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In “Money: A Definition” I referred to money as an “economic good, or any claim on such a good.” To clarify our definition of money I need to explain the term economic good.

Carl Menger, known as the father of Austrian economics, first defined the terms good and economic good for use in the study of economics. Menger gave the following definition of a good:

If a thing is to become a good, or in other words, if it is to acquire goods-character, all four of the following prerequisites must be simultaneously present:

  1. A human need.
  2. Such properties as render the thing capable of being brought into a causal connection with the satisfaction of this need.
  3. Human knowledge of this causal connection.
  4. Command of the thing sufficient to direct it to the satisfaction of the need.

Only when all four of these prerequisites are present simultaneously can a thing become a good. When even one of them is absent, a thing cannot acquire goods-character, anything already processing goods-character would lose it at once if but one of the four prerequisites ceased to be present. (My emphasis)
Carl Menger, Principles of Economics.

Based on this definition of a good, Menger continues to give a rather technical definition of an economic good. Basically, he says that any good for which the quantity required exceeds the quantity available qualifies as an economic good.

In somewhat simplified terms anything that satisfies a human need and exists in relatively limited quantities can qualify as an economic good. This means that any good that commands a market price (in terms of other goods) can play the role of money. Thus, peas, carrots, shoes, seashells, or ounces of gold could all act as money.

Historically, because it has characteristics that lend itself to the use as money (which I will discuss in later posts), gold has played a prominent role as a form of money. In addition to its other characteristics, gold fits all of those of an economic good. In our current money and banking system, however, gold has been completely eliminated as a form of money. What has been left in its place? And, can that replacement be considered an economic good?

In the current U.S. banking system we have basically two forms of money: 1) currency issued by the Federal Reserve System and the Treasury Department (and delivered by banks), and 2) credit accounts with banking institutions. In spite of their fiat nature, to which many people object, both currency and credit accounts fit the definitions of economic good and money.

In a sort of circular logic these two forms of information qualify as money. First, they satisfy the human need for a medium of indirect exchange – i.e. a need for money. Second, they exist in relatively limited quantities, thereby qualifying them as economic goods, which also qualifies them as money. The fact that one consists of otherwise relatively useless pieces of paper and the other consists of digital entries on bank records does not change that fact. In the end what matters is that the market has accepted these forms of information as economic goods and as media of indirect exchange – or as money.

Understanding the economic-goods-nature of our current forms of money will help you understand some of the concepts which I will discuss later in this series.

To hear most people talk you would think that they valued money for itself. In fact, people value money for its use in indirect exchange. Understanding indirect exchange will help you understand the role of money.

We divide exchanges into two types: direct and indirect. A direct exchange occurs when two people trade things that they value because they expect some utility from the things themselves. Each person values what they get more than what they give.

An indirect exchange ultimately requires at least three people and two transactions. In the first transaction one person gets something from which he expects to get more utility than from the thing he gave up. The second person gets something that has less utility for him than what he gave up. He values what he gets more, however, because he believes that he can trade it for something that has more utility to him than what he gave up in the first transaction.

In the next transaction the second person trades the good he got in the first transaction for something he values more than what he gave up in the first transaction. Thus, the second person indirectly exchanged the good he possessed for a good that he desired by using a third good as an indirect medium of exchange.

A simple set of tables demonstrates the shift in value for items used for indirect exchange.

Consider Fred, who has the following preference scale (albeit limited). He would exchange directly any item on the list (if he had it) for any item above it (if he didn’t have it). But, poor Fred only has a Snickers Candy Bar, which he would trade for any of the other items on his preference scale, except the Shiny Green Stone.

Fred’s Personal Preference Scale
Direct Exchange
1 Music CD
2 Glass of Beer
3 Novel
4 Hamburger
5 Snickers Candy Bar
6 Shiny Green Stone

Suppose that Fred finds out (on eBay maybe) that Sammy has a Music CD that he wants to trade for a Shiny Green Stone. This information causes a sudden shift in Fred’s personal preference scale (see the table below).

Fred’s Personal Preference Scale
Indirect Exchange
1 Music CD
2 Shiny Green Stone
3 Glass of Beer
4 Novel
5 Hamburger
6 Snickers Candy Bar

Fred now values the Shiny Green Stone more than everything on his preference scale other than the Music CD because he believes that, if he had the Shiny Green Stone, he could trade with Sammy for what he really desires. But, he’s stuck with the Snickers Candy Bar.

Fortune smiles on Fred when Willy, who’s been stuck the Shiny Green Stone, offers to trade it for Fred’s Snickers Candy Bar. Fred, who did not want the Shiny Green Stone in the first place, happily makes the deal. He then rushes off the make a trade with Sammy for the Music CD he covets.

At the present time the Shiny Green Stone has limited value for indirect exchange, since only Sammy wants it. But, what would happen if everyone (in this little economy) started accepting Shiny Green Stones for indirect exchange. That would have no effect on their utility value, but it would greatly increase their market value.

As a generally accepted medium for indirect exchange Shiny Green Stones would now fit the definition of money. Yet, no one would hold them (money) simply for the sake of holding Shiny Green Stones (money). They would hold them for the purpose of anticipated exchange.

