The most difficult aspect of money to understand is its function as a unit of account. In linear measurement we find the definition of a yard, or a metre, easy to accept. In former times these lengths were defined in terms of fine lines etched onto brass rods maintained in standards laboratories at constant temperatures. Money, however, is much more difficult to define because the value of anything is ultimately in the mind of the observer, and such values will change with time and circumstance.
Sir Isaac Newton, as Master of the Royal Mint, defined the pound sterling (£) in 1717 as 113 grains of pure gold. This took Britain off silver and onto gold as defining the unit of account. The pound was 113 grains of pure gold, the shilling was 1/20 of that, and the penny 1/240 of it.
By the end of the„19th century the gold standard had spread around most of the trading world, with the result that there was a single world money. It was called by different names in different countries, but all these supposedly different currencies were rigidly interconnected through their particular definition in terms of a quantity of gold.
In economic life the prices of different commodities and services are always changing with respect to each other. If the potato crop, for example, is ruined by frost or flood, then the price of potatoes will go up. The consequences of that particular price increase will be complex and unpredictable. Because of the high price of potatoes, prices of other things will decline, as demand for them declines. Similarly, the argument that the Middle East crisis following the Iraqi annexation of Kuwait would, because of increased oil prices, have led to sustained general inflation is, although widely accepted, entirely without foundation. With sound money (money whose purchasing power does not decline over time) a sudden price shock in any one commodity will not lead to a general price increase, but to changes in relative prices throughout the economy. As oil increases, other goods and services will drop in price, and oil substitutes will rise in price, as the consequences of the oil price increase work their unpredictable and complex way through the economy.
The use of gold as the unit of account during the days of the gold standard meant that the price of all other commodities and services would swing up and down with reference to the price of gold, which was fixed. If gold supplies diminished, as they did when the 1850s gold rushes in California and Australia were finishing, then deflation (a general price level decrease] would set in. When new gold rushes followed in South Africa and again in Australia, in the 1880s and 1890s, the general price level increased, gently, around the world, as there was more money in circulation.
The end of the gold standard began with the introduction of the Bretton-Woods Agreement in 1946. This fixed the value of all world currencies relative to the US dollar, which in turn was fixed to a specific value of gold (US$0.35/oz). However, in 1971 the US government finally refused to exchange US dollars for gold, and other countries soon followed. Governments printed as much paper money or coinage as they wanted, and the more that was printed, the less each unit of currency was worth.
The key problem with these government ‘fiat’ currencies is that their value is not defined; such value is subject to how much money a government cares to print. Their future value is unpredictable, depending as it does on political chance. In past economic calculations of the Australian Institute for Public Policy, incomes and expenditures were automatically converted to dollars of a particular year, using CPI deflators, which are stored in the Institute’s computers. When the Institute performs economic calculations into the future, it guesses at inflation rates and includes these guesses in its figures. The guesses are entirely based on past experience. In Australia most current calculations assume a three to four per cent inflation rate.
The great advantage of the 19th century gold standard was not just that it defined the unit of account, but that it operated throughout almost the entire world. Anthony Trollope tells us in his diaries about his Australian travels in 1872 that a pound of meat, selling in Australia for two pence, would have cost ten pence or even a shilling in the UK. It was this price difference which drove investment and effort into the development of shipboard refrigeration, and opening up of major new markets for Australian meat, at great benefit to the British public.
Today we can determine price differences between countries by considering the exchange rate of the day. In twelve months’ time, even a month’s time, however, a totally different situation may prevail, and investments of time and money made on the basis of an opportunity at an exchange rate of the day, may actually perform poorly because of subsequent exchange rate movements.
The great advantage of having a single stable world currency is that such currency would have very high information content. It tells people where to invest their time, energy and capital, all around the world, with much greater accuracy and predictability than would otherwise be possible.
Reading Passage 2 has four sections, A-D. Choose the correct heading for each section from the list of headings below.
List of Headings
i The effects of inflation
ii The notion of money and its expression
iii The rise of problematic modern currencies
iv Stable money compared to modern ‘fiat’ currencies
v The function of money
vi The interrelationship of prices
vii Stability of modern currencies
14. SECTION A
15. SECTION B
16. SECTION C
17. SECTION D
Look at the following causes and the list of results below. Match each cause with the appropriate result.
18. Oil prices rise.
19. The price of potatoes goes up.
20. Gold was the unit of account.
21. The amount of gold available went down.
22. Meat in Australia was cheaper than elsewhere.
List of Results
A The price of goods fluctuated in relation to a fixed gold price
B People developed techniques of transporting it to other places.
C Oil substitutes become more expensive
D More people went to live in Australia
E The price of other things goes down, because fewer people could afford to buy them
F The price of commodities remained fixed
G There is no observable effect.
H All prices went down, everywhere.
I Oil substitutes drop in price
Classify the following characteristics as belonging to
A money based on a gold standard
B government ‘fiat’ monopoly currencies
C both money based on a gold standard and ‘fiat’ currencies
23. it has a clearly defined value
24. its value by definition varies over time
25. its future value is predictable
26. its past value can be calculated
27. it makes international investment easier