The Role of Money

Summary

In Section 1, it is argued that the need for money as a means of payment is caused by the existence of uncertainty. A distinction is drawn between the narrower concept of a means of payment and the broader concept of a medium of exchange. A medium of exchange, but not a means of payment, would be needed even in an economy where everyone was certain of future events. In Section 2, the lack of personal information on the credit standing of the prospective purchaser is put forward as the main uncertainty that forces us to use a means of payment rather than rely on credit arrangements. Once forced into using a means of payment, the use of money is much more efficient than barter in a market context, though the range of transactions which do not pass through markets at all but are internalised in social groups is often underestimated. In order to serve as a means of payment, an object should embody sufficient information to make it generally acceptable without detailed and costly investigation. As is shown in Section 3, fiat currency can serve this purpose since its value is based on the power of the state. This power enables the authorities to enjoy seignorage, the margin between the nominal value of the notes and coin issued and the costs of their production. Since these production costs are very low, the authorities could in theory issue sufficient fiat money to buy up any additional quantities of goods and assets required. They are held in check in practice by the political unpopularity of the ensuing inflation. The existence of a gap between the real costs of issuing financial liabilities and their value makes it worthwhile for intermediaries (banks) to bid for deposits of currency by offering attractive substitute assets. During the nineteenth century transfers between current accounts (demand deposits) of banks became accepted as final payment, and so these deposits should also be included in the definition of money, as argued in Section 4. But the instrument that sets the payment transmission process in motion, the cheque payment, does not contain full information about the payer’s credit standing, etc., so that the transfer process contains more credit elements than in the case of cash payment.

The recent experience of inflation, a monetary phenomenon, has raised the question whether existing institutions — e.g., the government monopoly in the provision of fiat currency — have been partly responsible. Hayek has advocated more competition in the provision of currency, and other proposals for structural change and rules to determine the form and growth of the monetary base have been mooted. It has been suggested that it is unnecessary, and possibly undesirable, for the Government even to define the form of dominant base money and that banks could compete in the provision of alternative monetary units. It has also been suggested that the authorities present ability to influence monetary conditions lies precisely in their legal ability to restrict any such competition in the provision of currency. These various novel ideas are assessed in Section 5.