Another way a bank could create claims against itself was to issue bank notes. In London, goldsmith bankers introduced bank notes about the same as they introduced checks. Bank notes were pieces of paper that promised to pay the bearer a specific amount in gold when presented to the issuing bank for redemption. Whereas only the individual to whom the deposit was directed could redeem checks, notes could be redeemed by anyone who held them. Notes redeemable for gold or another valuable commodity are called fiduciary money. Fiduciary money was often "as good as gold" since the bearer could, upon request, redeem the note for gold. In some ways fiduciary money was better than gold because it took up less space and was easier to carry.
The amount of fiduciary money issued depended on the bank's estimate of the proportion of notes that would be redeemed for gold. The greater the redemption rate, the fewer notes could be issued based on a given amount of gold reserves. Initially, these promises to pay in gold were issued by private individuals or banks, but over time governments developed a larger role in their printing and circulation. The tendency to redeem notes for gold depended on the note holder's confidence in the bank's willingness to do so upon request.
Once fiduciary money became widely accepted, it was perhaps inevitable that governments would begin issuing fiat money, which consists of notes that derive their status as money by power of the state, of fiat. Fiat money is money because the government says it is money. Fiat money is not redeemable for anything other than more fiat money; it is not backed by a promise to pay something of intrinsic value. You can think of fiat money as mere paper money. It is acceptable not because it is intrinsically useful or valuable but because the government requires that it be accepted as payment. Fiat money is declared legal tender by the government, meaning that creditors must accept it as payment for debts. Gradually, people came to accept fiat money because of the belief that others would accept it as well. The money issued in the United States today and, indeed, paper money throughout most of the world is now largely fiat money.
The Value of Money
Why does money have value? As we have seen, various commodities served as the earliest moneys. Commodities such as corn or tobacco had value in use even if for some reason they became less acceptable in exchange. The commodity feature of the money bolstered confidence in its acceptability. When paper money came into use, acceptability was initially fostered by the promise to redeem it for gold or silver. But since most paper money throughout the world is now fiat money, there is no promise of redemption.
So why can a piece of paper bearing the image of Alexander Hamilton and a 10 in each corner be exchanged for a large pepperoni pizza or anything else selling for $10. People accept these pieces of paper because they believe others will do so. Fiat money has no value other than its ability to be exchanged for goods and services now and in the future. Its value lies in people's belief in its value.
The value of money is reflected by its purchasing power—the rate at which money is exchanged for goods and services. The higher the price level is, the fewer goods and services can be purchased with each dollar, so the less each dollar is worth. The purchasing power of each dollar can be compared over time by accounting for changes in the price level. To measure the purchasing power of the dollar in a particular year, first compute the price index for that year, then divide 100 by that price index. For example, the consumer price index for 1986 was 328, using 1967 as the base year. The value of a 1986 dollar is therefore 100/328, or about SO.30 measured in 1967 dollars. Thus, a 1986 dollar buys less than one-third the goods and services purchased by a dollar in 1967.
Too Much and Too Little Money
Money serves as a medium of exchange, a standard of value, and a store of wealth. One way to understand these functions of money is to look at situations in which money did not perform these functions well. Money may not function well as a medium of exchange because there is too little money, too much money, or because the price system is not allowed to operate. With prices growing by the hour, money no longer represented a stable store of wealth, so people were unwilling to hold money. With rapidly rising prices, relative prices also became distorted, so buyers and sellers had difficulty knowing the appropriate price of each good. Thus, money became less useful as a standard of value—that is, as a way of comparing the price of one good relative to another. Money still served as a medium of exchange, but as larger and larger amounts of money were needed to carry out the simplest purchases, money became more cumbersome. Exchange demanded more time and energy. In short, when there is too much money, the economy becomes less productive than when there is an appropriate amount of money.
On the other hand, if there is too little money in the economy or if the price system is not allowed to function, the economy may be reduced to barter, and, as we have seen, barter is inefficient. For example, just after World War II money in Germany became -largely useless because, despite tremendous inflationary pressure in the economy, occupation forces imposed strict price controls. Since prices were set well below what people thought they should be, sellers stopped accepting money, forcing people to use barter. Experts estimate that because of the lack of a viable medium of exchange, the German economy produced only half the output that it would have produced with a smoothly functioning monetary system. The German "economic miracle" that occurred after 1948 can be credited in large part to that country's adoption of a reliable monetary system. It has been said that no machine increases the economy's productivity like properly functioning money. Indeed, it seems hard to overstate the value of a reliable monetary system. Consider in the following case study a more contemporary example of the official currency failing to serve well as a medium of exchange.
Just as the division of labor creates the need for exchange, exchange creates the need for money. With money, exchange need not rely on the double coincidence of wants required with barter. People can sell their labor in return for money to be used for future consumption.
Barter was the first form of exchange. As the degree of specialization grew, it became more difficult to uncover the double coincidence of wants required with barter. The time and inconvenience involved with barter led even simple economies to introduce money.
Money serves three primary functions: a medium of exchange, a standard of value, and a store of wealth. The first money was commodity money, where a good such as corn served also as money. With fiduciary money, the second type of money introduced what changed hands was a piece of paper that could be redeemed for something of value, such as silver or gold. The third type of money introduced was fiat money, which is paper money that can not be redeemed for anything other than more paper money. Fiat money is given its value as money by law. Most currencies throughout world today are fiat money.