The Functions of Money
-Money didn’t always exist in paper and coin form. Over the course of time, many things have served as money. To economists, something is considered to be money if it fulfills three functions: 1) acts as a medium of exchange, 2) is an unit of account, and 3) serves as a store of value.[break]
Medium of Exchange
-In any economy, there will be people who want to sell their goods and services in exchange for other goods and services. Money helps facilitate that exchange.
-If we didn’t have money, we would revert back to the barter system, which requires a double coincidence of wants.
-A double coincidence of wants refers to when one person has something that another person wants and both are willing to trade for it.
-The necessity for a double coincidence of wants can seriously stall an economy.
-Suppose we have 3 people. A farmer who has wheat, a tailor who has clothes, and a baker who has pastries.
-The farmer wants clothes; he doesn’t want pastries.
-The tailor wants pastries; he doesn’t want wheat.
-The baker wants wheat; he doesn’t want clothes.
-If they are not willing to trade for things they don’t want, then they are stuck with what they have.
-Money serves as a medium of exchange to resolve this problem.
-The farmer can sell his wheat to the baker for money and use that money to buy clothes from the tailor.
-The tailor can sell clothes to the farmer for money and use that money to buy pastries from the baker.
-The baker can sell pastries to the tailor and use that money to buy wheat from the farmer.[break]
Unit of Account
-Money serves as a standard unit of measure to make it easy to figure out how much something costs.
-Without money, the prices of goods and services would all have to be listed relative to one another, which can get very confusing very fast, especially if there are a lot of items to consider.
-For example, how many piano lessons should a television be traded for? How many bookshelves is a cow worth? What does a five course dinner cost in socks? So on and so forth.
-Having money as a unit of account makes it easy to compare the price of one item to another without having to do research on relative prices.[break]
Store of Value
-Objects that are good candidates for money will have a good store of value, which will allow you to save your purchasing power today to be used in the future.
-For this reason, perishable goods like fruits and vegetables are bad candidates for money because they will go bad and rot when being stored.[break]
Types of money
-There are primarily two types of money: commodity money and fiat money.
–Commodity money is money that has inherent or intrinsic value, meaning that if the item wasn’t being used as money, that item serves some other purpose and will still have value.
-Examples of commodities that have served as money throughout history include grain, tobacco, and precious metals (like good and silver).
–Fiat money is the opposite of commodity money in the sense that it has no inherent or intrinsic value. The money value that fiat money has is the value that we give it.
-The money that is currently being used in the United States is fiat money. A $20 bill is nothing more than a piece of paper that says $20 on it. You can’t eat, wear, or play with this piece of paper. The only reason it has value is because you and everyone else says that it has value and are willing to accept is as a form of payment.[break]
Value of Money
-So where does a $20 bill derive its value from? Why can’t anyone just write “$20” on a green piece of paper and exchange that for goods and services? The answer to this question has several parts.[break]
-The most important facet of a money’s value is its acceptability. You would accept a $20 bill as a form of payment because you know that other people will also accept it as a form of payment.
-The entire monetary system hinges on the acceptability of money. The moment everyone decides to stop accepting something as a form of payment is the moment that item becomes completely worthless and ceases to be a medium of exchange.[break]
-Something that helps with the acceptability of the US dollar is that the government has decreed it to be legal tender.
-On each bill, it is written “This note is legal tender for all debts, public and private”.
-This means that dollar bills are a legal form of payment for any debt that was contracted in dollars. With that being said, keep in mind that private firms and the government are not mandated to accept cash. They can choose to specify payments in noncash items, such as checks, money orders, or credit cards.
Relative Scarcity and Stable Purchasing Power
-Like everything else in economics, the purchasing power of money is determined by supply and demand.
-If the supply of money increases too quickly relative to demand, the purchasing power of the money will decrease. This is known as inflation.
-While some inflation is acceptable, if there is too much for too long, money will cease to become scarce and will lose its ability to buy things because of its decline in value. In other words, this money will become a poor store of value which would cause people to stop accepting this form of money.
-In order to prevent that from happening, central banks (like the Federal Reserve) work hard to keep the money supply from expanding too quickly and to prevent massive amounts of inflation.
-The more stable a currency is, the more acceptable it is.[break]
-Sometimes people will take their money and exchange it for other stores of value (other assets) that are not money. For example, stocks, bonds, real estate, etc.
-Liquidity refers to how easy it is to convert that asset back into money.
-The liquidity of an object is set on a range from highly liquid to not liquid at all.
-By definition, cash is perfectly liquid (it is already money).
-Savings and checking accounts are less liquid than cash, because it involves extra steps to convert them back into money, but they are still highly liquid.
-Stocks and bonds are less liquid than bank accounts, real estate is less liquid than stocks, a complete mint collection set of Beanie Babies is probably less liquid than real estate, etc.