TOPIC 1
EVOLUTION OF MONEY
Introduction
In this lesson we are going to look at the historic background of money, what
constitutes
money, and its use in international trade. We shall also look at nominal and real prices
Money and Its Use in International Trade.
When specialization takes root as a mode of production in society, the logical sequel
is to barter and trade the surplus of the specialized output with other products made
by other people who have also specialized in their arts and trades.
In an unsophisticated society with least exposure to outside influences, the barter
system of trade is adequate to meet the exchange needs of society’s members.
However, the barter system of exchange has limitations in the absence of what
Stanley W. Jevons called a “double coincidence” of wants (Jevons, 1892)
With the absence of a “double coincidence” of wants, each person must make a
multiplicity of exchanges before acquiring the required goods and services.
The problem encountered by lack of “double coincidence” of wants can be overcome
when, through practice and custom, certain items of trade are accepted by the
majority of participants in trade as intermediate items or medium of exchange.
When this happens, these intermediate items or medium of exchange are called
commodity money.
In Kenya, cattle, camels, sheep and goats have played the role of commodity money
from time immemorial to date.
Each country in the world has at one time of its history used commodity money in
its trade transactions (Einzig, 1966).
However, for over 4000 years, the dominant intermediate item that has served as
commodity money is a group of precious metals, mostly silver, gold and, to a lesser
extent, copper. (Gary Smith, 1991)
Precious Metals versus Paper Money
Precious metals have many characteristics that are desired in commodity money.
They are intrinsically useful, convenient to carry, divisible and durable.
Their one major drawback is that, without expertise and technology, precious metals
are not easily verifiable for weight and purity.
To minimize the problem of debasing metal money by clipping, shaving or filing
bits of metal from the coins, governments passed legislation that defined the metal
content of a designated pure or full-bodied coin of gold, silver or copper.
, Full-bodied coins are currency coins made of pure currency metal, the size and
weight of which are defined by the monetary authority e.g a sterling pound gold
coin in Britain, a dollar gold coin in USA or the 1960s East African five-shilling silver
coin.
Before this legislative measure, the existence of coins of varying authenticity led to
Gresham’s law of 1558 which states: Bad money drives out good.
What this law meant in real life was that merchants hoarded pure quality coins or
full-bodied coins while they released into circulation lower quality coins.
In most cases, full-bodied coins were hoarded for purposes of performing the other
important role of money, viz: as a store of value.
To avoid the problems of debasing or hoarding full-bodied coins, use of difficult- to
–counterfeit paper money was printed as substitutes to coins.
The paper money had to be fully backed by precious metals held by the printer of
the paper money.
This meant that any holder of paper money had a right to its equivalent in precious
metals on demand.
Coins made of precious metals and paper money that is fully backed by metal, are
called “hard money.”
On the other hand, “soft money” usually refers to token coins and paper money that
are not backed by precious metal e.g. Kenya’s currency in circulation.
One big advantage of soft money is that, by Gresham’s law, there is little or no
incentive to hoard it and is kept in circulation to fulfill its other two functions as a
medium of exchange and as a unit of account.
Demand for and Supply of Precious Metals (Specie)
Just like any other economic good, the supply and demand for precious metals
determine their price.
On the supply side of specie, in the sixteenth century, the flooding of precious
metals from the New Lands (the Americas) to Spain as a result of Christopher
Columbus’ navigation adventure caused the first recorded continent-wide inflation
in Europe.
The resultant quintupling of prices in Spain during this period was quickly transmitted
to all Europe through trade because Madrid, the capital of Spain, was the center of
international trade at the time.
Similarly, the California gold rush in the first half of the nineteenth century caused
inflation in north America in the 1850’s.
The first recorded inflation throughout Europe in the 16th century caused social
tensions:
, Prices of goods and services in Europe rose dramatically Prices of labour (wages)
did not rise in tandem with those of goods.
Jean Bodin in his reply to the paradoxes of M. Malestroit came up with the first
fundamental principles of the quantity theory of money in 1568, which states:
“If the quantity of money in circulation is increased without a comparable increase in
the suppl y of goods, prices tend to react upwards.”
Later, students of economics discovered that an increase in the rate of circulation of
money had the same effect on price as an increase in the volume of money.
More recently, scholars have stressed that the course of prices is also influenced by the
rate at which people use their free balances for present (current) consumption as
opposed to investment (development) expenditure.
Sixteenth century contemporaries realized that price level rises (inflation) favored
debtors and penalised creditors.
It was clear to all that debtors had to produce less goods than before to meet their
money obligations
Debtors therefore got more money per unit of what they produced
Creditors were being repaid in terms of money, which bought only a fraction of
the goods it could have bought previously.
For manufacturers, they kept wages low despite the high prices of goods
As a result, their revenues were very high, causing profit inflation.
On the demand side of specie, it was during the mercantilists period (1500-1750), that
the demand for precious metals (specie) reached feverish peak.
During this period, accumulation of specie became an obsessions of merchants who
were eager to become wealthy and powerful.
For those countries, which did not posses mines of precious metals, or colonies with
mines of precious metals, the easiest option available to their merchants to accumulate
specie was through foreign trade of goods and services.
During the mercantilist era, the general belief was that specie (money in form of
gold and silver) was a source of wealth and power.
The pursuit of specie-accumulation was considered both an individual
merchant’s goal and a national duty.
Thus, during this period, national policy was geared towards encouraging specie
inflow (through promotion of exports), while specie outflow was discouraged by
restricting imports.
