Money : History and Evolution

Sukumar Nandi

Indian Institute of Management Lucknow

"The institution of money is,…….,a powerful instrument promoting wealth and

welfare" [ italics in original ]
A. C. Pigou (1941), p.24

Money in circulation, both paper and metallic currency, is the interest free
liability of the government1 and against this there are claims to virtually nothing . This
is because present- day money is hardly backed by gold and other foreign asset by
the government . This is fiat money and it is a legal tender, which the citizens of the
country are legally bound to accept as a medium of exchange. So money in circulation is
not backed by government liability and the government has virtual monopoly on the
provision of fiat money. Further, the government also controls the quantity of money.2
In the historical context, fiat money is very recent in origin with a lifespan of
a few decades. Its earlier form was commodity money. From history we find that use
of gold as money began in the sixth century B. C. in Turkey. Lumps of gold found in
the river bed were melted and converted into pieces of uniform sizes and then
stamped to give it legal sanction. This is the early form of commodity money with face
value equal to its intrinsic value. The commodities chosen were generally precious
metals with lighter weight for the convenience of carrying to distant places . But
sometimes seashells, cattle were also used as money. The technical characteristics of
commodities selected to serve as money are of minor importance. But the important
thing is that there should exist social institutions condoned by customs and/or law that
enable the economic agents to trade efficiently by following the specific rule that one
commodity traded in every exchange should be socially sanctioned as an exchange
intermediary. In the money using economy the rule of the game is very precise that
commodities buy money and vice versa ,but commodities do not buy commodities in any
organized market ( Clower,1969).

1
Here the central bank's role is not neglected. Actually the central bank works on behalf of the
government of the country. The concept of money as a fiduciary issue and a legal tender is true for all
countries irrespective of the level of development .
2
The central bank enjoys hardly any autonomy except in a few countries and so it is taken as granted that
the central bank follows the wishes of the government. Technically the currency in circulation are the
liability of the central bank.

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Money in the Early Period
The emergence of money in the early period can be known from the following :
"In primitive traffic the economic man is awaking but very gradually to
an understanding of the economic advantage to be gained by exploitation
of existing opportunities of exchange… Consider how seldom this is
the case, that a commodity owned by somebody is of less value in use
than another commodity owned by someone else! And for the latter just
the opposite relation is the case. But how much more seldom does it
happen that these two bodies meet! …. Even in the relatively simple
and so often recurring case, when an economic unit A requires a
commodity possessed by B, and B requires one possessed by C , while
C wants one that is owned by A -----even here, under a rule of mere
barter , the exchange of goods in question would as a rule be of necessity
left undone ." [ page 242]
Carl Menger (1892)

In the early dawn of history when people realized the problem of barter, they
started using precious metal as medium of exchange. In 2500 BC. the people in
Egyptians produced metal rings for the use as money. By 700 BC. a Group of
seafaring people called the Lydians became the first in the western world to make
coins The Lydians (of western Turkey, 700 – 637 BC.) used coins to expand their
vast empire . The Greeks and Romans continued to make coins and they passed that
tradition to later generations. Greek Drachma was found in 400- 344 BC. at Thessaly
in Eastern Greece. In the eighteenth century trade and commerce increased in
Europe and coins became wide in circulation. One of the most widely used coins was
the Spanish 8 Reale and it was split into fraction like half a coin or 4 bits, a quarter
was 2 bits etc.
Metallic coins made of precious metal are the example of commodity money
and it was acceptable because it had the intrinsic value. At times the metal value used
to differ with the face value leading to large scale hoarding or melting down of the
coins as the situation warranted.
Paper money was first invented by the Chinese and it began in the T’ang
Dynasty ( 618- 907 AD.). During the Ming Dynasty in 1300 AD. , the Chinese
placed the emperor’s seal and the signature of the treasurer on a crude paper . The
latter was made of mulberry burke and it was of the size of a notebook paper. After the
Chinese the paper currency the experiment spread to other countries . Also
representative money was developed in some countries which are token or pieces of
paper that could be exchanged for a specific commodity such as gold or silver. In
the later years of 19th century, the government of the USA and some European
countries issued gold and silver certificates. This type of money was very useful
to make large payments. Thus is seems that the authorities in those early years
realized the need for high denomination currencies to facilitate trade and commerce.

