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.
