Chapter 9.1: Money and Its Functions
9.1 Defining Money by Its Functions
Learning Objectives
By the end of this section, you will be able to:
•Explain the various functions of money
•Contrast commodity money and fiat money
What is money? Money for the sake of money is not an end in itself. You cannot eat dollar bills or wear your bank account. Ultimately, the usefulness of money rests in exchanging it for goods or services. As the American writer and humorist Ambrose Bierce (1842–1914) wrote in 1911, money is a “blessing that is of no advantage to us excepting when we part with it.” Money is what people regularly use when purchasing or selling goods and services, and thus both buyers and sellers must widely accept money. This concept of money is intentionally flexible, because money has taken a wide variety of forms in different cultures.
When one describes Bill Gates as wealthy, implying he could afford nearly anything, we’re speaking about his abundance of wealth. While Gates possesses a significant stake in Microsoft, he cannot directly purchase goods from stores using these shares.
Money is anything that society deems acceptable as a common unit to facilitate the exchange of goods services and resources.
The alternative for a society without money is to produce their own goods and services (each household) or barter. However, barter only works when you have two parties who each want what the other has or can provide. We call this a coincidence of preference which we will discuss below.
Barter and the Double Coincidence of Wants
To understand the usefulness of money, we must consider what the world would be like without money. How would people exchange goods and services? Economies without money typically engage in the barter system. Barter—literally trading one good or service for another—is highly inefficient for trying to coordinate the trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide. For example, if an accountant wants a pair of shoes, this accountant must find someone who has a pair of shoes in the correct size and who is willing to exchange the shoes for some hours of accounting services. Such a trade is likely to be difficult to arrange. Think about the complexity of such trades in a modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and goods.
Another problem with the barter system is that it does not allow us to easily enter into future contracts for purchasing many goods and services. For example, if the goods are perishable it may be difficult to exchange them for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries. Additionally, while the barter system might work adequately in small economies, it will keep these economies from growing. The time that individuals would otherwise spend producing goods and services and enjoying leisure time they spend bartering.
Functions for Money
Money solves the problems that the barter system creates.
Money provides three functions:
Medium of Exchange– money acts as an intermediary between the buyer and the seller. Instead of exchanging accounting services for shoes, the accountant now exchanges accounting services for money. The accountant then uses this money to buy shoes. To serve as a medium of exchange, people must widely accept money as a method of payment in the markets for goods, labor, and financial capital.
Unit of Account – to quote prices. To assign different values for a t-shit and a pen. This means that money serves as a ruler by which we measure values. Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs.
Store of Value – money functions as a store of value, allowing individuals to save purchasing power over time. For example, buy buying gold.
Liquidity is the most important characteristic of money. Moneyness reflects the ease with which an asset can be transformed into cash. Liquidity can entail the straightforward conversion of an asset into cash, yet at times, it also implies the ability to convert assets into cash without enduring significant losses.
Many individuals who accumulate wealth may opt to invest in antique pieces or rare paintings. Nevertheless, antique pieces cannot be used for purchases at grocery stores. Put simply, while assets like antiques may hold considerable value, they lack liquidity, requiring several steps to sell the antique, obtain cash, and then proceed to the grocery store for shopping.
Therefore, when deciding in what form to hold their wealth, one has to balance the liquidity of each possible asset against the asset’s usefulness as a store value. Money is the most liquid asset but is far from perfect as a store of value. For example, when prices rise, the price level and the value of money falls. When goods and services become more expensive, each dollar in your wallet can buy less.
Different Types of Money
Commodity money refers to money that exists in the form of a commodity with inherent value. Intrinsic value implies that the item possesses value independent of its use as currency. For instance, gold is a prime example.
Commodity Backed Money – also known as the “Gold Standard” refers to paper money that is convertible to gold on demand. Governments that issue commodity backed money cannot print money, without backing it up with something of value. When using the “Gold Standard” then such money is backed up with gold. Historically, commodity-backed money, particularly when using the gold standard, has been used to ensure the stability of currency and control inflation. However, modern economies have largely moved away from commodity-backed systems in favor of fiat currencies, which are not backed by any physical commodity but rather rely on government decree and trust in the issuing authority.
Fiat money – is money without intrinsic value but is declared by a government to be a country’s legal tender. The United States’ paper money, for example, carries the statement: “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.” It cost less than $1 to produce $1. Yet the $1 is worth $1 by government decree. Therefore, it is imperative that the government controls the amount of money in circulation in order to maintain the value of the dollar.
This chapter is a revised version of the chapters 14.1 Defining Money by Its Functions in Principles of Macroeconomics 3e by OpenStax, published under a Creative Commons Attribution 4.0 International License. Other additions and modifications have been made in accord with the style, structure, and audience of this guide.
