Understanding Money Theory: History, Functions, and Inflation

History and Functions of Money

Monetary Theory: Money is a generally accepted medium of exchange for goods and services.
Evolution of Money: In the primitive period, before the advent of money, trade relied on barter. As markets grew, commodities with high acceptance (such as wheat or cattle) began to act as monetary intermediaries in transactions. With the advancement of civilization, precious metals (gold and silver) took over this role. Following the 1930s crisis, commodity money transitioned into abstract or symbolic money backed solely by state authority rather than intrinsic metal value, yet retaining purchasing power in the market.

Historically, two periods are distinguished:

• Natural Money Period: Money circulated freely without state intervention, based on social consensus.
• Legal Money Period: Characterized by legal regulation where the state intervenes, setting characteristics, denominations, weight, and purity, while backing it with a stamp to ensure authenticity for forced circulation and unlimited legal tender power.

Functions of Money:

1. Medium of exchange
2. Unit of account (measure of value)
3. Store of value (saving and hoarding)
4. Standard of deferred payment (credit)
5. Basis for accounting records

The essential functions are the medium of exchange and measure of value. To fulfill these efficiently, money must exist in sufficient quantity to permit full economic transactions while remaining stable in value over time.

Measure of Value: It is necessary to express the value of goods in monetary units. Each good's worth is determined by its marginal utility, which is first expressed subjectively and then made objective in the market as prices. Money serves as the common denominator to measure both material and immaterial goods.

Medium of Exchange: This function stems from the measure of value, but it is more abstract, serving as a tangible symbol that represents generalized purchasing power. This exchange capacity is reinforced by its status as legal tender.

Internal and External Payment Methods

Internal Payment Methods: Composed of central bank notes without gold backing, and currently, bank money (checking money), represented by checks, and quasiponey, which includes easily liquidable credit documents like promissory notes, bills of exchange, etc.

Before the 1930s crisis, bank notes had rigid metallic gold backing. Following the crisis, due to the rigidity of metal quantities and technical production constraints, countries declared general inconvertibility, officially abandoning the gold standard. Bank money is created through the checking account system using commercial checks. Checks circulate in place of physical cash with general acceptance, though they are not legal tender with unlimited discharge power. Checks are cleared internally within the same bank or through central bank clearinghouses.

Quasiponey consists of private documents issued by entities based on trust and credit. While they lack forced circulation or unlimited legal tender, they are widely accepted and fulfill monetary functions as easily liquidable credit documents.

External Payment Methods: Payments destined outside the national territory include foreign currency (such as the US dollar, which historically exercises primary international monetary functions), foreign exchange documents (checks, bills of exchange, foreign drafts), and gold (which retains international monetary status due to intrinsic value and ease of transaction).

Quantitative Theory of Money

Quantitative Theory of Money Value: Originally formulated by classical economists and later refined, it is widely accepted in economic theory:

The monetary mass ($M$) multiplied by the velocity of money circulation ($V$), divided by the volume of transactions ($T$), determines the general price level ($P$), which reflects the value of money. The equilibrium price level arises from the balance between aggregate demand (driven by money quantity and velocity) and aggregate supply (goods traded in the market).

• M (Money Supply): Amount of money comprising cash, bank money, and quasiponey.
• V (Velocity of Circulation): Number of times a monetary unit changes hands in exchange for goods during a specific period.
• T (Transaction Volume): Determined by the available quantity of goods, including current production multiplied by accumulated stock traded in the market.
• P (Price Level): General price indicator that has an inverse relationship with the value of money; if prices rise, the value of money falls, and vice versa.

Velocity of Circulation: This is a complex factor to measure because it largely depends on future psychological projections, inflation, and deflation expectations. Other influencing factors include the periodicity of income receipt, access to credit, and the degree of industrial integration.

Normal Money Requirements and Monetary Disequilibrium

Determining the exact quantity of money an economy requires is complex because it depends on specific circumstances and economic policy goals, primarily full employment and price stability. The money supply must be sufficient to ensure full employment without triggering inflation.

If unemployment rises above the traditional 5% threshold, this symptom alone does not signal a lack of demand or a shortage of money. Other causes of unemployment exist, such as technological, frictional, or structural unemployment caused by replacing workers with machinery or shifting labor during economic transitions.

The most frequent cause of generalized unemployment is a lack of aggregate demand, which can typically be remedied through monetary expansion, provided other causes are not at play. Similarly, if price indicators reflect constant inflation, it cannot be assumed in absolute terms that there is an excess of circulating money; inflation can stem from cost pressures rather than excess demand.

Causes and Effects of Inflation

Inflation: A steady and sustained rise in the general price level. To understand it, causes must be distinguished from effects:

Demand-Pull Inflation

Occurs when aggregate demand exceeds aggregate supply, creating a gap between nominal income (payment capacity) and real income (goods traded). Monetarily, it often originates from budget deficits covered by central bank money creation, acting as an invisible tax that extracts resources from the private sector through monetary devaluation.

Cost-Push Inflation

Arises from imbalances in the general price level driven fundamentally by widespread increases in the costs of producing goods, such as monopolistic price-fixing of oil.

Causes: Inflation can stem from an increase in the money supply without a corresponding increase in available market goods, or from an increase in the velocity of circulation. Other causes include the physical destruction of goods due to catastrophes or negative inflationary expectations. These causes can act jointly, meaning inflation's causality is complex and not merely the result of a simple expansion of the money supply.

Effects: From a purely economic standpoint, inflation's effects may seem mild if aggregate demand is maintained near full employment. However, the negative effects are primarily social in nature:

• Unfair Income Redistribution (Regressive Impact): Harms workers whose wages are fixed by long-term contracts and adjusted only periodically, causing them to lose purchasing power over time.
• Business Profits: Entrepreneurs may temporarily benefit if prices rise faster than rigid wages, increasing their profit margins until the next wage adjustment.
• Fixed-Income Earners: Holders of fixed incomes, rents, and interest are penalized unless protected by indexation adjustments.
• Savers and Asset Holders: Owners of physical assets may preserve their wealth, while holders of cash or fixed monetary claims suffer losses unless adjusted for inflation.
• Debtors: Long-term debtors often benefit as the real value of their obligations diminishes, provided debts are not indexed.

Bank Money and Regulation

Bank money (Checking money) is created through the checking account system using commercial checks. Checks circulate in place of physical cash with general acceptance, though they are not legal tender with unlimited discharge power. Checks are cleared internally within the same bank or through central bank clearinghouses, where banks study transactions and maintain a theoretical cash reserve requirement (traditionally calculated around 20%).