variances in quality of the underlying good which may not have fully agreed commodity grading. The difference between the two functions becomes obvious when one considers the fact that coins were very often 'shaved', precious metal removed from them, leaving them still useful as an identifiable coin in the marketplace, for a certain number of units in trade, but which no longer had the quantity of metal supplied by the coin's minter. It was observed as early as Oresme, Copernicus and then in 1558 by Sir Thomas Gresham, that bad money drives out good in any marketplace (Gresham's Law states "Where legal tender laws exist, bad money drives out good money"). A more precise definition is this: "A currency that is artificially overvalued by law will drive out of circulation a currency that is artificially undervalued by that law." Gresham's law is therefore a specific application of the general law of price controls. A common explanation is that people will always keep the less adultered, less clipped, sweated, less filed, less trimmed coin, and offer the other in the marketplace for the full units for which it is marked. It is inevitably the bad coins proffered, good ones retained.

The fact that a bank or mint has always been able to generate a medium of exchange marked for more units than it is worth as a store of value, is the basis of banking.[ dubious ] Central banking is based on the principle that no medium needs more than the guarantee of the state that it can be redeemed for payment of debt as "legal tender" – thus, all money equally backed by the state is good money, within that state.[ dubious ] As long as that state produces anything of value to others, its medium of exchange has some value, and its currency may also be useful as a standard of deferred payment among others, even those who never deal with that state directly in foreign exchange.

Of all functions of money, the medium of exchange function has historically been the most problematic because of counterfeiting, the systematic and deliberate creation of bad money with no authorization to do so, leading to the driving out of the good money entirely.

Other functions rely not on recognition of some token or weight of metal in a marketplace, where time to detect any counterfeit is limited and benefits for successful passing-off are high, but on more stable long term social contracts: one cannot easily force a whole society to accept a different standard of deferred payment, require even small groups of people to uphold a floor price for a store of value, still less to re-price everything and rewrite all accounts to a unit of account (the most stable function). Thus it tends to be the medium of exchange function that constrains what can be used as a form of financial capital.

It was once common in the United States to widely accept a check (British English : cheque ) as a medium of exchange, several parties endorsing it perhaps multiple times before it would eventually be deposited for its value in units of account, and thus redeemed. This practice became less common as it was exploited by forgers and led to a domino effect of bounced checks – a forerunner of the kind of fragility that electronic systems would eventually bring.

In the age of electronic money it was, and remains, common to use very long strings of difficult-to-reproduce numbers, generated by encryption methods, to authenticate transactions and commitments as having come from trusted parties. Thus the medium of exchange function has become wholly a part of the marketplace and its signals, and is utterly integrated with the unit of account function, so that, given the integrity of the public key system on which these are based, they become to that degree inseparable. This has clear advantages – counterfeiting is difficult or impossible unless the whole system is compromised, say by a new factoring algorithm. But at that point, the entire system is broken and the whole infrastructure is obsolete – new keys must be re-generated and the new system will also depend on some assumptions about difficulty of factoring.

Due to this inherent fragility, which is even more profound with electronic voting, some economists argue that units of account should not ever be abstracted or confused with the nominal units or tokens used in exchange. A medium is just that, a medium, and should not be confused for the message.[ dubious ]

See also

Related Research Articles

Barter Exchange of goods

In trade, barter is a system of exchange where participants in a transaction directly exchange goods or services for other goods or services without using a medium of exchange, such as money. Economists distinguish barter from gift economies in many ways; barter, for example, features immediate reciprocal exchange, not delayed in time. Barter usually takes place on a bilateral basis, but may be multilateral. In most developed countries, barter usually only exists parallel to monetary systems to a very limited extent. Market actors use barter as a replacement for money as the method of exchange in times of monetary crisis, such as when currency becomes unstable or simply unavailable for conducting commerce.

A currency, in the most specific sense is money in any form when in use or circulation as a medium of exchange, especially circulating banknotes and coins. A more general definition is that a currency is a system of money in common use, especially for people in a nation. Under this definition, US dollars (US$), pounds sterling (£), Australian dollars (A$), European euros (€), Russian rubles (₽) and Indian Rupees (₹) are examples of currencies. These various currencies are recognized as stores of value and are traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are defined by governments, and each type has limited boundaries of acceptance.

