236 Reading: The Functions of Money
The Functions of Money
So our first question is, what is money? If you happen to have one on you, take a look at a $5 bill. What you’ll see is a piece of paper with a picture of Abraham Lincoln on one side and the Lincoln Memorial on the other. Though this piece of paper—indeed, money itself—has no intrinsic value, it’s certainly in demand. Why? Because money serves three basic functions. Money is the following:
- A medium of exchange
- A measure of value
- A store of value
To get a better idea of the role of money in a modern economy, let’s imagine a system in which there is no money. In this system, goods and services are bartered—traded directly for one another. Now, if you’re living and trading under such a system, for each barter exchange that you make, you’ll have to have something that another trader wants. For example, say you’re a farmer who needs help clearing his fields. Because you have plenty of food, you might enter into a barter transaction with a laborer who has time to clear fields but not enough food: he’ll clear your fields in return for three square meals a day.
This system will work as long as two people have exchangeable assets, but needless to say, it can be inefficient. If we identify the functions of money, we’ll see how it improves the exchange for all the parties in our hypothetical set of transactions.
Medium of Exchange
Money serves as a medium of exchange because people will accept it in exchange for goods and services. Because people can use money to buy the goods and services that they want, everyone’s willing to trade something for money. The laborer will take money for clearing your fields because he can use it to buy food. You’ll take money as payment for his food because you can use it not only to pay him but also to buy something else you need (perhaps seeds for planting crops).
For money to be used in this way, it must possess a few crucial properties:
- It must be divisible—easily divided into usable quantities or fractions. A $5 bill, for example, is equal to five $1 bills. If something costs $3, you don’t have to rip up a $5 bill; you can pay with three $1 bills.
- It must be portable—easy to carry; it can’t be too heavy or bulky.
- It must be durable. It must be strong enough to resist tearing and the print can’t wash off if it winds up in the washing machine.
- It must be difficult to counterfeit; it won’t have much value if people can make their own.
Measure of Value
Money simplifies exchanges because it serves as a measure of value. We state the price of a good or service in monetary units so that potential exchange partners know exactly how much value we want in return for it. This practice is a lot better than bartering because it’s much more precise than an ad hoc agreement that a day’s work in the field has the same value as three meals.
Store of Value
Money serves as a store of value. Because people are confident that money keeps its value over time, they’re wil