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The History of Paper Money

Why do we use paper?

Since the beginning of humankind, we have been trading goods. Before humans started to cultivate their own food, they would often trade goods they found. This system worked as hunters and gatherers, but once our goods became specialized, trading became more difficult.

This difficulty in trading is due to something called the coincidence of wants. Trade can only work between two people if both individuals want what the other has. For example, let’s say you have food and I have clothes. I want your food and you want my clothes, so we are able to trade. But, let’s say you want my clothes but I don’t want your food, how would we trade?

One solution would be to find a third party who is wanting to trade for food and has something that I want, but this system starts to become complicated as more people start to trade and the economy starts to grow.

Instead of finding this third person, people adapted to finding a third good that doesn’t spoil, can’t be easily replicated, and that everyone agrees has value. This third good is something that economists call a commodity good. An example of a commodity good is gold or silver.

Today, cigarettes are often used as a commodity good in places with limited access to paper money. Or, as described in this video, a group of people on the island of Yap used giant limestone donuts as their commodity good:

However, while commodity goods bridge the gap of the coincidence of wants, they also have their weaknesses. Because it is easily mined, gold and silver can often have damaging effects on the economy.

For instance, Spain brought a lot of silver in from South America to Europe, all at one time, and ended up inflating the value of silver because they added so much of it into their economy at once. Commodity goods can also be heavy and hard to transport long distances. Can you imagine lugging around a limestone donut every time you wanted to purchase food?

China ran into this problem during the Tang Dynasty (618 - 907 AD). Merchants would use gold coins to trade for goods, but found the weight of the money to be cumbersome. They would leave their coins with a trusted agent, who would then record on paper how much money had been left as a deposit. Merchants would take this paper to the market and exchange it for goods. Those who traded their goods for paper would then go back to the trusted agent and take out the coins that were owed to them.

Thus, the invention of paper money was founded! Paper money fit the role of having a shared value, it was hard to replicate, and it doesn’t spoil. It helped solve the complications that come from the coincidence of wants in a large economy and it was much easier to transport from place to place.


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