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How did it become possible to exchange apparently valueless pieces of paper for goods? This paper provides an equilibrium account of the transition between barter and fiat money regimes. The explanation relies on the intervention of a self-interested government which must be able to promise credibly to limit the issue of money. To achieve credibility, the government must offset the benefits of seigniorage by’internalizing some of the macroeconomic externalities generated by the issue of fiat money. The government’s patience and the extent of its involvement in the economy are key determinants of whether the transition can be accomplished. 

Barter is a type of trade where goods or services are exchanged for a certain amount of other goods or services; no money is involved in the transaction. It can be bilateral or multilateral as trade. It is a word frequently used as a synonym for 'negotiate/negotiation', but this usage is incorrect. A common form of barter during colonial times was tobacco. Also bushels of grain and wampum were popular forms.

Barter trade is common among people with no access to a cash economy, in societies where no monetary system exists, or in economies suffering from a very unstable currency (as when hyperinflation hits) or a lack of currency.

A disadvantage of using bilateral barter is that it can depend upon a mutual coincidence of wants. Before any transaction can be undertaken, each party must be able to supply something the other party demands. To overcome this mutual coincidence problem, some communities have developed a system of intermediaries who can store, trade, and warehouse commodities. However, the intermediaries often suffer from financial risk.

To organize production and to distribute goods and services among their populations, many pre-capitalist or pre-market economies relied on tradition, top-down command, or community democracy instead of market exchange organized using barter. Relations of reciprocity and/or redistribution substituted for market exchange. Trade and barter were primarily reserved for trade between communities or countries.

Barter becomes more and more difficult as people become dispossesed of the means of production of widely-needed goods. For example, if money were to be severely devalued in the United States, most people would have little of value to trade for food (since the farmer can only use so many cars, etc.)

In finance, the word "barter" is used when two corporations trade with each other using non-money financial assets (such as U.S. Treasury bills). Alternatively, the standard definitions of money could be seen as being too narrow and needing to be expanded to increase near-money assets.

From Wikipedia, the free encyclopedia 

Historical Development (of Money)

Before the invention of money, trade and commerce were accomplished through the barter system, the trading of one type of goods for another. Three major problems are associated with the barter system. First, trade can occur only if each of the trading parties has something the other wants. Second, the purchase and sale transactions cannot be separated, but must be simultaneous. The sale or purchase of goods cannot be deferred. The third major problem relates to perishable goods. If the owner of perishable goods cannot trade those goods immediately, they soon lose their value.

Mediums of Exchange

Something that would be considered valuable at any time was needed to solve these problems; that is, a universal medium of exchange or a commodity to make it possible to express the value of all other items.
Over the centuries many items have served as mediums of exchange. The American Indians used beads made from shells, called wampum. Early colonists of North America at one time used tobacco. Cigarettes and liquor were used in Germany immediately after World War II because of the extremely low value of the offical currency. Fur pelts, whale teeth, grain, salt and livestock are but a few of the other commodities that, at one time or other, have been used as mediums of exchange.

Metals eventually became the prevailing medium of exchange because of their intrinsic and relatively stable value. When a purchase was made, an appropriate amount of metal, was shaved off an ingot as payment. It was from this use of metal as a medium of exchange that coins evolved.

Coins

How did it become possible to exchange apparently valueless pieces of paper—fiat money—for goods, and why did it take so long for pure fiat money to become prevalent, given the obvious benefits to its issuers? The juxtaposition of these questions at first seems paradoxical. This paper argues that the answers to these two questions are fundamentally linked. The first question has occupied monetary theorists for decades, though much of modern monetary theory has avoided it in favor of one that is closely related but more easily answered: Can an artificial economy be structured in a reasonable way so that there are equilibria in which an apparently worthless commodity has a positive price? The second puzzle has received little attention, though on reflection it is striking that widespread use of purely fiat money is a twentieth century development (Milton Friedman and Anna J. Schwartz, 1986), since the idea and physical implementation are simple.

This paper presents an explicit solution to the first puzzle in a simple artificial econ- omy. In formal terms I ask whether there is an equilibrium transition path between a barter equilibrium and a steady state monetary equilibrium. The paper also suggests a possible solution to the second, less widely considered puzzle. The answer suggested here is that the money issuer or government must attain a critical level of “credibility” before the transition can take place.

Most economists would probably relate a stylized “history of money” something like the following: As specialization caused problems in coordinating trade, societies naturally settled upon certain commodities, usually metals, as media of exchange. Later the minting of a certain quantity of a metal into coin acted as a signal of the quantity and purity of the metal. The signals of standardization needed credibility and the process of standardization

1was therefore frequently undertaken by governments who had established a reputation for some degree of honesty (which they frequently exploited). From coinage, which was commodity money in most senses, it was a relatively small step to substitute the use of paper representing contracts between the bearer and a bank or government. The contract specified payment on demand of a fixed quantity of a commodity (or coin).
From time to time, particularly during periods of crisis, governments suspended convertibility of paper currency, i.e., they reneged on the contract. Why did the currency continue to have value (though it frequently depreciated relative to goods) during suchepisodes? The obvious answer to this question focuses on the belief that convertibility would soon be restored.1 While it is an easy matter to verify whether coinage has been debased, it is not easy to verify a government’s good intentions or lack thereof. Therefore the government must have already established credibility in some way before the episode of inconvertibility so that economic actors have some reason to believe that the suspension is temporary.

The next stage is troubling for monetary theory, though hints of the trouble have already arisen above. Relatively recently in historical terms, governments have renounced even the intention of restoring convertibility of their currencies. Individuals are expected to accept intrinsically worthless pieces of paper—fiat money—in exchange for goods and services. These pieces of paper no longer represent any contract and there is no expectation that they will in the future. Paradoxically, they continue to be an acceptable medium of exchange. How can such a situation be supported? Obviously, one requirement is that the supply of paper money be limited. The question of the government’s credibility again arises, but the government has the conflicting motive of seigniorage. “Credibility” in this context must mean that individuals believe that the government will not attempt to exploit this source of seigniorage to the point where money becomes worthless. 

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