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For most of human histor y societies have functioned without money. The development of tokens to represent value is a relatively modern development and for thousands of years those tokens were deemed to have an intrinsic value. It is only in the last 500 years or so that money has been represented by tokens with a legal status but no intrinsic value. At first such notes were issued backed by real physical assets (gold) but today that linkage has been completely broken. The most commonly used mediums for money in historic times were gold and silver. Other more exotic currencies, to our way of thinking at least, have included salt and cowr y seashells. Gold in par ticular has always had a fascination because of its unique physical qualities. Gold does not tarnish as silver does or rust as iron does. It can be beaten into extremely thin leaf.
It has attractive, decorative qualities and is used widely in jewelr y. It is of a uniform standard – gold from Egypt cannot be distinguished from gold extracted from the New World. This is not the case with organic products such as coffee or saffron. At the time of writing the price of saffron was around $400 an ounce, in line with that of gold, but prices var y depending on quality and source. Gold also has a scarcity value. It is not a common element and is difficult to extract from the ground. It is a ver y dense element and requires little storage space.
When gold is used as a medium of exchange it provides a way in which different products and ser vices can be given equivalent values in terms of a given weight of gold. To illustrate this point we use a highly stylized example taken from Dreamworld.
Dreamworld is a wonderful place where cream and chocolate are not fattening and air planes leave on time. When necessar y in Dreamworld we can assume no transaction costs, no taxes, no bid–offer spread, we can borrow or lend what we choose at the risk-free rate whenever we want, companies pay dividends only when required, there is no counter par ty risk and we don’t need to worr y about capital allocation issues! Dreamworld has a ver y convenient location and is populated largely by finance academics. One group can use the power of its simplifying assumptions to formulate fundamental theories. The second group woks on how to modify these theories to take the chosen assumptions into account.
In this example we will ignore the costs of capital investments, taxes and transaction costs, the impact of skill levels on labor costs and so on. We will take only human labor into account. Suppose it takes 10 days of human labor to produce one ounce of gold, five days to make a table, 20 days to build a car t and one day to clean a house. For the markets to be in equilibrium the table should be sold at half an ounce of gold, the car t for two ounces and the cleaner should get one-tenth of an ounce for his daily efforts.
In periods of high inflation or uncer tainty over the future value of paper money many people turn to gold as a way to preser ve value. A paper currency may lose all of its value in the event of a regime change or a militar y defeat. Gold hidden in a hole in the garden provides a way to preser ve value. It is a generally accepted axiom (although not always borne out by facts) that the price of gold rises in terms of political and economic uncer tainty. There are, however, significant problems with using tokens that have an intrinsic value as money:
Transaction costs. Gold is completely negotiable and there is no foolproof way to establish ownership. Gold ornaments or coins can be melted down and recast as standard bars. Its density makes it difficult to move large amounts easily and this also makes it vulnerable to loss. The physical deliver y of gold involves risks arising from natural disasters such as a ship sinking in a storm or human inter vention in the form of theft. Gold has to be kept in a secure location and shipments require tight security. Transport has been both slow and difficult for most of human histor y. All of these factors push up transaction costs.
Costs to the economy. Gold’s intrinsic value comes from demand for its use in jewelry, in specialist applications such as the decoration of churches and temples and, in modern times, in the electronic and space industries. Gold extraction requires significant capital investment and labor and is the source of damaging environmental pollution. Using gold as a medium for money ties up capital and human resources that could be used in a more productive manner. King Midas learnt the hard way that gold cannot satisfy human hungers.
The world’s central banks all have vaults where they store their gold reser ves. Between them they hold thousands of tons of gold. The US gold reserve is held at Fort Knox, one of the world’s most secure facilities, where it is jealously guarded. At least squirrels use their hoards to help them sur vive the winter. There is something delightfully ironic about a system where one group of people expend huge effor t to extract a metal from one hole in the ground which is then sold to another group of people who, at huge expense, put it in their own hole in the ground.
Supply and demand. Our simple example showing the equivalence of values in gold based on labor inputs looked only at the supply side. Suppose that demand for car ts exceeded that which could be produced. In this situation car t builders might be able to sell each cart they made at 21/2 ounces of gold. This would attract people making tables or digging for gold to switch to making car ts and would result in a reduction in the supply of gold and tables, pushing up the price of tables relative to car ts and lowering the price of car ts in terms of gold. This would continue until equilibrium between the markets was re-established.
When the Spanish discovered huge quantities of gold in the New World, much of it already extracted and refined, they thought they had made their for tunes – and many of the early conquistadors did. But the huge influx of gold had a much wider impact. With the supply of gold (money) expanding rapidly the price of real goods and ser vices in terms of gold rose. In modern times this would be seen as a period of high inflation. There was no change in the real output of the Spanish economy but a transfer of wealth took place from those who had held gold as a store of value and those on fixed incomes to people who had invested in real assets.
Debasement. A gold or silver coinage can be debased in one of three ways. Ver y pure gold is ver y soft and is usually mixed with a base metal, such as silver, to make a harder alloy. A carat, or karat, is a measure of the propor tion of precious metal in an alloy. Twenty-four-carat gold is pure gold while 18-carat gold is 18/24 or three-quar ter gold. The authority to mint coins in medieval times usually rested with the monarchy.
A king could make his gold go fur ther by increasing the level of silver contained in newly minted coins. In some instances the coinage in circulation would be recalled, melted down and reissued in a debased form. For obvious reasons people preferred to hold onto older coins with the same nominal face value but a higher gold content. People tried to pay for goods and ser vices with coins that had the lower gold content. This is the basis for what is known as Gresham’s law, “Bad money drives out good money”, after Sir Thomas Gresham the master of the royal mint in the reign of Elizabeth I. In modern times the US dollar has become the preferred currency in many developing and transitional economies. This reflects greater confidence in the US dollar retaining its value and being conver tible than in the local currency.
A second method was to shave metal off the edges of the coins. To tr y to prevent such practices coins were produced with serrated edges. Most countries continue to produce coins milled in this manner but the serrated edges are now only useful in slot and vending machines. The last method was to take a lower value base metal, such as lead, and to produce counterfeit gold-plated coins.

Money is a commodity that we tend to take for granted. Most of us think of money as cash, but cash is just a small por tion of broad money. Most financial transactions are conducted using checks, electronic transfer of funds or credit cards. Economists have a number of different definitions of money. We do not need to define these here par ticularly as definitions vary from country to countr y and this is ver y much moving into the realm of macroeconomics. It is, however, worth reviewing the three fundamental functions that money performs.
Accounting basis. Money provides a means of accounting for the value of real goods. It allows, for example, one to compare the cost of a cup of coffee with the price of a telephone call.
Store of value. Money represents a form of savings, whether it is in the form of a bank deposit or cash. It provides a means of making purchases of real goods and ser vices in the future. It is not a good store of value in an inflationary environment, however.
Means of exchange. Money provides a means of exchange for real goods and ser vices. In the absence of money transactions between two par ties would have to be done on a barter basis. Bar ter is a ver y inefficient means of effecting transactions. Money reduces transaction costs and makes the real economy more efficient.
The first subjects to examine are how money is created and the role of banks in that process. In most countries the central bank controls how much money is created. The creation of money has always reminded me of a magician’s sleight of hand. While your intellect tells you one thing no matter how many times you see the trick it is still impossible to work out how it is done. The ancient street hustle of the “three cup” trick is a good example. In the case of money the con is contained in the word confidence.