Understanding the value of money in indirect exchange will help you properly evaluate statements such as:

  • Monetary stimulus.
  • He’s worth $1 million.
  • That car is worth $40,000.
  • That rich guy has more money than he knows what to do with.
  • We need more bank liquidity, a.k.a. more money.
  • And many more…

I will frequently revisit and elaborate on the simple, but overlooked, concept of indirect exchange in this series about money and banking.

Money: A Definition

It seems appropriate to start a series on money and banking with a precise definition of money—particularly after I ridiculed Mr. Ben Bernanke for not adequately defining a dollar. In this article I will provide a good working definition of money. I will describe briefly the key elements in this definition. Then, having provided this background, I will provide more discussion about these elements in other articles in this series.

The 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.

The key phrases, or primary elements, of this definition consist of: economic good, general, medium of indirect exchange, and final means of payment. I will describe each of these elements separately.

Economic Good

The term economic good has specific meaning in economics. A good consists of any resource that satisfies a human need. A good becomes an economic good when the need for that resource exceeds the available quantities.

This definition also includes the phrase “or any claim on such a good.” This phrase means that any form of money substitute—such as bank notes and checking accounts—also fills this broad definition of money. The inclusion of this characteristic plays an important role in understanding the money used in our current economic structure.

The concepts of subjective value and marginal utility apply to money, just as they do to any economic good. We will see in later discussions, however, that varying quantities of money do not add or detract from economic well-being, but they do affect economic decisions.

Medium of Indirect Exchange

The role of money as a medium of indirect exchange distinguishes it from most other economic goods. Unlike other economic goods the value of money to the owner lies not in its utility but in its acceptance in exchanged for other economic goods. Many people, including many economists, forget to include this important distinction in their definition, and understanding, of money. Money gains value and utility with its acceptance in exchange for other goods.

General

The word general plays a significant role in the precise definition of money. People can use any economic goods as media for indirect exchange. The word general implies a wide acceptance of a particular good in those exchanges. Because of that wide, or general, acceptance, people have confidence that a wide range of people will accept units of that good in exchanges for other goods.

Final Means of Payment

When a person accepts money in an exchange, he knows that it requires no further conversion in order to be used in future exchanges. This phrase in the definition of money excludes items like credit cards or IOUs, which require the receiver to take further action in order to take ownership of an economic good.

Conclusion

I should acknowledge that this definition does not include some of the characteristics that people frequently include in their definition of money, for example a store of value or a unit of account. These characteristics do not define money. Instead they become uses for money as defined.

A precise definition of money provides a good background for further discussions of the subject of money and banking. I plan to expand my description of some of these elements of money in future articles.

This post introduces a series of articles on the subject category of Money & Banking. Within the overarching subject of free markets, no other subject category has the importance of Money & Banking. This subject deals with our primary medium of indirect exchange and the banking system which creates and transmits money.

If you think I overstate the importance of Money & Banking consider this:

Nearly all economic transactions use money.

  • You (probably) get paid with money.
  • Money connects all financial transactions.
  • Money represents the primary component of most prices.
  • Economists & governments state early all economic data in terms of money.
  • Governments use money in virtually all transactions.
  • International transactions occur in terms of money.
  • And this list could go on for three pages…

Any time you engage in a transaction for economic good using money, you only understand half the transaction, if you do not fully understand the nature of money, how it’s created, the role it plays in the economy, and the information that money prices transmit.

We tend to believe, since money plays a ubiquitous role in economic transactions, that we already understand the meaning of money and what role it plays. Many of the erroneous economic decisions we make as individuals, organizations, and government entities, result from misunderstanding money.

Even if we admit that we don’t understand money, we tend to have confidence that economists and people who influence the money supply really do understand money. But don’t believe it. Evidence of the misunderstanding of money can be seen everywhere. Let me give one specific example that I believe demonstrates my point.

One might think that the chairman of the Federal Reserve System, our central banking system, would know the answer to the simple question, “What is the definition of a dollar?” Yet, read the response that Ben Bernanke gave in a hearing before the House Financial Services Committee to the question asked by Rep. Ron Paul, “What is the definition of a dollar?”

“My definition of the dollar is what it can buy. Consumers don’t want to buy gold; they want to buy food, and gasoline, and clothes and all the other things that are in the consumer basket. It is the buying power of the dollar in terms of those goods and services that is what is important, and that’s what I call price stability.”

Ben Bernanke, Chairman, Federal Reserve System
Wednesday, March 2, 2011
House Financial Services Committee

[View the portion of the house financial services testimony in which this quotation occurred.]

In a series of articles, which I will post in this space every Wednesday, I will clear up Mr. Ben Bernanke’s confusion, or at least the confusion of those who believe his comments. I will also address the topics that I listed above and much more.

Although I have made a basic outline of the topics that I wish to cover in this series of articles, I want to respond to questions which come up about the subject of Money & Banking as they arise from news articles, web posts, and—most importantly—comments and questions that you post in the comments section below. Please feel free to add your comments, questions, and corrections.

Please return next Wednesday.


Portion of Ben Bernanke’s March 2, 2011, House Financial Services Committee testimony.

Neither one of these gentlemen receives high marks for eloquence, but you would think that the Fed chairman could rattle off a more precise definition of the dollar.

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