Understanding Money: History, Systems, and Inflation

The Genesis of Modern Currency

With the decline of feudalism in Europe, markets began to organize and expand. Keeping gold at home became dangerous, leading to the emergence of specialized houses, often run by goldsmiths, that held gold securely. In exchange for deposited gold, people received certificates, which soon gained an equivalent value to the gold itself. Gradually, individuals stopped withdrawing their physical gold, relying solely on these certificates for transactions. This evolution marked the precursor to modern banking systems.

From Commodity to Symbolic Money

The pivotal moment when currency transitioned from a commodity to a mere symbol occurred when its exchange value surpassed its intrinsic use value. In this symbolic form, currency is no longer a commodity but a representation used to facilitate exchange. Governments eventually assumed a monopoly over currency issuance, establishing centralized monetary systems and replacing the fragmented practices of numerous goldsmiths.

Key Types of Money

• Representative Money: Paper currency that is fully backed by a physical commodity, such as gold, held in reserve. It is typically issued by the government, which maintains a monopoly over its production.
• Fiat Money: Paper currency that is not backed by any physical commodity. Its value is derived from government decree and public trust.
• Subsidiary Coin: Small denomination coins primarily used for making change or minor transactions. For example, one would not typically purchase a major item with only pennies.
• Book Money (Demand Deposits): Funds held in bank accounts that can be accessed on demand, such as through checking accounts. It is called "book money" because it primarily exists as accounting entries. Despite being a deposit, its immediate accessibility makes it function as currency.

Understanding Monetary Systems

The Gold Standard

The Gold Standard is a monetary system where the value of a currency is directly linked to a specific quantity of gold (e.g., $1 equals 1 gram of gold). While it makes inflation difficult due to its inherent rigidity, this characteristic is both its primary strength and weakness. As economic production increases, gold reserves often cannot keep pace, leading to a shortage of currency. This limitation can become an obstacle to the growth of a capitalist economy.

The Fiat Money System

In a Fiat Money System, currency is not backed by gold or any other physical commodity. Its value is based on government decree and public confidence.

Legislative Oversight in Currency Issuance

Some monetary systems incorporate a mechanism where the government must seek permission from the legislative body (e.g., Congress) to issue new currency. This process limits the executive branch's power and enhances transparency in monetary policy decisions.

Functions and Characteristics of Currency

Currency serves two primary functions:

• Medium of Exchange: It facilitates transactions, allowing goods and services to be exchanged without the need for barter.
• Unit of Account: It provides a common measure for valuing goods and services, enabling comparisons of worth.

The main characteristic of currency is its liquidity: its universal acceptance as a means of payment. Currency is a widely accepted asset, and the U.S. dollar, for instance, is known for its high liquidity globally. Historically, commodities like salt also exhibited high liquidity, being divisible and stable enough to serve as a medium of exchange.

Commodity Money

Commodity money is an ancient form of currency where goods themselves, such as livestock, grains, or precious metals, were used directly as money. In contrast, symbolic currency (like modern banknotes) derives its credibility from the issuing authority and represents value without being intrinsically tied to a commodity.

Currency's role as a unit of account allows it to determine the relative value of goods. However, during periods of inflation, money loses this function because its purchasing power constantly changes, making price comparisons unreliable.

The amount of money in circulation is largely controlled by the government, which holds a monopoly on currency issuance. As an economy grows, more exchanges occur, necessitating an increased supply of currency.

Understanding Inflation

One common cause of inflation is an increase in the money supply (e.g., by printing more money) without a corresponding increase in production. This leads to more money chasing the same amount of goods, driving prices upward due to increased demand relative to supply.

Brazil, prior to the implementation of the Real Plan, experienced persistently high inflation, often ranging from 20% to 40% annually. Notable spikes occurred in 1973 (20%) and 1974 (doubling due to the oil crisis), and again in 1979 (80% due to another oil crisis). In the 1990s, inflation soared to over 2000% per year, largely influenced not by excessive currency issuance but by widespread monetary correction (indexation).

A strategy to combat inflation is to implement a containment policy, which involves cutting public spending and discouraging consumption. While effective, such policies carry the risk of causing economic recession by stagnating or even reducing production.

Monetary correction was introduced to help manage inflation, with the expectation that it would decline over time. However, as inflation persisted, monetary correction itself created an inflationary inertia. During periods of high inflation, currency tends to circulate much faster as people rush to spend it before its value erodes further.

Basic Categories of Currency

• Commodity Currency:
  • Non-metallic (e.g., salt, grains)
  • Metallic (e.g., gold, silver)
• Book Money (Demand Deposits)
• Symbolic Currency:
  • Banknotes (Representative Money and Fiat Money)
  • Subsidiary Coins