In the last post I posed some questions. What is currency? What is money? What is a world reserve currency? Each of these are different and I will discuss them as we go.
First, we'll go with the most broad...Money.
From wikipedia (http://en.wikipedia.org/wiki/Money) -
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past, a standard of deferred payment.
So basically, anything could be money as long as it fits the requirements of being generally accepted. Throughout history, many things have been called money...salt, rocks, sticks, tobacco, cotton, cattle, metal coins, paper...you name it, it's probably been money at some point in history. Again, the important thing is that it is generally accepted.
So how does money come about? Every single item that was ever considered money came about through the barter system. People would trade their labor or products for other products or labor.
Here's an example...
Joe Farmer lives in a remote location of the world called Islandia. His family lives with him and they all farm their land. In fact, they are so good at it, that they can grow enough food to not only feed their own family, but they can take their extra food miles into town to trade for other goods they need like shoes, wood, etc. Joe Farmer finds a nice pair of shoes at the local shoe smith named Eric Nike that is so good at making shoes, his family has all the shoes they need, but doesn't have a lot of food. So Joe approaches Eric and wants to trade some of his food for some shoes. They work out a deal to trade 20 ears of corn for 1 pair of shoes. (This is called barter). Everyone is happy and they move on.
Now Eric Nike needs to get some leather to make another pair of shoes. He goes down to Fred Rancher and asks him for some leather. Fred has plenty of rawhide from all of his cattle. Eric proposed a trade of a pair of shoes for 3 rawhides. Fred declines as he doesn't need shoes. So Eric proposes another trade, 15 ears of corn for 2 rawhides. Fred declines again as he doesn't really like corn, he's more of a potato kind of guy. Eric is upset because without rawhide, he can't make any more shoes. He now has to find out from Fred what he is willing to trade some rawhide for. Fred tells him that he really wants those potatoes. Eric now has to go and try to barter with Vince Farmer who grows potatoes.
As you can see, this would become a very tiresome affair just to get some rawhide. What if Vince doesn't want shoes or corn? He then has to find out what Vince would want to get potatoes, to get the rawhide he needs. This problem is called the "double coincidence of wants." This problem is how money is created within an economy. What they needed was a "medium of exchange." Something that is generally accepted by everyone so they can easily trade their products and labor with one another.
In Islandia, the group of people in their village all decided that they would go with the one item that is small, lightweight and portable, easily divisible, and something that is acceptable to all. They decided on 12 inch sticks because it fits all of the previous requirements, and it's a harder item to acquire on their remote island that doesn't have a forest nearby. Another key part of the stick was that it was used to build their huts. So not only did it fit the criteria, but it was also a valuable product in itself.
Since the institution of the 12 inch stick as a medium of exchange (Currency), people were able to sell their products and labor for the stick (or a part of the stick) and get any product they wanted. Then people started to go on adventures to find more sticks. It took a lot hard work, risks, building of boats, savings of food, etc. When these adventures came back after finding a large island with a rain forest, they brought a huge amount of sticks with them that were very valuable. This is what helped grow the economy even more as new sticks were brought into Islandia.
As Islandia's adventurers went out to find more sticks, people from another island came to Islandia. One group from the island of Rockton was looking for more mountain islands. What they had was a lot of shiny metals that the people of Islandia have never seen before that they thought they could wear as jewelry. Rockton was also on an adventure, they were wanting to find more shiny metals for their island, as that was the medium of exchange (Currency) in Rockton because it was so hard to find and dig up. The people of Rockton didn't find a mountain on Islandia, but instead found that they loved the corn and potatoes that they had never seen before, so they traded.
This was great, both economies were able to get new products they wanted and never had before. Up until Rockton didn't want corn and potatoes any more. They also didn't want any sticks (Islandia's currency) as there were plenty of those in their own mountains. They needed another medium of exchange. Since the shiny metal was valuable to both Rockton and Islandia, they decided that all trade between the two islands must be done in shiny metals. This is what I would call a World Reserve Currency.
Next we will take this example and apply it to the real world.
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