What is Money?
Money is what money does.
What is Money? The quick answer is money is what money does. So what does money do?
Money has four primary functions:
- Money serves as a medium of exchange
- as a store of value,
- as a unit of account,
- and a standard of deferred payment.
Without money as we know it today, we would be stuck in a barter economy. Where all transactions are conducted by barter, which involves the direct exchange of one good or service for another of equal value. Bartering has serious shortcomings:
Coincidence of wants
Bartering requires finding a person who both has what you want and who wants what you have at the same point in time. Exchange can only take place if there is a double coincidence of wants. The probability of a double coincidence of wants is minuscule. Which leads to increased transaction and opportunity costs. As you need to search for a person who has the items you need and needs the items you have to trade.
A measure of value
In a barter market, one would require an exchange rate for every pair of goods and services. Think of walking into a grocery store instead of seeing a price on an apple you see the exchange rate is two peaches, or one banana, or 100ml of milk, etc. This is impractical to set up as it is not possible to display all the combinations. It is also impossible to maintain as the relative value of goods and services change constantly. If a single item in a store goes on sale. Each item in the store will have to be repriced.
Subdivision is not possible
When you are conducting a barter transaction, the items for trade needs be of equal value. If the agreed exchange rate is one apple for two peaches, you cannot trade half an apple for one peach. The items being bartered is seldom sub divisional.
Transactions in time, not over time
A typical barter transaction happens at the moment - on the spot. You cannot trade one apple now for two peaches in five months’ time. How do you know the person you are trading with will still be around? Will the person be able to deliver two peaches in five months? What happens if the price of apples is now four peaches in five months’ time? Should he give you two peaches or four peaches?
Table of Contents
- Money is What Money Does
- Medium of Exchange
- Standard of Defered Payment
- Store of Value
- Unit of Account
- Properties of Money
Medium of Exchange
One school of thought holds the opinion money’s most important function is as a medium of exchange to facilitate transactions.
Money acting as a medium of exchange removes the need for a double coincidence of wants. One can sell what you have - swop your goods or service for money. Then buy what you want - swop your money for goods or services.
Benjamin Franklin observed about money:
“It is Cloth to him that wants Cloth, and Corn to those that want Corn; and so of all other necessaries, it is whatsoever it will procure.”
Regardless of what people have agreed among themselves what this medium of exchange is. He also observed the medium of exchange should be spread throughout, enabling anyone with the medium to exchange - to buy and sell. In his words:
“There is a certain proportionate quantity of money requisite to carry on the trade of a country freely and currently; more than which would be of no advantage in trade, and less, if much less, exceedingly detrimental to it.”
We are touching on another function of money here acting as a store of value, which we will elaborate on later. You can swop what you have for money now. Wait to swop that money for what you need in the future. When money also serves as a store of value there are conflicting factors. Because a store of value can become more valuable if it is scarce in the marketplace. When the medium of exchange is scarce, people will pay to rent it (in this case via interest). This has the potential to act as a brake on economic activities. People horde this money, reducing the velocity of money in circulations. This creates a shortage of the medium of exchange hampering economic activity. Benjamin Franklin mentions in his autobiography how a physical lack of paper money held the economy of Philadelphia back. The act of printing money increased the supply and encourage economic activity.
As many nations have learned one cannot print money indefinitely. If there is too much money in circulation, it loses its value. The economy grinds to a halt as people are unwilling to accept it in exchange for goods and services at its face value.
A critical and essential function of a medium of exchange:
- is to be widely acceptable,
- readily available
- and have relatively stable purchasing power (real value).
Standard of Defered Payment
Money can store a value to purchase something later on. The inverse would be one can purchase something now and pay for it with money at a later point in time. Hence the concept of money acting as a standard of deferred payment. It is important to note money in this case does not provide credit; it provides a measure to enable credit. Credit is critical for the modern economy.
If money is acceptable for payment today, it also needs to be acceptable in the future as a means of payments for purchases today. If you think about it loans, credit etc. are all defined repayment terms referencing money. without money it will be complex to have credit
Store of Value
To function as a medium of exchange, money must hold its value over time - a store of value. A store of value is the function of an asset when it can be stored, retrieved and exchanged later, while being predictably useful when retrieved. A store of value is anything that keeps purchasing power into the future.
