The Pure Commodity Standard of Money
If there had been no money, trade would have been by barter. You can imagine how ineffective the barter system would have been. In a barter system, people exchange goods and services for other goods and services. Therefore, the barter system requires the double coincidence of wants.
What if there were a barter system now? Suppose you want to learn about international finance, and a professor knows something about international finance.
In a barter system, they would have met in the market, with you carrying a sign stating, I need lessons in international finance, and, in exchange, I can cook for whoever would teach me the subject, and the professor carrying a sign stating, I can teach international finance, in exchange for cooking.
Why was there a change from the barter economy to an economy with money? When you note the places where the first examples of money appeared, it is clear that societies that were engaged in regional and even international trade must have realized the inefficiencies of the barter system. Among these societies with early examples of money are civilizations of Asia Minor, China, the Indus valley, and the Nile valley.
A common characteristic of most of these early civilizations were that they were located in fertile regions and enjoyed surplus agricultural production. Their increasing exchange of agricultural goods with other types of goods (spices, textiles, metals, and so forth.) in a barter setup may have motivated the idea how efficient a monetary economy could be.
The first examples of money were coins of precious metals, such as gold or silver coins, which may date back to seventh century BC in Asia Minor and China. The first metallic standard is also called the pure metallic standard (gold or silver specie standard).
Note that, even 3,000 years ago, civilizations understood that you shouldn’t grow money in your backyard. If you did, rapidly increasing money supply would lead to higher inflation rates, thereby decreasing the purchasing power of money. Therefore, instead of using beans or olives as money, civilizations used precious metal coins, because the supply of precious metals is limited.
Sometimes people are nostalgic and think that monies of yesteryears were more reliable. For example, you may think that having coins in circulation made of precious metal would make an economy inflation-proof. However, the rulers understood how to create income for themselves even in a pure metallic standard.
Whenever the ruler’s treasury needed extra funds (for example, to finance a war) it reduced the precious metal content of coins and replaced it with an inexpensive metal, which is called debasement. If the initial gold content was 99 percent, the ruler decreased it to 75 percent, for example, and used the difference to buy whatever he needed to buy.
Rulers of these early civilizations were also clever enough to keep the look of the debased coins the same as the good ones. Early bankers or businessmen could put the coins to some tests, such as weighing them, and determine which ones were debased, but simple folks couldn’t do so.
Gresham’s Law states that bad money drives out good money, meaning that people who knew the difference between good and debased coins used the debased ones as payments for goods and services and saved the good coins. Good coins disappeared from circulation, and bad coins in circulation drove up prices.
In addition to debasement, new gold mines may have been discovered. Such a discovery then increased the amount of gold in circulation, thereby increasing the price level and creating inflation. This exact scenario happened in Spain when expeditions to new continents brought back gold and silver in the late 15th and 16th centuries. Therefore, even in a pure commodity standard, inflation is possible.