EVOLUTION OF MONEY
Introduction
In this lesson we are going to look at the historic background of money, what
constitutes
money, and its use in international trade. We shall also look at nominal and real prices
Money and Its Use in International Trade.
When specialization takes root as a mode of production in society, the logical sequel
is to barter and trade the surplus of the specialized output with other products made
by other people who have also specialized in their arts and trades.
In an unsophisticated society with least exposure to outside influences, the barter
system of trade is adequate to meet the exchange needs of society’s members.
However, the barter system of exchange has limitations in the absence of what
Stanley W. Jevons called a “double coincidence” of wants (Jevons, 1892)
With the absence of a “double coincidence” of wants, each person must make a
multiplicity of exchanges before acquiring the required goods and services.
The problem encountered by lack of “double coincidence” of wants can be overcome
when, through practice and custom, certain items of trade are accepted by the
majority of participants in trade as intermediate items or medium of exchange.
When this happens, these intermediate items or medium of exchange are called
commodity money.
In Kenya, cattle, camels, sheep and goats have played the role of commodity money
from time immemorial to date.
Each country in the world has at one time of its history used commodity money in
its trade transactions (Einzig, 1966).
However, for over 4000 years, the dominant intermediate item that has served as
commodity money is a group of precious metals, mostly silver, gold and, to a lesser
extent, copper. (Gary Smith, 1991)
Precious Metals versus Paper Money
Precious metals have many characteristics that are desired in commodity money.
They are intrinsically useful, convenient to carry, divisible and durable.
Their one major drawback is that, without expertise and technology, precious metals
are not easily verifiable for weight and purity.
To minimize the problem of debasing metal money by clipping, shaving or filing
bits of metal from the coins, governments passed legislation that defined the metal
content of a designated pure or full-bodied coin of gold, silver or copper.
, Full-bodied coins are currency coins made of pure currency metal, the size and
weight of which are defined by the monetary authority e.g a sterling pound gold
coin in Britain, a dollar gold coin in USA or the 1960s East African five-shilling silver
coin.
Before this legislative measure, the existence of coins of varying authenticity led to
Gresham’s law of 1558 which states: Bad money drives out good.
What this law meant in real life was that merchants hoarded pure quality coins or
full-bodied coins while they released into circulation lower quality coins.
In most cases, full-bodied coins were hoarded for purposes of performing the other
important role of money, viz: as a store of value.
To avoid the problems of debasing or hoarding full-bodied coins, use of difficult- to
–counterfeit paper money was printed as substitutes to coins.
The paper money had to be fully backed by precious metals held by the printer of
the paper money.
This meant that any holder of paper money had a right to its equivalent in precious
metals on demand.
Coins made of precious metals and paper money that is fully backed by metal, are
called “hard money.”
On the other hand, “soft money” usually refers to token coins and paper money that
are not backed by precious metal e.g. Kenya’s currency in circulation.
One big advantage of soft money is that, by Gresham’s law, there is little or no
incentive to hoard it and is kept in circulation to fulfill its other two functions as a
medium of exchange and as a unit of account.
Demand for and Supply of Precious Metals (Specie)
Just like any other economic good, the supply and demand for precious metals
determine their price.
On the supply side of specie, in the sixteenth century, the flooding of precious
metals from the New Lands (the Americas) to Spain as a result of Christopher
Columbus’ navigation adventure caused the first recorded continent-wide inflation
in Europe.
The resultant quintupling of prices in Spain during this period was quickly transmitted
to all Europe through trade because Madrid, the capital of Spain, was the center of
international trade at the time.
Similarly, the California gold rush in the first half of the nineteenth century caused
inflation in north America in the 1850’s.
The first recorded inflation throughout Europe in the 16th century caused social
tensions:
, Prices of goods and services in Europe rose dramatically Prices of labour (wages)
did not rise in tandem with those of goods.
Jean Bodin in his reply to the paradoxes of M. Malestroit came up with the first
fundamental principles of the quantity theory of money in 1568, which states:
“If the quantity of money in circulation is increased without a comparable increase in
the suppl y of goods, prices tend to react upwards.”
Later, students of economics discovered that an increase in the rate of circulation of
money had the same effect on price as an increase in the volume of money.
More recently, scholars have stressed that the course of prices is also influenced by the
rate at which people use their free balances for present (current) consumption as
opposed to investment (development) expenditure.
Sixteenth century contemporaries realized that price level rises (inflation) favored
debtors and penalised creditors.
It was clear to all that debtors had to produce less goods than before to meet their
money obligations
Debtors therefore got more money per unit of what they produced
Creditors were being repaid in terms of money, which bought only a fraction of
the goods it could have bought previously.
For manufacturers, they kept wages low despite the high prices of goods
As a result, their revenues were very high, causing profit inflation.
On the demand side of specie, it was during the mercantilists period (1500-1750), that
the demand for precious metals (specie) reached feverish peak.
During this period, accumulation of specie became an obsessions of merchants who
were eager to become wealthy and powerful.
For those countries, which did not posses mines of precious metals, or colonies with
mines of precious metals, the easiest option available to their merchants to accumulate
specie was through foreign trade of goods and services.
During the mercantilist era, the general belief was that specie (money in form of
gold and silver) was a source of wealth and power.
The pursuit of specie-accumulation was considered both an individual
merchant’s goal and a national duty.
Thus, during this period, national policy was geared towards encouraging specie
inflow (through promotion of exports), while specie outflow was discouraged by
restricting imports.
