Medium of Exchange
Any item that is widely accepted in exchange for goods and services
The medium of exchange (MOE) is any item that is widely accepted in exchange for goods and services. In other words, it is an intermediary instrument or system that simplifies the sale, purchase, or trade of goods and services.
It is anything accepted as a measure of value and a standard of exchange of goods and services in a particular country, region, or place. Most societies use currency, but stones, salt, gold, etc., have also been used for the same purpose.
Its origin is assumed to have arisen in the ancient past due to the awareness of the limitations of the barter system. It allows for greater efficiency in an economy and enhances the speed and satisfaction derived from overall trading activities.
Its purpose is:
1. Facilitating the exchange
First and foremost, a MOE exists to assist with purchases or sales. The trade process is carried out using (if the participating parties acknowledge its value).
Providing an element with a known and collectively agreed value becomes a generally acceptable way to settle economic transactions.
2. Acting as a universal value indicator
Regardless of the location, its dynamics are understood by the parties participating in the exchange.
As a result, it helps facilitate global trade.
3. Storing value
It continues to have a stored value over time. The stored value does not depend on how long it was held, so it can be continuously traded.
Apart from money, other mediums can be considered for swapping if their value remains the same or increases over time.
4. Measurement unit
It serves to describe values, which allows for the calculation and negotiation of prices.
Currency as a medium of exchange has made the economic dynamics in modern societies possible. The standardization of currency has enabled faster trade.
Its essential function is to have real value by possessing steady purchasing power. It should be reliable, interchangeable, and include intrinsic value.
The key characteristics of a MOE are represented in the diagram below:
The market measures the value of goods and services to consumers using MOE as a unit of measurement. It establishes a stable weight that parties can negotiate around instead of exchanging many items.
For furthering fairness in exchanges, economic growth, welfare, and the efficient allocation of resources, the determination of price is a must.
The Barter System and Its Drawbacks
Barter, in the context of trade, is a system of exchange that deals with directly swapping goods and services without using any MOE. It takes place on a bilateral basis.
In countries like Australia and New Zealand, bartering still requires an appropriate tax invoice declaring the value of the transaction.
A barter has the following features:
Parties often trade items they are willing to forgo, implying demand focus for different types of goods. The negotiations are made following the needs and wants of the parties at the time of the trade.
Both the parties involved are equal and free. They do not have any advantage over each other and are free to exit from the interaction anytime they want.
The goods are traded simultaneously. In the case of services, the two parts of the trade can occur at different points in time.
In this system, a transaction moves objects between the regime of value. For example, if person A has 10 kilograms of wheat that he values as less than five kilograms of wool, he can exchange it with person B.Person B has five kilograms of wool and values it as less than ten kilograms of wheat. Here, the objects "move between the regime of value" because the traded item is more valuable to the recipient than the original owner.
There is no real way to value each side of the trade.
Barter comes with the benefit that both parties get to know each other, which makes imposing trade sanctions on dishonest partners and conducting future trade easier.
DISADVANTAGES
A barter has the following disadvantages:
1. The "double coincidence of wants" problem: Both parties must have what the other wants. Otherwise, no trade can occur.
2. Not all goods can be divided up: A barter transaction cannot occur if one party has a costly but indivisible good and the second party doesn't want such an expensive good.
For example, person A may have some herbs, and person B may have a dairy cow. The value of the two commodities is very different, and the milk-producing cow can't be divided up to be traded.
3. A lack of standard of deferred payment and no standard measure of value: Absence of a common estimate of value. This creates the need for lengthy negotiations regarding current and future exchanges (such as for debt).
4. Uncertainty in the future value of the item: Storing wealth for the future is impractical when society relies on many different tradable goods.
Some goods are perishable, such as the herbs above. Others are subject to changes in consumer tastes.
Types of Medium of Exchange
Most forms of money are categorized as MOE. It enables anyone who possesses it to participate as a player in the market. A consumer makes an adequate bid in response to an asking price while purchasing a good or service.
The benefits of using money are:
It solves the double coincidence of want as it separates the act of sale and purchase. One can sell goods for money to whoever wants them, and one can buy the goods from whoever they wish to.
It serves as a unit of account and acts as a standard to measure the exchange value of all commodities. It enables the maintenance of business accounts.
Money is light and available in convenient denominations, so it is easy to store.
It serves as a standard of deferred payment by facilitating contract building involving future payments.
It helps maximize the satisfaction of consumers and the profit of producers as it provides freedom of choice, power to pursue dreams like starting a business or building a home, and security.
It promotes specialization, planning of production, and consumption and facilitates the smooth exchange of goods and services.
The forms are commodity money, representative money, cryptocurrency, and fiat money.