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A Stable Numeiraire
One important aspect of commodity money is that it is a stable numeraire and it
helps keeping the price stability. Even Aristotle, in his book, Ethics, noted that
commodity money was well suited for the price stability. According to him:
“Money, it is true, is liable to the same fluctuation of demand as other commodities, for
its purchasing power varies at different times; but it tends to be comparatively constant.”
(Ethics, translation 1943)
The commodity money system delivers a nominal anchor for the price level, and this is
realized through the profit-maximization principle. This was applicable in the case of
mint producing coins in the middle ages and later. The mechanism can be as follows.
Suppose there is a way to convert goods into silver and silver into goods at a constant
cost, that is, in ounces of silver per unit of goods. This can be considered as (1) the
extraction cost of silver, or (2) the world price of silver in case of small open economy.
The mint converts silver into coins after the purchase of silver in bulk from the market, it
also decides when to melt the coins to make it into silver bars. This is a private sector
activity, and the rule of the government is limited to two actions. It specifies how much
silver goes into a coin and it collects a seigniorage tax (Sargent & Velde, 1997).
The profit maximization principle will dictate the private sector mint to
adjust the revenue with the cost , the latter being the cost of buying silver bars from the
market along with the cost of production. This includes again the cost of labour. Again
the mint itself can be engaged in the extraction of silver, which determines the unit price
of silver. The revenue of the mint is the value of the coins produced and, assuming that
each coin is of the same weight, the revenue depends on the number of coins and their
denominations. The mint will find equilibrium when the following equality holds::
Market Value of Coins (or, the Inverse of Price level ) = Cost of
Silver + Seigniorage Tax + Cost of Production
The above rule will ensure that the mint will continue minting coins. When this is
violated, i.e. the market value of coins is less than the combined total of the right hand
side, minting of coins will stop. This also determines whether the mint will produce
new coins or start melting the existing coins, and this ultimately depends on how the
price level relates to the following parameters : the cost of silver content, cost of
production and seigniorage rate. The price level can not go too low, or the mint could
not make unlimited profits by minting new coins and spending them. Again, the price
level cannot go too high, or the mint would make profits by melting down the coins.
Thus the absence of arbitrage facility for the mint places restriction on the price
level and this remain within an interval determined by the minting point and the
melting point ,as shown in the figure (Figure 1).

Figure 1. Price level within a domain

Minting Point Melting Point

------*--------------I----------------------*----------
Price Level

The system described above has some unique features. Here the quantity of money is
not controlled by the government. The additions or deductions to existing money stock

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( stock of coins ) are made by the mint run in the private sector on the basis of the
movement of price level. The price incentive in the market operate and this makes the
system self-regulatory. When coins become too few, their value increases and price
level falls. The mint point is reached and more coins are added to the existing stock.
This increases the supply of money, and the price level (i.e., price of coins falls ). When
the number becomes too large , the market value reaches the intrinsic metal value and
even below, and it becomes imperative for the mint to melt the coins and reduce the
number.
Within the interval the price level depends on how the money stock is related to the
volume of transactions and this follows the famous Quantity of Money Equation of
Irving Fisher

PT = M V …. (1)
Where P, T,M and V are price level, total transactions , money stock and velocity of
circulation respectively. As long as the price level remains within the interval , the
stock of money (the number of coins ) does not change. The changes in the volume of
transactions or income will shift the price level up or down within the interval. When
the push is severe so that it touches the melting point or the minting point , money
supply changes.
One important implication of the above system of private sector minting of coins
is that run-away inflation of the type seen in the twentieth century is not possible in
the commodity money regime. Inflation is the product of the fiat money system.

