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

In the previous post, I discussed the gold standard’s phase-out. When we used commodity money, we developed a medium of account (MoA) valid for both gold and cash. This could only occur if one was fixed to the other. Silver was phased out in the nineteenth century, and gold was phased out in 1968, following a rise in gold prices in the second half of the twentieth century. Following this, only the currency remained MoA.

Why is fiat money valuable? This question is actually composed of two distinct inquiries. To begin, how do we define the value of a MoA to society? Second, how does a nominal MoA acquire value? MoA is both a medium of exchange and a store of value. What might an asset performing these functions be worth? Its value as a medium of exchange is probably 1% of GDP, and its value as a store of value is between 1% and 10% of GDP. Thus, how can we be sure? Because MOAs have historically been interest-free. Thus, the stock itself is the net value of the interest for which the cash stock is forfeited. Furthermore, currency reserves typically range between 1% and 10% of GDP.

Occasionally, you will hear someone assert that fiat money is “essentially” worthless. What exactly does this imply? If fiat money loses its function as a medium of exchange, it loses all value. On the other hand, gold and silver are valuable in other fields, and this is not the case for them.

This situation then reveals a more fundamental issue: while the monetary system is unquestionably valuable, this does not explain why an asset is assigned a monetary value. We were unable to deduce its worth from the preceding questions. Numerous theories on this subject may be mutually exclusive:

  1. Unlike t-bills, it has a fixed nominal price, making it suitable for transactions. In comparison to t-bills, they are obtained at favorable nominal values. Private small denomination currency issue may be banned.
  2.  There is some social contract/bandwagon effect at work here. This is probably the most frequently encountered response: Individuals will accept it as money simply because everyone else will.
  3. In an emergency, assistance can be provided. For instance, suppose technological advancements render cash obsolete by 2049. The public may believe that the government will redeem it for some sort of asset in this situation rather than allowing hyperinflation. This can be interpreted as public confidence in the government’s ability to prevent hyperinflation.
  4. The government permits individuals to pay taxes using this unit, thereby legitimizing it.
  5. The unit is backed by assets on the balance sheet of the central bank.

Indeed, all of these theories are compatible with one another. During the final years of the gold standard, the majority of people preferred to pay with cash and small coins. This situation conditioned people to view cash as money. If you were an economist studying inflation in 1968, the demise of gold as a medium of exchange would appear to be a critical decision. On the other hand, the public was unconcerned about this because they were already accustomed to using money as money. Appearance and aesthetics are critical in economics (and politics): if something is used as money, it is money.

Indeed, even if only the social contract/bandwagon effect is sufficient from this point forward, this does not mean that other factors are absent – rather, they are concealed in the shadows. If the public expected the government to begin hyperinflation tomorrow, the value of cash would plummet.

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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