This section is from the book "Money And Banking", by William A. Scott . Also available from Amazon: Money and Banking.
The phrase medium of exchange describes a group of instrumentalities which serve as a go-between in commercial transactions. In the United States it includes gold, silver, nickel, and copper coins, several varieties of government notes, bank-notes, checks and drafts, bills of exchange, and several other kinds of documents less commonly used. Each of these is appropriately called a medium of exchange because it is used as a go-between in the exchange of commodities. For example, suppose a farmer brings butter and eggs to market, and wishes to exchange them for groceries. In all probability he will not make the exchange directly, but through the medium or by the mediation of coins; that is, he will trade his butter and eggs for coins and then trade the coins for groceries. A labourer wishes to exchange several days' work for a coat, but he will rarely find a tailor who needs his services, and who will, therefore, be able and willing to trade a coat directly for a certain number of days' work. Instead he will trade his services with some one who needs them for coins or government notes or bank-notes or both, and then trade the coins or notes for the coat. It is possible, and it often happens, that a considerable period of time intervenes between the first trade and the last. The farmer may sell his produce a whole year or even longer before he trades the coins or notes received for other commodities. Indeed, he may never himself complete the trade, but transfer the right so to do to some one else. In any case the coins, notes, or other documents received will be used in buying other things and will thus fulfil their mission as a medium of exchange. In the same way people use checks, drafts, bills of exchange, and various other documents.
Like the standard of value, the medium of exchange owes its existence to certain wants which were felt very early in the history of commerce, and upon the satisfaction of which further progress depended. These wants are three in number, namely: that for some means of exchanging commodities of unequal value, that for some means of accumulating wealth in such a form as to make it available at any time for the purchase of any and all commodities, and that for facilities for borrowing and lending.
The first of these may be illustrated as follows: A farmer has an ox for sale and desires a pair of shoes. He may succeed in finding a man who has shoes for sale and wants beef, but the ox is worth twenty pairs of shoes and he wants but one, and very likely the shoemaker wants only a few pounds of beef instead of a whole ox. Manifestly the trade cannot take place unless the farmer is willing to take nineteen pairs of shoes which he does not want and the shoemaker twenty times as much beef as he wants, or unless the farmer is willing to kill his ox, to hand over to the shoemaker an amount of beef equal in value to the shoes and to keep the remainder. Of course there might be other people in the community quite willing to take the beef which neither the farmer nor the shoemaker wants, but that would not help the matter unless these traders should happen to want the various commodities which their neighbours might be willing to give in exchange for it. On the assumption that the farmer wants only a pair of shoes and the shoemaker only a few pounds of beef, the willingness of other people to buy the surplus might not improve the situation.
The need for some means of accumulating wealth is obvious. Frugal people wish to make preparations for the future, and, if the aggregate of their products exceeds that of their consumption, they are able so to do, provided some means of saving exists. The most obvious one which suggests itself is that of hoarding surplus products, but this is a very precarious method in case the products in question are perishable, or are subject to frequent fluctuations in value or are so bulky that the process of hoarding them is very expensive. Most of the ordinary products of industry are subject to one or more of these contingencies. Hence, in the absence of some special provision for the accumulation of wealth, the risks involved are so great as to prevent saving on any large scale.
The need of facilities for borrowing and lending is equally obvious. A farmer may have no accumulations to tide him over the period during which his crops are growing, or he may wish to keep his produce for a rise in price, or he may wish to extend his agricultural operations by more fully stocking his farm, by the use of superior implements, or by the cultivation of more acres. In any one of these cases he needs to borrow, and inability to do so might seriously interfere with his prosperity. In an advanced industrial community there are always people quite competent to carry on successful industrial operations who do not possess the requisite capital, and many people, on the other hand, who have capital but do not wish to engage in industry. Facilities for borrowing and lending are needed to bring these two classes together for their mutual profit and that of the community. This need might equally well be illustrated by the case of a really sound business man who has temporarily met with misfortune, or by that of a young man capable of profiting by an education but lacking the funds necessary for its acquisition, or by many other situations which will readily occur to the student upon reflection.
Let us now inquire how a medium of exchange satisfies these wants. Our assumed case of the farmer and the shoemaker will assist us. It will be remembered that these two persons found difficulty in exchanging their products on account of the wide difference in value between the farmer's ox and a pair of shoes. If, in the community to which these two traders belonged, there had been some one durable commodity which was an object of universal desire and consequently daily bought and sold and sure to be in general demand in the future, the way out of their difficulty would have been easy. Even though he might not have wanted it for his own consumption, the farmer would have been quite willing to accept this commodity in payment for the balance due him from the shoemaker, simply because he would have been able to trade it at any time for anything he might chance to want. The shoemaker, likewise, would not have been seriously inconvenienced by the surplus beef, provided he had been able to sell it to his neighbours for this highly exchangeable commodity. By way of illustration let us suppose that gold is a commodity well known and highly valued by every member of the community and considered so very precious that no one doubts the continuance of its value and high estimation through future generations. Being very durable and possessing great value in small bulk, it can be easily kept for any length of time, and, on account of the belief in the continuance of its value, every one feels safe in keeping it by him, and is confident that at any time in the future he can dispose of it for whatever he may desire or need. Being also readily divisible, it is easy to arrange for equivalents of almost any value. Under these circumstances, then, the farmer would have been quite willing to sell his ox for the pair of shoes and the balance in gold, and the shoemaker would have been willing to sell to his neighbours in exchange for gold the beef which he did not want, neither one perhaps intending to consume the gold itself, but being confident of his ability to exchange it at any time for whatever he might chance to desire. Since other traders under similar circumstances would follow the example of the farmer and the shoemaker, all the members of the community would speedily acquire the habit of taking gold in exchange for their produce, even when they did not need it for consumption, because they could exchange it for whatever they might chance to want at any time more easily than their own product. When any commodity comes to be generally used in this way, it becomes by that fact a medium of exchange.
In our illustration the medium of exchange obviated the difficulty of exchanging two commodities of unequal value, namely, an ox and a pair of shoes. It is evident that it might also be used as a means of accumulating wealth, and also for facilitating borrowing and lending. Being by its very nature a commodity which every person is willing to take at any time in exchange for his goods, no risk would be involved in hoarding it; and people who had succeeded in accumulating it could loan it to others who needed for any purpose to make immediate purchases and lacked the means. The people discussed in our illustration would naturally keep their savings in the form of a hoard of gold. The various commodities of their own production or manufacture being perishable and, perhaps, of uncertain value and consequently incapable of being hoarded, would be exchanged for gold, which could be kept without loss and readily sold for other commodities whenever desired. This hoarded gold could also be loaned to others who need to make immediate purchases but lack the means. In this case, of course, some guarantee that the gold would be returned when wanted would have to be given, but, granted the requisite degree of confidence between man and man, the gold would make possible the loan with all of its conceivable advantages to both borrower and lender.