The Role of Money in Trade and Economics

Is money a means or ends?  Confusion over the answer to this question dominates much of the popular conversation regarding economic policy and methods.  Those who see money as an end tend to focus on the production side of economics; wealth is generated by producing and selling things.  The more you sell, the higher your profit, the more wealthy you are (this is the main argument behind mercantilism).  When money is treated as a means, then the focus tends to shift more towards the consumption and trade side of economics: wealth is created when people trade things of lesser value for things of higher value (this is the main argument behind free trade).  Precisely exploring the role of money in trade and economics will go a long way to understanding the means of wealth in society.

Money does not predate economic activity.  Money arose out of economic necessity.  In a simple two-person word, it’s easy to see how a barter economy based on comparative advantage can develop.  One person can make fishing hooks while the other fishes, for example.  They specialize in their comparative areas of expertise and barter physical goods for physical goods.  Both are made better off without the need for money.

But, as the world expands, the barter economy becomes more complex and can start to break down.  That is because barter requires double coincidence of wants.  In other words, to successfully barter, you need something that the other person wants.  I am an academic.  In a barter economy, all I can offer are my economic writings.  If I go to the grocery store and the grocer just happens to want an economic tome for the same amount of groceries I just happen to want, then a trade can be arraigned.  But, if he doesn’t, then no trade can occur.  What can solve this problem?  Well, what if there were some medium of exchange, something that both he and I wanted that could be exchanged in lieu of the physical goods/services but could itself be exchanged for physical goods/services?  A numeraire, if you will?  That numeraire is what we call “money.”

Money solves the double coincidence of wants problem.  I can sell my economic ramblings to some university or bookstore patron in exchange for money and turn around and exchange that money for groceries.  The bookstore patron needn’t necessarily have anything physical I desire other than his money; he needn’t provide me any good or service (he’s already done that for someone else).  He need only give me some pieces of paper.  Likewise, I needn’t perform any services for the grocer (I’ve already done that by providing the book to the patron).  I need only supply her with the desired amount of money.

Money also acts well in reducing transaction costs by being divisible.  Going back to our barter example, neither fish nor fishhooks are particularly dividable.  Selling someone one-and-a-half fishhooks is to really sell them one fishhook and a broken fishhook.  A barter deal may not come about because the amount needed to be exchanged in intact units would be too high.  But money solves this problem.  If, for example, my book sells for $10 and the number of groceries I want to purchase cost $5, then I can essentially sell half-a-book to pay for my grocery bill because money can be divisible.  So, the introduction of money as a numeraire into trade increases the number of transactions, thus the depth of the market and the potential wealth gains, into an economic system.

But, as this discussion shows, money is merely a means of increasing the number of transactions.  The goal is not to acquire money, but rather to acquire money in order to be exchanged for something else (don’t believe me?  How many people are clamoring for forms of money, like the Murphy-Bill, to pay bills?  I got a whole bunch of them for anyone who wants them).  In any given transaction, one may exchange their good/service for money, but that is because the money they acquire is desired to be used in other, more valuable, means (if the value they got from the money was less than the value they got from the labor, they’d not exchange).  Money, in and of itself, provides no other uses (indeed, one of the reasons something is chosen as money is because it has no other use.  For example, would anyone want pictures of dead people and numbers on paper if they couldn’t be exchanged for something else?).  You cannot eat money.  It can only satisfy wants and demands by being exchanged.

Let’s apply this reasoning to international trade.  Money is a means to an ends (consumption).  Thus, people trade with other people on the other side of political borders in order to consume.  Just as I traded my money with the grocer to consume food, I traded a few bills with a French producer to consume gin.  I “exported” my labor to the grocery store so I could “import” food.  I “exported” my labor to the French distiller so I could “import” gin.  Thus, we can see that “exports” are what are given up in a trade (the cost) and “imports” are what are gained (the benefit).  Unfortunately, much popular conversation surrounding trade has this exactly backward.  A “successful” trade is one where a person (or group of people called a “nation”) export more than they import.  In other words, they give up more than they get.  This would be akin to saying the person who is a “successful” grocery shopper is the one who spends the most at the grocery store and gets the least in return.  The “smart” shopper spurns all bargains, sales, discounts, and specials.  Indeed, the “winning” shopper would be the one who demands he pay higher prices.  The “best” shopper “laughs” at all the other shoppers who are buying food in bulk, buying what’s on sale, buying specials.  He laughs at the foolish shopper who, by taking advantage of low prices, buys a month’s worth of food for a week’s salary while he buys a week’s worth of food for a month’s salary.

If we treat money as something that merely represents a divisible number of physical goods and services, we can see that all trade is still ultimately bartering.  Just as the goal of barter exchange is to get as much as possible while giving up as little as possible (that is, to “import” as much as possible while “exporting” as little as possible), the goal of trade is to get as much as possible (import) while giving up as little as possible (export).  the inclusion of money into the equation does not change the underlying logic.

3 thoughts on “The Role of Money in Trade and Economics

  1. Love it. I’m assigning this post to my home schooled grandson as a reading assignment for Economics..With proper attribution of course!

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  2. Which is why I’ve decided there is no trade deficit.
    Since trade, at least uncoerced trade, occurs at the margin where the items being traded are equal in value, international trade means exchanging some amount of money for goods worth that amount. Hence, the deficit is zero.

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  3. >—-“But, as this discussion shows, money is merely a means of increasing the number of transactions.”

    The word “merely” is up to mischief here. Money certainly IS a means of increasing there number of transactions. Showing that does not in any way prove that that is the ONLY effect of money. And it’s not the only effect of money.

    Many people see a value in holding money they never expect to spend. People often value money for the status, security, and power it confers. Individuals vary from one another in in the value they see in holding money as opposed to using it to consume things. The liquidity preference of given individuals often changes at different times in their lives.

    The presence of a money economy also gives rise to emergent phenomena that are never seen in a barter economy. A financial panic and ensuing depression or recession can decrease the number of transactions in a way that is very different from what you would see if money was just a straightforward extension of people’s bartering desires.

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