Back to Basics, Pt. 2: It’s all about appearances

In the previous post, I covered the phase-out of the gold standard. During the times when we were using commodity money, a medium of account(MoA) was developed that is valid for both gold and cash. For this to happen, one had to be fixed on the other. Silver was abandoned in the 19th century, and gold was abandoned in 1968 after gold prices rose in the second half of the 20th century. After this point, only the currency remained as MoA.

Why is fiat money worth something? This question actually contains two different questions. First, how do we define the value to society of having a MoA? And second, how can a nominal MoA have value? MoA is a tool for exchange and can also be considered as a store of value to a point. What might an asset with these roles be worth? Its value as a medium of change is probably 1% of GDP, and as a store of value, it is somewhere between 1% and 10% of GDP. So how can we know that? Because MOA traditionally did not pay interest. Therefore, the net value of the interest for which the cash stock is forfeited is the stock itself. And currency stocks tend to be between 1% and 10% of GDP.

Sometimes you hear people say that fiat money is “essentially” worthless. What does this mean? If fiat money loses its role as a MoA, it has no value. However, gold or silver is also important in other fields, and this is not the case for them. 

This situation then reveals a deeper problem: Of course the monetary system is valuable, but this does not explain why an asset is considered a monetary value. We couldn’t learn what valued him from the above questions. There are several theories that may be compatible with each other on this subject:

  1. Unlike t-bills, its nominal price is fixed, which makes it suitable for transactions. Unlike t-bills, they are obtained at favorable nominal values. Private small denomination currency issue may be banned.
  2.  Some kind of social contract/bandwagon effect. This is probably the most common answer you come across: People will take it as money because everyone else will.
  3. Support can be provided in an emergency. For example, let’s say technological change is expected to make cash obsolete by 2049. The public may believe that the government will redeem it for some sort of asset instead of allowing hyperinflation in this situation. This can be thought of as public confidence that the government will not allow hyperinflation.
  4. The government allows individuals to pay taxes with this unit, thus making it official.
  5. The unit is supported by assets on the central bank balance sheet.

In fact, all of these theories may be correct, they are compatible with each other. In the last days of the gold standard, people mostly preferred to use cash and small coins. This situation made people get used to seeing cash as money. If you’re an economist looking to study inflation in 1968, the end of gold as a MoA would seem like a crucial decision to you. However, the public did not care much about this – they were already used to using money as money. Appearances and aesthetics are quite important in economics(as well as politics): if something is used as money, then it is money.

In fact, even just the social contract/bandwagon effect is sufficient from this point forward, but that doesn’t mean that other factors are absent – rather they are hidden in the shadow. If the public had expected that the government would suddenly start hyperinflation tomorrow, the value of the cash would collapse.

This post has been long enough, so I’ll leave it for the next post to study the money quantity theory. In the next post, we will see how and using what tools the central bank can control the value of money(and naturally, NGDP).

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