Let’s talk about money and, more specifically, the functions and characteristics of money. We use money every day, but how often do we really think of it? Sure, we check the amount we have sitting in our bank account, but that’s typically it. Economists generally define money as a commodity accepted by general consent as a medium of exchange. But that’s not the only thing money does. Besides being a medium of exchange, money also accounts as a unit of account and a store of value. No matter if we are talking about money as cowry shells in Africa to strings of beads that the Native Americans used, money must be able to fulfill these functions. Without money being able to fulfill these three important functions, then what we consider money would not last nor be used consistently.
The Three Primary Functions Of Money
Throughout the history of money, there have always been three primary functions that money serves in an economy: a medium of exchange, a unit of account, and a store of value.
Let’s break these down a little further.
First: Medium of Exchange
What does it mean that money is a medium of exchange, and why is it an essential function of money? Essentially, a medium of exchange means that money is widely accepted as payment for goods and services. When I go to the supermarket, I do not worry about whether or not they will accept my payment in money. This is partly because the business believes they can exchange the money for other goods and services, and the fact that the U.S. government protects my right to pay with U.S. dollars ensures that it stays as an effective medium of exchange.
Second: Unit of Account
Merriam-Webster defines a unit of account as “a monetary unit or measure of value (as a coin) in terms of which accounts are kept, and values stated.” The basic idea here is that we need something in the economy that gives the value of all things a common denominator to understand the value of the given item. For example, if I am looking to buy a new car, the price could be quoted in computers, rice, shells, oil, or any number of things.
Theoretically, they could quote me 20 Macbooks for the car at the dealership or 250 tons of shells for the car. You can quickly see how money makes this much easier because it is our common measuring stick of value. Instead of worrying about today’s price of shells or whatever the merchant would want to quote you in, you can just look at the measuring stick (money) to understand the effective cost of what you are exchanging for the item today.
Third: Store of Value
Simply put, money must be able to hold its value. If I work and get paid today, I don’t have to spend it today because it will still be valuable next week, next month, or next year. Money is not a perfect store of value due to inflation, but it does a good job. Comparing money to corn that might rot or other goods that could weather away, it is highly effective. The ability to hold its value is an extremely critical function of money that allows for its continued use.
Characteristics Of Effective Money
Money has three primary functions that play a role in an effective economy, but it also has key characteristics that influence its effectiveness and longevity.
1) Durability
Money needs to be able to stand the test of time under relatively consistent use. A chicken is relatively durable, but environmental factors such as drought, and flooding, could cause the chicken to be sick or die, which would severely reduce or eliminate its value and are difficult to replace. Compare that with One-hundred dollar bills that are fairly durable, can be replaced if they become damaged, and the bill’s value is much more resilient to everyday use.
2) Portability
If you have trouble moving money, it’s not very effective. A cow is fairly durable, but it’s not overly easy to transport a cow especially compared to a one-hundred-dollar bill.
3) Divisibility
I need to be able to exchange money for other denominations. A 100-dollar bill can be exchanged for a 50, two 20s, and a 10-dollar bill. I’m not sure how to easily do that with a chicken or cow.
4) Uniformity
Money needs to be uniform and consistent to keep the value consistent. If I were in a marketplace, how would I determine the value of one chicken compared to another? Sure it can be done, but it’s much more difficult. Chickens and cows come in many sizes, shapes, and colors. Compare that to a dollar bill. A dollar bill is always the same weight, size, and shape, making the conversation simple.
5) Limited Supply
If there were an unlimited pool of money, it would lose its value. At the same rate, if there isn’t enough money for everyday use, it won’t be effective. You can see the natural problems when it comes to stones, chickens, or cows. The dollar isn’t immune to these problems but that’s where the federal reserve comes into play. They regulate money so that it retains its value over time.
6) Acceptability
Even though chickens and stones have an intrinsic value, some people may not want or accept them as payment. If it isn’t generally accepted, then the money source will not be effective in its primary functions.
It’s safe to say that the money we have today is a great improvement from what we had hundreds of years ago.
To summarize, money has three primary functions in an economy. Money needs to be a medium of exchange, a unit of account, and store of value. Money has six general characteristics that affect its place in the market which are durability, portability, divisibility, uniformity, limited supply, and acceptability.
