A First Principles Framework to Economics and Finance (3)
Part 3. Money
Following our discussions of the Division of Labor and Trade (Part 2), the next building block we will introduce is Money. So what happens when there is a Division of Labor and Trade? People start to barter with one another with the Outputs (i.e. goods or services) they create for the Outputs of other people.
What happens when bartering becomes too difficult, cumbersome, or time consuming? For example, what do you think would happen if a person wants to barter his cow for some potatoes? Well, he will probably end up with thousands of pounds of potatoes in return. (Good luck finishing all of the potatoes!)
Here is where Money gets introduced. Money was invented for the purpose of making Trade easier across space and time. As we will see, with Money, a person need not barter away endlessly but can now have a medium to enable transactions to take place much easier.
These are the three key functions that Money has to have to enable trade. Money has to be able to serve as (i) a Unit of Value, (ii) a Medium of Exchange and (iii) a Store of Value. A Unit of Value creates a numerical way to quantify the value of the goods/Outputs that are being exchanged. A Medium of Exchange serves as an intermediate item that people can exchange Outputs into (hence allowing the above cow for potatoes trade to happen). A Store of Value allows for the consumption of Outputs to be deferred to the future. This is a very important function as this creates the ability for people to exchange Outputs across time. As Money can serve as a Store of Value, a person can delay the consumption of Outputs to a time in the future and need not consume such Outputs right away.
Another first principles way of understanding Money is one that was discussed by Elon Musk in his recent interview with Lex Friedman. Elon described money as “information” or as a “database for resource allocation…across time and space.” He also noted that Money does not have power in and of itself. Why is that? The extreme example he used is that if you are stranded on a tropical island and you have a trillion dollars, it’s useless. The reason that in this scenario Money is useless is that there is no resource allocation, i.e. there are no Outputs, therefore, Money, as a way to allocate the Outputs, serves no purpose. In our example, resource allocation can be thought of simply as the allocation of consumption of the Outputs that are created in our society/economy. Money is a medium by which people can exchange their Outputs for other people’s Outputs. It is only when there are valuable Outputs being created that money has meaning. In a performing society, the person who creates the most valuable Outputs, in exchange, will receive the most Money for which he can then use to purchase more of the Outputs of other people. Money describes the relative value of the Outputs created and helps facilitate the allocation of how the Outputs are consumed.
With the help of Money, based on the concepts we have introduced, we now have a society of people bustling with economic activity, specialized in a production process that they have a relatively advantage in (Division of Labor), and Trading with others for different Outputs facilitated by the ease of using Money. Next time we will discuss increasingly more sophisticated forms of specialization and introduce the formation of Corporations (Part 4).
*Money also plays a very important role in the financial system and financial markets. We will save this part of the discussion for Part 7 when we introduce Financial Systems and Governments.