EVOLUTION OF MONEY - THEREBY INFLATION

Did you ever wonder how the paper currencies actually emerge? We know that the gold, silver and other metals were used in exchange of the required goods and services passing the epoch of barter system market. What are the factors that led to the change of medium of exchange all over the world? Let me scrutinize, step by step, the fruition of fiat money which is the existing currency form. Prior to that, let us understand “money”.

As said, there are two types of goods.1) Free goods 2) Economic goods. Economic goods are classified as the capital goods, consumer goods and money. Now, is money to be considered as a good? Absolutely right! It is a good and money is backed up with two obligations, 1) It is used and valued in order to gain what we need.2) It should be scarce to perform its function and retain its definition. The direct exchange of goods for goods (Barter system) is replaced with the indirect exchange of money for goods.

Basically, anything which created familiarity in the market was tried to be used as money. For example, tobacco in Virginia, women in Middle East, rats, whisky, stones, salts and sea shells etc. But not one particular thing provided ease in the hands, moreover, leading to the hyper inflation in few states. There was a constant search for the best suitable money. Then came the era of precious metals which continued for years as they were easy to store and are durable. Also, they are stable in value and scarce in nature which preserves its value.

Let us know the strategy followed then. The usage of silver and gold had been seen magnificently. Though UK adopted gold as its currency, USA took to silver denomination. Anyhow, gradually USA drifted to the gold as currency. As the two great powers started trading in gold, most of the countries followed the same. In this way, the gold was established as the world currency.  In the earlier days of gold as currency, lumps were used in exchange for goods. For instance, if I needed 1 kg of rice which costs 1 gram of gold, I would hand over a lump available in my pocket to the vendor, he weighs it and checks if it was pure without any alloy mixed. If it was pure, he would grate 1 gram of gold from the lump and give me back the remaining. Nevertheless, there comes a day where people got vexed using lumps which led to the foundation of a new way of using gold i.e., by minting coins which directly projected its value on each coin.

As the gold was a scarce resource, the economy stood stable for a long period letting people have a planned and prosperous life. The digging of gold in various countries like Australia etc pushed up the availability of gold worldwide. Thus, started piling up many private mints resulting in the issue of many gold coins in the market. This led to the plummeting rise of prices causing inflation. Now, how do you control inflation when the government does not own the mints or has got no advantage of the monetary policy to curb the excess gold flow in the market? Until this point, the money as in gold was minted and transacted among the common masses. Did anyone imagine of a terror striking situation like this? No. Ever since, people started giving up in gold as currency and started hoarding everything in their hands knowing it would lose its value as government would announce a new currency trial as the past times.

But, this time it was not the same that happened. Government took the monopoly over the money as in the printing, circulating, curbing and any related functions to avoid the cranking out of private mints and also to make it easy. Government created a bank called central bank to guideline the entire banking system in order to mould them in a progressive path. Also, it introduced paper currency which backed the value of gold. This was, therefore the step towards the gold standard currency era.

 For instance, USA government reserved a particular amount of gold, say, 200 tonnes and fixed the value as $100 per ounce of gold. The important thing to be noted is that, it was a fixed exchange rate system. So the exchange rate was fixed as $100 per ounce that means, anyone can exchange one ounce of gold by paying $100. Now how did the foreign exchange emerge with the gold standard? Now say, UK government reserved some gold and fixed the value of its pound as 1500 pounds per ounce, then the value of $1 equals to 15 sterling pounds. This is possible only if all the countries adopt the gold standard, if not trade was not possible.

There are many arguments which support that the gold standard aids the stability and credibility in the economy when it lacks discipline. It lubricated the system to run smoothly for over years. The observed stability in prices and the employment rate led the country towards a prosperous end. But there came a time for its fall. Let us analyse the gradual fall of the gold backed currency as we proceed.

People believe that the politicians cannot manipulate the currency supply if it is backed with a gold standard. But there is nothing which is impossible for the politicians. When the demand increases for the ounce due to its limited supply, the dollar value against it devalues. That is, if it is $20/ounce and after the rise of demand, it will be valued as $35/ounce. Now they have to pay more dollars for one ounce now. This exhausts the credit available among the people as the government cannot print excess money as they are bounded by the gold standard. This situation tends to the wage cuts which directly affects the output. The wage cuts provoke trade unions which induces a chaos in already unstable situation. Unemployment rate increases gradually. Economy dooms persistently and stagnates. The public start hoarding the dollars in the fear of future consequences. This ends up with recession and eventually results in depression.

In consideration to the foreign trade, the cost of exports increase resulting in lesser exports directly affecting the balance of payments producing a deficit. This cringed away the economy to stoop even lower.

If we take the case of the great depression of 1929, USA, UK and many other countries exhausted the flow of currency in the market. This led to the stagnation and the unemployment grew largely. People were idle, without sufficient money to get the basics of the life. The economy started to starve. The people who deposited in the banks as savings, started to withdraw everything to meet the basic expenses for living restricting the banks to lend anymore. All the countries were in the lapse of meeting the worse. So, most of the countries, abolished the gold standard and started the issue of fiat currency. Whichever country had switched from the gold standard had to experience a mild recession unlike those who had not, like USA and UK. Those like USA and UK, who did not shift from gold standard were hit deep.

In the end, it was necessary for everyone to leave behind the gold standard and jump into the fiat currency system. Fiat currency is the currency backed by the word of the government. The central bank is institutionalised in order to check the money flow in the market, banking, growth, GDP, inflation etc. conceiving these parameters, It decides on when and how the currency should be produced in order to keep the economy growing as the money is not backed by gold and has got no limits for the issue. In the same way, when there is inflation, the excess money from the economy is seized. The issuing and curbing of currency is based on the monetary policy of RBI. The policies of monetary policy help to maintain stability in the economy.

Are not there any problems arising out of the fiat money usage in the current scenario? It was recession mostly seen during the gold standard era but there is unravelling of inflation around the entire world now. The fiat money and inflation are explained in the coming blogs.