Pupils' Book: Money and Monetary Policy (2024)

Money is something we encounter in every facet of our daily lives. The first thing that springs to mind for most of us when we hear the word “money” is coins and banknotes. We talk about “making money” when we refer to our income. We say that we are “spending money” when we go shopping. For major purchases we sometimes have to “borrow money” by taking out a loan, either from someone we know or from a bank.

It is no accident that the term “money” gets used in so many different ways: it is a reflection of the myriad functions that money performs in our economic lives.

Money facilitates the exchange of goods and services in modern economies characterised by a high degree of division of labour and specialisation.

Without money, we would have a barter economy.

If money did not exist, people in societies with economies predicated on exchange would have to swap goods directly. This would not be especially convenient. You would have to find a person offering precisely what you are looking for and, at the same time, that person would have to need exactly what you are seeking to swap. If a direct exchange could not be found, you could end up with long barter chains before everyone gets what they need. On top of that, the exchange rates of each item to all other goods would need to be painstakingly determined.

Money, on the other hand, functions as a generally recognised and accepted pivot item in the exchange network, facilitating trade. The basic exchange of “goods for goods” instead becomes a double swap – “goods for money” and “money for goods”. Using money also means that the purchase and sale of goods does not have to happen at the same time and in the same place. Furthermore, money provides a general measure with which the value of all goods can be expressed and easily compared.

The central role of money in a modern market economy can be demonstrated using a simple model:

On one side, we have households that supply labour and demand consumer goods. On the other side, we have businesses that offer consumer goods and need workers. This means that there are different flows running between households and enterprises. A cash cycle runs counter to the cycle of consumer goods and labour: households receive income from businesses in the form of money for the work that they do. This can then be used to purchase consumer goods.

The central role of money is tied to the three functions that it performs in modern economies.

Ultimately, money is whatever is generally accepted as money.

Little is known about the origins of money. Some experts believe it has its roots in religious offerings, others in barter trade, and others draw a link to the development of debt relationships. For centuries, valuables like gold, silver, salt or certain shells served as money. Nowadays, we use coins and banknotes with little intrinsic value. The balances we hold in our bank accounts are now recorded only in the form of bits and bytes. Although we cannot even hold it in our hands like this, we still accept it as money because we trust in its value. Ultimately, money is whatever is generally accepted as such within a society at a given time. Money is what money does.

A basic form of money is commodity money. Another term for this is “paying in kind”. Examples include cowrie shells, bars of salt, furs, feathers and cattle.

The Latin word for money is “pecunia”, derived from “pecus”, meaning cattle. On the Pacific island of Yap, stone discs of varying sizes with a hole in the middle served as a means of payment (stone money).

As early as prehistoric times, the precious metals gold and silver performed a monetary function. Like bronze, which was also frequently used, they have the advantage of being relatively scarce, durable and easily divisible. The introduction of metal-based currency helped solve the problems associated with using perishable goods as money.

The use of commodity money is not limited to any particular era or culture. For instance, if people lose their trust in the official currency, it is possible for commodity money to make a comeback. One example of this happening was in Germany shortly after the Second World War, when cigarettes replaced the then worthless Reichsmark as a means of payment on the black market. The 1948 currency reform brought the introduction of the Deutsche Mark, which put a stop to the black market and spelled the end of the “cigarette currency”.

It is much easier to use commodity money like gold and silver as currency if it is issued as uniform standardised units rather than always having to weigh differently sized bits of metal or bars. If an authority establishes rules for uniform pieces of metal, produces them according to these rules, certifies them by applying a special motif and then brings them into circulation, a coin is born.

The oldest known coins date from the middle of the 7th century BC and came from the Kingdom of Lydia in what is now western Turkey. Back then, they took the form of small nuggets of metal with a design stamped on them. Over time, the stamped pieces of metal became increasingly broader, flatter and better rounded.

The concept of standardised coins bearing a stamp spread fast. The first coins depicted symbols stemming from nature or mythology, and later often portraits of rulers. The coin issuer possessing the right to mint coins (the coinage prerogative) guaranteed by way of their image or symbol that the coins had been produced in accordance with the rules governing coinage.

Coinage laws usually prescribed that minted gold coins and large silver coins should have a face value slightly higher than the price of the precious metal they contained. This served to cover the costs of coin production, but also to prevent coins from being quickly melted down again for their raw materials and thus undoing the laborious work that had gone into turning the metal into money. Nevertheless, coinage laws were also clear that a sufficient amount of gold or silver should be contained in each coin.

Since precious metals have always been particularly valuable, a single large silver coin – let alone a gold coin – would be worth so much that you could not use it to pay small amounts. For that, you needed “small change”. This consisted of what are known as fractional or token coins. Their value was significantly higher than the price of the raw materials they contained and the production costs. Today, the vast majority of modern coinage takes the form of token coins.

Unlike metal coins, paper monetary tokens have barely any material value. However, they make it possible to transport and share large sums of money far more easily and safely, and thus more quickly and cheaply.