Machines and Change in Production Process:

Around 1550 a major shift in minting technology took place in Germany. Two
processes were developed to mechanize the minting process using machines to cut
into shape uniform blanks and impress these with a design. The screw-press
technology had been proved to be better than the alternative, known as the cylinder-
press technology; but because of cost consideration, the latter became popular in
many countries. The King of Spain heard about the cylinder –press technology and
installed the technology in his state mint. The coins produced in the mint had been
smooth and uniform This experiment then spread to other states in Europe .

The laissez -faire Experiment:

Royal Charter created private monopolies during 1613- 44 AD and various
individual firms were allowed exclusive right to issue token coinage , though these
were not made legal tender and the quantities were limited. The laissez-faire regime
was typified by the absence of government- issued small denomination coins and by
the issue of tokens by private parties and local governments. In the late sixteenth
century about 3000 London merchants issued tokens . During the period 1644 – 1672,
more than 12700 different type of tokens were catalogued and these were issued
in 1700 English towns. Though privately issued, some of these issues were
authorized by the government. The experiences in France and other parts of Europe
were more or less similar . In 1672 private tokens were declared illegal and
government monopoly was asserted. The Royal mint started minting copper coins.
With the invention of steam engine the minting technology was further upgraded and

4
scale of production increased. Boulton’s steam presses produced copper coins for
the government in France, and the British government also entrusted the company for
the same task. But the government later bought the technology and established state
monopoly in minting in 1817. What happened in England quickly spread to other
parts of Europe.

With the spread of technology, the kings realized the need of issuing coins
of small denominations using different metal (copper) and maintaining a fixed exchange
relation between the value of two metals. Sometimes, smaller amount of metal was
used to make coins of smaller denominations. But the advantage of large scale
production paved the way for debasement of metallic currency by the use of inferior
quality metals whose face value was much higher that the metal value.
The above issue relates to the value of money and long ago N. W. Senior(1969)
wrote:
'… …the value of money… does not depend primarily by the quantity of it
possessed by a given community , or in the rapidity of its circulation, or
on the prevalence of exchanges, or on the use of barter or credit,……
excepting the cost of its production."[ p. 78]

The need for increased volume of physical money with an increase of trade and
commerce along with an improvement in technology made it possible for the
government to look for metal or non-metal objects which could be used as token money
serving the purposes of money as a medium of exchange. Here the face value of money
was much higher compared to the intrinsic value and the cost of production of money
will be much lower. Thus, the cost of production was no longer a hindrance to the
expansion of money supply if the situation warranted. This was the beginning of the
emergence of fiat money and the states realized the potential of this mechanism to
command resources from the society without much effort.

Fiat Money
In modern world, money is the typically paper currency with no intrinsic value
of its own. People hold this currency because money is the only asset that provides
exchange services which other assets cannot provide. The emergence of fiat money has
been due to the fact that commodity money is not a cost less affair and when paper
money was introduced ,it was realized that the cost of the production of money had been
much less compared to commodity money. The production and maintenance of money
requires the use of economic resources. So the welfare aspect of the resource using
money ,which is much higher in case of commodity money , increases when paper money
is used. For this reason society should have an incentive to replace high-cost commodity
money by low cost paper money. Because the latter requires few resources for production
and maintenance, its use increases welfare. This welfare aspect of money is sometimes
missed in the academic discussions. Money is not really a veil in the modern world!

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 The need for money and its evolution has been studied from different angles. In
the search-theoretic literature, trade results from chance encounters . In such a situation
,need for money arises because it minimizes the cost of transactions due to a double
coincidence of wants. In the absence of the latter, money is used in exchange or nothing
takes place ,and they change commodities when double coincidence of wants are
satisfied ( Kiyotaki and Wright, 1993, Thronton, 2000 ).

This chapter introduces money in the historical perspective and there is indication
that money as a commodity is global in nature . The exchange of commodities may also
happen between two individuals who by the whims of history now belong to two
different nations! That induced mankind to make some arrangement for facilitating
international movement of money. The historical evolution of the global financial
architecture and its consequence on the demand for money in the domestic economy on
the one hand and the price of the domestic money in the international field on the other is
a complex question. This is discussed in the next chapter.