To serve as a measure of value or a medium of exchange, the medium needs to have constant inherent value of its own. Alternatively, the medium needs to derive value from being linked to a definite basket of goods and services. We measure inflation as the change (in percentage) of a basket of goods and services. Inflation is measuring the decreasing purchasing power (value) of money. So your ideal store of value item has a constant intrinsic value and stable purchasing power.
One reason gold and silver were popular as a medium of exchange and store of value:
- is because it was inert
- was convenient to move due to even small amounts of gold having considerable value
- and had a constant value.
For the average person these days, the most common store of value is money. Money is popular as a store of value because of its liquidity. Something is liquid when it can easily be exchanged for other goods and services, without impacting on the assets price.
Having this function as a store of value, we hoard large quantities of money. Money’s usefulness as a store of value declines if there are significant changes in the general level of prices. So if inflation rises, purchasing power declines, your value decreases. You can think of it as paying a storage cost, similar to buying gold and renting a storage box at a bank. If this storage cost is high, you will better of not holding this asset.You see this in countries with hyperinflation. People spend their money quickly instead of saving it. Even the mere fear of a currency losing its store of value function in future purchasing power, it fails functioning as money. People switch to use currencies from other countries as a substitute. Most recent examples would be Zimbabwe and Venezuela.
As mentioned previously one school of thought considers the medium of exchange function as money‘s most valuable function. Alternative school of thought the so-called Cambridge cash-balance theory, argues money’s ability to store value is more important than its function as a medium of exchange.
Demand for money derives according to the Cambridge theory from its ability to store value. This is contrary to the other school of economic thinking, which argues demand arises when we use money for exchange.
If we store money for a period and it does not maintain its value, we cannot use it in exchange for goods and services. So money would not solve the double coincidence of wants problem. Therefore, we would not adopt it as a medium of exchange. This Cambridge theory makes a very valid point.There are many other stores of value besides money, for example art, land, and even Pokemon cards. Inflation makes money not a great store of value.
Money or more broadly defined cash and cash equivalents has high liquidity, low transaction fees and is easily transported. The other stores of value lack this liquidity, as it is not easily exchangeable and you will incur higher costs to exchange it. If you need to dispose of it in a short timeframe, you will need to do it below its fair value. Money, as a medium of exchange, is readily accepted everywhere. Your local convenience store seldom accept Pokemon cards as a means of payment. This benefit comes at a cost, money has a liquidity discount. Where most other stores of value have an illiquidity premium.Unlike other stores of value, money comes in several convenient denominations. Making it easy to exchange the exact amount of monetary value for the useful value of the item you are buying. This brings us to moneys functioning as a unit of account.
Unit of Account
Most people have a rough idea of their weight in kilograms or the weight of items they buy at the grocery store. Ever wondered how a scale knows how much a kilogram weigh?
For over a century we set the international standard of a kilogram against the international prototype of the kilogram. A circular cylinder made of a platinum alloy. It has a mass equal to the mass of one cubic decimetre of water under atmospheric pressure and at the temperature of its maximum density around 4 °C. From 20 May 2019, the Planck constant will be the new base.
This Platinum cylinder has been the base of a unit of weight to enable countless other activities by acting as a common unit. Money has a similar function as a unit of account, providing a common measure of the value of goods and services. Money acting as a common measure of value enables all goods and services to be priced in terms of this medium. Instead of pricing items against each other.
Knowing the value or price of a good in terms of money. Enables both the supplier and the purchaser of the goods to decide how much of the goods to supply and how much of the goods to purchase. This unit of account allows us to render the value of various goods, services, assets and liabilities in multiples of the same unit.
This single medium simplifies the process to set and adjust the relative values of goods and services in a marketplace.
In most cases, money as a medium of exchange can be subdivision’d into smaller units to the same value of any good or service. Just like we can subdivide a kilogram into grams. Being sub-divisible enable a more precise exchange of one item of value for another item of value.
Money, especially in the form of fiat currencies, is the standard measurement of wealth. Money is the mechanism used by us to measure the value of all goods and services in our economy. A mechanism of pricing is the essential condition for a fair exchange, efficient allocation of scarce resources and even for the operation of justice.
Properties of Money
To fulfil its various functions, money should own the following characteristics:
- Fungible: its units must be capable of mutual substitution
- Durable: to withstand repeated use
- Portable: easily carried and transported
- Re-cognisable: its value must be easily determined.
- Stable: its value should not fluctuate.
- Accessible: in common circulation
- Storable: low cost of preservation
- Valuable: high market value in relation to volume and weight
- Securable: resistance to counterfeiting