The oldest paper money was issued over a thousand years ago by state authorities in China. This Chinese paper money was endowed with purchasing power only by imperial decree. State-issued paper money of the kind used for many years in China failed to gain a lasting foothold in Europe at the time, despite attempts by various governments. State-issued paper money was not backed by any commodity value, relying instead on the power and credibility of the state.

In medieval Europe, meanwhile, it was the merchants who created their own payment documents, introducing bills of exchange. In one of these bills, the drawee (somebody buying goods, for example) would commit to pay a specified amount of money, in the form of gold or silver, at a certain point in time upon presentation of the bill. By issuing bills of exchange, selling them to one another and exchanging them among themselves, merchants and bankers needed far less physical gold or silver for trade purposes. They were able to pay for things more quickly, easily and securely than with coins and used these promissory notes to lend each other money.

Besides bills of exchange, other promises of payment later began being used in Europe for commercial payment purposes: bankers or goldsmiths offered safekeeping for their customers’ precious metals and issued a deposit receipt as confirmation. The precious metals were paid out again upon presentation of the receipt.

This led to increasingly widespread use of banknotes, which were initially issued by private banks, from the 17th century onwards. “Stockholms Banco” is considered Europe’s first central, note-issuing bank. Owing to a shortage of silver, copper plates began being minted as money in Sweden in 1644. These plates could weigh up to 20 kg, making them impractical for everyday use and often making it necessary to employ a team with horse and cart to transport them. Because of these difficulties with the copper plates, banknotes were an instant hit with the public when they came into circulation in 1661.

The value of the “Credityf-Zedel” was intended to be guaranteed by a royal deposit at the bank, which provided basic cover for the banknotes issued. However, the majority of the notes were issued as loans against future discoveries of metal in the country, which is why the bank was extolled to the king as a kind of virtual gold and silver mine. The credit notes issued by Stockholms Banco are regarded as Europe’s first banknotes.

This principle became the foundation of central banking, which caught on throughout Europe, particularly in the 19th century. Central, note-issuing banks bought gold and silver, as well as merchants’ bills of exchange, and issued banknotes in return. You could redeem these banknotes at the bank and receive the notes’ value paid out in precious metal at any time. Banknotes were an enhancement to the money supply and made it easier to deal in large sums of money. In Germany, banknotes first became legal tender in 1909.

While currencies were at least partially backed by gold until well into the 20th century, most economies today operate with what are known as “fiat” currencies without any precious metal coverage. The term “fiat” (Latin for “let it be done”) points to the fact that fiat money originates solely at the behest of the legislative bodies of a given state conferring upon it the status of legal tender.

With the introduction of paper money, the value of money was unhitched from the material from which it is made. In the form of banknotes, money is not only less cumbersome to transport but also considerably cheaper to produce. Theoretically, unlimited numbers of banknotes could be printed. This is why control over currency in circulation has been placed in the hands of public central banks.

Book money is transferred “immaterially” from account to account.

In addition to paper money, another form of money evolved in the large mercantile cities of northern Italy as well as in Amsterdam, Hamburg and Nuremberg at around the same time. Book money – or giro money – is money that only exists as records in banks’ account books. Merchants could open accounts with the giro banks in order to move funds from account to account. At the same time, banks started to provide their customers with additional book money in the form of loans. As a result of this innovation, banknotes and coins only make up a small fraction of the money in circulation today; “immaterial” book money has prevailed. Our bank statements show us how much book money we have. Nowadays, however, money is no longer moved around by making credits and debits on paper in account books, but, instead, by computer or using electronic media.

Crypto-assets are not official money.

Some years ago, a seemingly new category of money emerged. Known as crypto-assets, these are also often misleadingly referred to as “cryptocurrencies”. Crypto-assets are privately generated digital tokens, created and used in computer networks. They are purely digital and work on the basis of encryption technologies (cryptography). The original idea was to create a means of payment that is independent of government institutions and commercial banks, enabling private individuals to make payments to each other without the need for state-controlled currency or money held in banks. The intention was to weaken governmental influence over the monetary system and make cross-border payments faster and cheaper to carry out. The most well-known and widely used crypto-asset is bitcoin, the concept for which was first published in 2008. The technical foundation on which bitcoin and many other crypto-assets are based is known as blockchain technology. This involves a ledger recording all transactions that have been executed. This ledger is managed and viewed by all of the network’s participants, as opposed to a central entity.

The frequently used term “cryptocurrency” has the ring of official money, but this is not actually the case. Crypto-assets are not backed by a public central bank, there is no legal basis and no government regulation to ensure stability and acceptance. This means that nobody can be obliged to accept a payment made using a crypto-asset. Similarly, there is no legal entitlement to exchange crypto-assets for an official currency. Crypto-assets fulfil the functions of money only to a very limited degree. In terms of use as a means of payment, acceptance is incredibly low. There are barely any outlets where vendors will take them as payment for goods. Also, prices are seldom expressed in crypto-assets, making them unsuitable as a unit of account. Strong fluctuations in value mean that they are anything but a reliable store of value. Crypto-assets are thus primarily an instrument of speculative investment.