These can further be categorized as money with intrinsic value and money without inherent value.
Money with Intrinsic Value
The two types of money with intrinsic value are:
1. Commodity money
Its value comes from an economic good, usually a resource with whole or substantial fungibility. These objects have value in buying goods or use in themselves, i.e., intrinsic value.
It is durable, divisible, rare, and easily exchangeable. It is the only type of money with an underlying value.
For example, gold, copper, silver, salt, tea, peppercorns, barley, alcohol, silk, nails, candy, etc. In pre-revolutionary America, wampum, maize, beaver pelts, iron nails, and tobacco were commodities.
Gold and other metals were used in the price system as durable and easily warehoused stores of value. Animal furs converted into beaver pelts created a viable currency in the economy where precious metals were not used.
In Canada, fur traders established pelts as the standard currency. They also showed exchange rates between goods: 5 pounds of sugar for a beaver pelt, one pair of shoes for one, 20 fish hooks per beaver pelt, etc.
The advantages include:
- It provides more flexibility to the money holder.
- It offers more opportunities to its holders to get rich quickly.
- It is less subject to inflation.
- It can serve other purposes apart from being a MOE. For example, gold can be used for making jewelry.
The disadvantages include:
- Its face value is not consistent across regions.
- Many commodities used were perishable.
- They are difficult to transport.
- They sometimes lacked fungibility, making them difficult to exchange.
2. Representative money
Any MOE represents something of value but has little or no value of its own. It can be printed or digital. It must have something of intrinsic value supporting the face value.
It can be a claim on a commodity, for example, a gold certificate, silver certificate, or something with a face value greater than its value as a substance. Many government-produced banknotes and coins were backed by gold and silver.
The first evidence of this dates back to Tang-dynasty China when traders began using receipts from deposit shops, where they held their goods and heavy commodity money instead of coins.
The advantages include:
- It is easy to use and transport, as opposed to commodity money.
- Since it is tied to a physical object, it is less susceptible to erosion of its value caused by inflation.
- The supply of money grows naturally to accommodate demand and results in stable prices in an economy.
The disadvantages include:
- Since the value is tied to physical goods, low resource production results in a fall in the value of money as a smaller portion of the resource is available for each piece of the representative currency.
- It places value on certain things and leaves out other necessary measures of value.
- It does not allow the government to ease economic losses in case of significant economic fluctuations.
Money without Intrinsic Value
The two types of money without intrinsic value are:
1. Cryptocurrency
Cryptocurrency is a digital currency designed through a computer network.
It does not rely on any central authority to maintain or uphold it. The data of individual coin ownership is recorded in a digital ledger that controls the creation of additional coins.
Many cryptocurrencies are decentralized networks and are based on blockchain technology.
These are virtual currencies that enable secure online payments without the use of third-party intermediaries.
These are commonly available in the form of Bitcoin and can be mined or purchased from cryptocurrency exchanges. The increasing value of cryptos made them a popular trading instrument.
The advantages include:
- It represents a new, decentralized paradigm for money. It eliminates the possibility of a single point of failure affecting transactions and financial records.
- It ensures an easy and fast transfer of funds between the two parties.
- Investment in cryptocurrencies can generate profits.
- It serves as an intermediate currency to streamline money transfers across borders.
The disadvantages include:
- Over time it has become a popular tool for criminal activities like illicit purchases and money laundering.
- In reality, ownership is highly concentrated rather than decentralized.
- It involves expensive energy costs and the unpredictability of mining.
- When traded in the public market, it suffers from price volatility.
2. Fiat money
Fiat money is a type of currency that is not backed by any commodity and does not have an intrinsic or use-value. They are declared by legal proclamation from the government to serve as a means for sufficient payments for any monetary debt.
Currently, most countries use paper-based fiat currency, which serves only as a mode of payment. It cannot be converted or redeemed like commodity-backed money.
The advantages include:
- It serves as a good MOE as it has stored value, provides numerical values for trade, and facilitates exchange.
- It possesses excellent seigniorage as governments tend to profit from issuing currency, which implies that it is more cost-efficient to produce than other money.
- It enables some insulation of economies from the extreme effects of natural fluctuations in the business cycle.
- A central bank can maintain control over the supply of fiat money, which facilitates the management of economic variables like interest rate, money velocity, liquidity, and collection of reserves.
The disadvantages include:
- It is less stable compared to representative money.
- The risks of creating an economic bubble, which later bursts and hurts the economy, are higher due to the unlimited money supply.
- It risks losing value due to inflation and, in extreme cases, experiences hyperinflation.
- If citizens lose faith in the currency, the money will no longer hold value.
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