Money as a Social Contract

Lecture 2

T
his lecture, begins with a basic de¿nition of “money” and traces the
evolution of money through ¿ve stages: barter, commodity money,
coined money, paper money backed by coins, and ¿at money, which
is what we use today. Throughout this evolution, you’ll see that money
operates as a social contract—members of society agree to accept money in
exchange for goods and services. As we’ll see, this contract has developed
as it has because members of society have constantly sought to meet 2
competing goals: to lower the cost of trade while ensuring that money retains
its value.

“Money” De¿ned
x The standard de¿nition of money used by economists is something
that can be used as a medium of exchange.

x Money is valued, not because it is intrinsically useful, but because

it can be exchanged for useful things.

x This connection between money and exchange helps us understand

the most important point in this lecture: Money is a social
contract that lowers the cost of trading and has evolved gradually
through time.

Barter
x Barter, de¿ned as exchange without money, is the ¿rst stage in the
evolutionary history of money.

x In Money and the Mechanism of Exchange, the economist William

Jevons stated, “The ¿rst dif¿culty in barter is to ¿nd 2 persons
whose disposable possessions mutually suit each other’s wants …
there must be a double coincidence, which will rarely happen.”

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 x The search for a narrowly de¿ned trading partner is costly because it
takes time and the costs of locating trading partners and negotiating
trades are disincentives to specialization.

x Primitive societies faced tremendous incentives to lower the

cost of barter and often settled on successful schemes, including
credit arrangements.

Commodity Money
x The next stage in the evolution of money is the development of
commodity monies. A society uses commodity money when
individuals typically buy and sell goods by exchanging a particular
commodity that is agreed upon in the society to be acceptable
for exchange.

x Commodity money has taken many different forms, including salt,

cowry shells, large stones, and bricks of tea.

x Government has often played a role in deciding which commodity

would function as money. For example, if a ruler or leader favored
a certain kind of shell or feather, it might become money, although
the commodity chosen as money must be scarce.

Coined Money
Lecture 2: Money as a Social Contract

x As primitive peoples traveled beyond the borders of their homelands,

they frequently found that their local money was not accepted and
sought alternative ways to facilitate trade. Metals, especially gold,
silver, bronze, and copper, were found to be valued in many societies,
leading to the next stage in the evolution of money: the use of metals,
in particular, metal coins.

x Several forces favored the use of metal rather than other

commodities as money. Metal could be used to make a variety of
goods, such as knives; it was durable; and it was typically more
valuable (per unit of weight) than other commodities, which lowers
the cost of transporting money.

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 Photos courtesy of Classical Numismatic Group, www.cngcoins.com.
Coining money provided governments with revenues because the government
typically owned the mints that converted raw metals into coins and collected
fees from those who sold metals to the mint.

x There were, however, 2 disadvantages to using lumps of metal as

money: It was costly to verify the true metallic content and purity
of a lump of metal, and it was costly to weigh the lump.

x By creating coins from metal, governments lowered the costs of

using metal as money.

x The mint owner could also raise revenue by lowering the metal
content of its coins. The word seigniorage denotes the revenue
that a government obtains by deÀating the value of its money.
Seigniorage could be as simple as shaving metal from the edges of
the coin or as complex as changing the price that the mint offers for
metal to be coined.

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 Paper Money Backed by Coins
x The transition from coins to paper money is rooted in the practice
of allowing citizens to deposit their goods in temples and palaces,
which were relatively secure, well-guarded structures and were able
to protect the citizens’ wealth. The origins of paper money are the
“warehouse receipts” received for deposits of precious metals and
other commodities.

x The receipts themselves began to function as money when third

parties traded them for commodities, rather than withdrawing their
deposits. This practice represents the next step in the evolution of
money: using money backed by a metal money, such as gold or silver.

x The use of this paper money lowered exchange costs because it was
easier to exchange warehouse receipts than deposits.

x The managers of depositories soon realized that they could make

loans to new parties by issuing new warehouse receipts. The
scheme worked because on any given day, only a small fraction of
deposits were withdrawn from the depository.

Fiat Money
x The ¿nal step in the evolution of money is the creation of ¿at
money, money that is valuable in exchange because a government
Lecture 2: Money as a Social Contract

declares it is.

x In 1844, the Bank of England established a rigid link between the

amount of paper money in circulation and the gold reserves of the
Bank of England. This meant that the supply of money in England
would Àuctuate with the gold reserves of the bank and with the
availability of gold in general. Discoveries of gold in the New
World led to rising prices of goods in terms of gold.

x For the next 130 years, it was typical for Western economies to
back their paper money with gold. In most cases, paper money was
convertible; that is, holders of paper money could demand gold in
exchange at a rate set by the government.

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 x In times of national emergencies, for example, in World War I and
World War II, nations abandoned the gold standard and suspended
the convertibility of their currencies. Suspending convertibility
allowed nations to ¿nance some of the costs of war by issuing more
currency than their gold stocks would have previously permitted.

x At the end of both World Wars, nations returned to the gold standard
but quickly experienced problems. The supply of gold grew too
slowly and erratically to allow the supply of money to keep pace
with growth.

x For a time, the International Monetary Fund supplemented the

supply of gold with “paper gold” called “special drawing rights.”
But the gold standard ended with President Nixon’s decision in
1973 to permanently suspend the convertibility of the U.S. dollar
into gold.

x In Western economies today, we use pure ¿at monies that are

backed by no commodity. The money is valued partly because
governments declare it to be “legal tender for all debts public and
private.” Ultimately, however, money is valued because people
agree it is valuable; people agree to accept money in exchange
because they believe they can use money to purchase useful things
whenever they wish.

Four Takeaways from the Evolution of Money

x Money is a social contract in that members of society agree to
accept money in exchange for goods and services.

x This social contract has developed gradually through history

because it has taken time to develop the trust necessary to exchange
something of intrinsic value (a pound of nails) for something of no
intrinsic value (a pound note).

x The contract has developed as it has because members of society

have constantly sought to meet 2 competing goals: to lower the cost
of trade while ensuring that money retains its value.

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 x Government is essential to the organization of monetary
arrangements. Throughout history, government has played a crucial
role in the development of the money contract. Today, it allows us
to operate in a highly ef¿cient ¿at money exchange system. But our
¿at holds its value only if our Federal Reserve keeps the supply of
money from growing too rapidly. If the Fed fails, inÀation results—
and inÀation is the modern counterpart to seigniorage.

Important Terms

barter: Exchange without money.

commodity money: A particular commodity that is agreed upon in the

society to be acceptable for exchange.

¿at money: Money that is valuable in exchange because a government has

declared it to be.

money: Something that can be used as a medium of exchange.

seigniorage: The revenue that a government obtains by deÀating the value

of its money.

Suggested Reading
Lecture 2: Money as a Social Contract

Einzig, Primitive Money.

Jackson, The Oxford Book of Money.
Radford, “The Economic Organization of a P.O.W. Camp.”
Smith, The Wealth of Nations.

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