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. The measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time. The opposite of inflation is deflation

Commerce relates to "the exchange of goods and services, especially on a large scale". It includes legal, economic, political, social, cultural and technological systems that operate in a country or in international trade.

Financial capital is any economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their products or to provide their services to the sector of the economy upon which their operation is based, i.e. retail, corporate, investment banking, etc.

This aims to be a complete article list of economics topics:

Purchasing power is the amount of goods and services that can be purchased with a unit of currency. For example, if one had taken one unit of currency to a store in the 1950s, it would have been possible to buy a greater number of items than would be the case today, indicating that the currency had a greater purchasing power in the 1950s. Currency can be either a commodity money, like gold or silver, or fiat money emitted by government sanctioned agencies.

In economics standard of deferred payment is a function of money. It is the function of being a widely accepted way to value a debt, thereby allowing goods and services to be acquired now and paid for in the future.

In economics, unit of account is one of the functions of money. The value of something is measured in a specific currency. This allows different things to compared against each other; for example, goods, services, assets, liabilities, labor, income, expenses. It lends meaning to profits, losses, liability, or assets.

In commodity money, intrinsic value can be partially or entirely due to the desirable features of the object as a medium of exchange and a store of value. Examples of such features include divisibility; easily and securely storable and transportable; scarcity; and difficulty to counterfeit. When objects come to be used as a medium of exchange they lower the high transaction costs associated with barter and other in-kind transactions.

A complementary currency is a currency or medium of exchange that is not a national currency, but that is thought of as supplementing or complementing national currencies. Complementary currencies are usually not legal tender and their use is based on agreement between the parties exchanging the currency. According to Jérôme Blanc of Laboratoire d'Économie de la Firme et des Institutions, complementary currencies aim to protect, stimulate or orientate the economy. They may also be used to advance particular social, environmental, or political goals.

The history of money concerns the development of social systems that provide at least one of the functions of money. Such systems can be understood as means of trading wealth indirectly; not directly as with barter. Money is a mechanism that facilitates this process.

Money Object or record accepted as payment

Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The main functions of money are distinguished as: a medium of exchange, a unit of account, a store of value and sometimes, a standard of deferred payment. Any item or verifiable record that fulfils these functions can be considered as money.

Metallism is the economic principle that the value of money derives from the purchasing power of the commodity upon which it is based. The currency in a metallist monetary system may be made from the commodity itself or use tokens such as national banknotes redeemable in that commodity. The term was coined by Georg Friedrich Knapp to describe monetary systems using coin minted in silver, gold or other metals.

In macroeconomics, chartalism is a theory of money which argues that money originated with states' attempts to direct economic activity rather than as a spontaneous solution to the problems with barter or as a means with which to tokenize debt, and that fiat currency has value in exchange because of sovereign power to levy taxes on economic activity payable in the currency they issue.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

References

  1. Mankiw, N. Gregory (2007). "2". Macroeconomics (6th ed.). New York: Worth Publishers. pp. 22–32. ISBN   0-7167-6213-7.
  2. Krugman, Paul & Wells, Robin, Economics, Worth Publishers, New York (2006)
  3. Abel, Andrew; Bernanke, Ben (2005). "7". Macroeconomics (5th ed.). Pearson. pp. 266–269. ISBN   0-201-32789-9.
  4. William Stanley Jevons, 1875. 'Money and the mechanism of exchange' Chapter 1 http://oll.libertyfund.org/titles/jevons-money-and-the-mechanism-of-exchange
  5. https://www.investopedia.com/terms/m/mediumofexchange.asp
  6. William Stanley Jevons, 1875. 'Money and the mechanism of exchange' Chapter 4 http://oll.libertyfund.org/titles/jevons-money-and-the-mechanism-of-exchange
  7. T.H. Greco. Money: Understanding and Creating Alternatives to Legal Tender, White River Junction, Vt: Chelsea Green Publishing (2001). ISBN   1-890132-37-3
  8. Hifzur Rab (2009) 'Freedom, Justice and Peace Possible Only with Correct wealth measurement with a Unit of Wealth as Currency' HIJSE 26:1, 2010
  9. Hifzur Rab (2006) 'Economic Justice in Islam' AS Noordeen, Kuala Lumpur, Malaysia.

Bibliography