To illustrate the use of money in an economy let's return to our simple three-person economy described in chapter 4. In that economy all goods were shared out by directly bartering for other goods. In the real world that's very inconvenient because it requires what is known as a coincidence of wants: person A must want what person B has to trade at the same time as person B wants what person A has to trade. Also the value of tradable goods must be the same. For example if I raise cattle and a farmer grows potatoes, then it is difficult for me to trade when I only want a small quantity of potatoes, even if the farmer wants a cow. I would need to buy a vast quantity of potatoes in return for a cow and hope to trade them with others for other goods before they became unusable. Also barter is very difficult to arrange when more than two people are involved. I might have turnips to trade and want potatoes, but Fred, who grows potatoes doesn't want turnips, though he does want carrots. Bill grows carrots and wants turnips, but doesn't want potatoes. Between the three of us we could come to some kind of arrangement, but first of all we have to find each other from amongst the community, and then we have to work out a strategy that gives us all what we need without anyone being unduly disadvantaged. Imagine the difficulty when there are thousands of widely dispersed people.
In our simple economy jewellery would probably be used as money. Each person would keep a surplus to trade with in addition to that used for their own purposes. The person making the jewellery would also make standardised items that could be used for trading purposes. Let's say that in 10 hours the jeweller can make a standard bracelet, so in a week three can be made as well as three lots of luxury food. In our economy labour is the basis of value, so one bracelet would be worth, for one person, one week's worth of basic food, one week's worth of luxury food, one week's worth of clothing, or half a week's worth of wheelbarrows. Initially each would continue to barter goods with each other, and in doing so would build up a stock of bracelets. When each had built a surplus of bracelets over and above their own decorative needs they could use the excess to trade with each other. Because each wants what the others produce the bracelets would circulate but not accumulate, so that when there were enough bracelets for trading purposes the jeweller would make other items for decoration rather than continue to make bracelets that weren't needed.
The question then arises: How many bracelets are needed as money in our simple economy (i.e. surplus to those used for personal decoration)? The answer is that since surplus bracelets are only needed to facilitate transactions, there must be enough to allow all the necessary transactions to take place. In one week each person produces and trades four units of wealth (where one unit is one week's worth of basic or luxury food, jewellery or clothing, or half a week's worth of wheelbarrows). Although each person produces six units, two are for their own use. Hence assuming all transactions take place each week, each person needs four bracelets for trading purposes, or twelve bracelets in all in the economy. Having four bracelets allows any person to buy a week's worth of goods before they need to sell anything, because when they sell they receive back the bracelets that they used to buy goods with earlier. Therefore no more than four bracelets are needed per person, and with more frequent trading fewer would be needed.
The quantity of money needed by a society is determined by the value and frequency of transactions it wishes to carry out.
What would happen if the jeweller continued to make bracelets when there were already enough in the economy for trading purposes? In that case there would be an oversupply, and people would become reluctant to trade their goods for bracelets because they already had enough. If I was producing basic food, then my willingness to buy a bracelet would be less than the jeweller's willingness to sell it, so the price of the bracelet would fall - I would offer less than a full week's worth of basic food, and this would be accepted because the jeweller doesn't want to be left with an excess of bracelets. No-one else would offer a full week's worth of their goods either. That is inflation and is the signal for the jeweller to make things other than bracelets because bracelets are no longer profitable - the time it takes to make a bracelet can be more profitably spent making something else. This illustrates a very important and basic rule of trade:
In free trade, when buyers' willingness to buy is less than sellers' willingness to sell the price falls, and vice versa.
What if there weren't enough bracelets in the economy to allow all the necessary transactions to take place? Let's say the jeweller stopped making bracelets because they weren't profitable in order to make other things. Over time as bracelets broke or were lost the number would diminish, causing an undersupply. Then two things would happen. Transactions that a person wanted to make would not take place if the buyer had no bracelets, and a buyer with bracelets would be able to demand more than a week's worth of other goods because the scarcity of bracelets would make them worth more. The way this would work is that with fewer bracelets than available goods sellers would be fearful of being left with unsold stock so they would be more willing to sell goods than buyers would be willing to part with bracelets, so to compensate they would offer more goods per bracelet, in the knowledge that they could buy more goods from others for the same reason. This is deflation, which can be very damaging to a real economy because it prevents transactions taking place that both parties want to take place, and stagnation, unemployment and often widespread poverty can be the result. In our simple economy, at the first hint of deflation the jeweller would realise that making bracelets would be more profitable than making other things, so bracelet production would resume until there were again enough to allow all required transactions to take place.
In this simple economy the availability of money in the form of bracelets is self-correcting only because money is produced by a worker in the economy who is free to produce more or less of it in response to profitability.
In an economy where money can't be produced by workers its availability is not naturally self-correcting, and this leads to severe problems that arise for counter-intuitive and therefore widely misunderstood reasons - discussed in the next chapter.