177 Defining Money by Its Functions
What you’ll learn to do: define money, explain the functions of money, and define liquidity
You use money nearly every day, but in this section, you will take a deeper look at what money really is—what it represents, why it has value, and what purpose it serves.
Learning Objectives
- Explain the functions of money
- Contrast commodity money and fiat money
Barter and the Double Coincidence of Wants
Money for the sake of money is not an end in itself. You cannot eat dollar bills or wear your bank account. Ultimately, money is only useful because you can exchange it for goods and 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; thus for something to be considered money, it must be widely accepted by both buyers and sellers. This concept of money is intentionally flexible, because money has taken a wide variety of forms in different cultures.
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 use the barter system. Barter—literally trading one good or service for another—is highly inefficient for conducting transactions. In a barter economy, an exchange between two people requires a double coincidence of wants, which means that what one person wants to buy is exactly what the other person wants to sell. This is harder than it sounds.
Suppose an accountant wants a new pair of shoes. The accountant doesn’t just need to find someone who has a pair of shoes in the correct size to sell, but they have to find a person who will also be willing to exchange the shoes for what the accountant has to offer, namely accounting services. Trades like these are likely to be difficult to arrange. Now imagine how this would work in a complex, modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and different goods & services. The number of transactions that end up taking place is likely to be much smaller than in an economy with money.
Another problem with the barter system is that it does not allow us to easily enter into future contracts for the purchase of many goods and services. For example, if the goods are perishable it may be difficult to exchange them today for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries harvested today. Because the strawberries won’t last, such a transaction is unlikely to occur.
While a barter system might work adequately in small economies, it will limit these economies’ growth. The time that individuals would otherwise spend producing goods and services and enjoying leisure time would instead be spent bartering.
Functions of Money
Money solves the