Introduction

Many people who have studied economics think of money as a medium of exchange. In fact money acts as a medium of indirect exchange. So, what does indirect exchange mean?

I will explain by example:

You want to trade your iPod for a bicycle that your friend Fred wants to trade for a skateboard. You and Fred will not make a trade, because neither would end up with something he values.

You learn that your other friend, Dan, has a skateboard just like the one that Fred wants, and Dan coincidently wants an iPod.

You offer to trade with Dan—his skateboard for your iPod. You then take the skateboard, which you really don't want to keep, to Fred and trade with him for the bicycle you have eyed.

This transaction consists of indirect exchange, and, for you, the skateboard acts as a medium of indirect exchange.

Using Money

In this example, the skateboard has value to you only because you anticipate trading it for the bicycle. Money has value to people for the very same reason, but money has an advantage over the skateboard because many other people will accept it in trade for things they want to exchange.

The shoe/wheat segment of the market, upon which I have structured this model, decides to use money as a medium of indirect exchange. They will continue to exchange all shoe production for all wheat production, but they will now do it indirectly, using money.

In this model they each will trade all their money for the other producers' product. They will operate in this manner whether the quantity of money increases or declines.

Thus, using money as a medium of indirect exchange will still accomplish their objective of trading all the production of shoes for all the production of wheat.

I start the model of indirect exchange using money by showing dollar prices, and their changes, with a fixed supply of money.

Prices

As you look at the charts that follow, please keep in mind the primary role of dollar prices. They convey information. We have seen a little of that with direct exchange prices. When the production of an economic good increases its direct exchange price, in terms of other goods, declines. When production declines the direct exchange price increases. We get information about the trend of production levels without knowing exactly the amounts produced.

When we use money, we should get the same information, but comparing production relative to a much broader array of goods.

Now, let's look at the scenarios in an environment of a fixed quantity of money.