Money serves four key functions in the economy:
1. It acts as a medium of exchange.
2. It is a unit of account.
3. It is a store of value.
4. It offers a standard of deferred payment.
Medium of Exchange
If you are a teacher or an accountant, you are paid money for your services. You then use that money to buy goods and services. You essentially exchange your teaching or accounting services for food, clothing, rent, and other goods and services. But unlike with barter, where goods and services are exchanged directly for other goods and services, the exchanges you participate in involve money.Money is providing the service of a medium of exchange. That is, money is the medium through which exchange takes place. Because, by definition, money is generally accepted as payment for goods and services or as payment for debts, you know that the money your employer pays you will be accepted at the stores where you purchase food, clothing, and other goods and services. In other words, you can specialize in producing teaching or accounting services without having to worry about directly producing the other goods and services you require to meet your needs, as you would in a barter economy
Unit of Account
Using a good as a medium of exchange provides another benefit: Instead of having to quote the price of a single good in terms of many other goods as is the case with barter each good has a single price quoted in terms of the medium of exchange. This function of money gives households and firms a unit of account, or a way of measuring value in the economy in terms of money. For instance, in the current U.S. economy, each good or service has a price in terms of dollars.
Store of Value
Money allows value to be stored easily, thereby providing the service of a store of value. If you do not use all your accumulated dollars to buy goods and services today, you can hold the rest for future use.Note, though, that if prices in an economy rise rapidly over time, the amount of goods and services a given amount of money can purchase declines, and money’s usefulness as a store of value is reduced. Of course, money is only one of many assets that can be used to store value. In fact, any asset shares of Apple stock, Treasury bonds, real estate, or Renoir paintings, for example represents a store of value. Indeed, financial assets, such as stocks and bonds, offer an important benefit relative to holding money because they generally pay interest or offer the possibility of increasing in value. Other assets also have advantages relative to money because they provide services. For instance, a house provides its owner with a place to sleep.Why, then, does anyone bother to hold money? The answer goes back to liquidity, or the ease with which an asset can be exchanged for money. Money itself is, of course, perfectly liquid, while you incur transactions costs when you exchange other assets for money.When you sell bonds or shares of stock to buy a car, for example, you pay a fee, or commission, online or to your broker. If you have to sell your house on short notice because you have been transferred to a job in another part of the country, you will have to pay a commission to a real estate agent and probably have to accept a lower price to exchange the house for money quickly. To avoid such transactions costs, people are willing to hold some money, even though other assets offer a greater return as a store of value.
Money is also useful because of its ability to serve as a standard of deferred payment in credit transactions.Money can facilitate exchange at a given point in time by providing a medium of exchange and unit of account. It can facilitate exchange over time by providing a store of value and standard of deferred payment. For example, a furniture store may order 25 dining room tables from a furniture manufacture by promising to make full payment in 60 days.
Distinguishing Among Money, Income, and Wealth
It’s important to keep straight the differences between money, income, and wealth. We often say that individuals in Forbes magazine’s list of richest Americans have a lot of money.We don’t really mean that they have a lot of paper currency in their pockets (or hidden away in their mansions or yachts); instead, we mean that they own valuable assets, such as stocks, bonds, or houses. Money, like other assets, is a component of wealth, which is the sum of the value of a person’s assets minus the value of the person’s liabilities. However, only if an asset serves as a medium of exchange can we call it money. A person’s income is equal to his or her earnings over a period of time. So, a person typically has considerably less money than income or wealth.
What Can Serve as Money?
Having a medium of exchange makes transactions easier and thus allows the economy to work more efficiently. The next logical question is:What can serve as money? That is, which assets should be used as the medium of exchange? We noted earlier that any asset can be used as money, provided that it is generally accepted as payment. In practical terms, an asset is suitable to use as a medium of exchange if it is
- Acceptable to (that is, usable by) most people.
- Standardized in terms of quality, so that any two units are identical
- Durable, so that it does not quickly become too worn out to be usable.
- Valuable relative to its weight, so that amounts large enough to be useful in trade can be easily transported.
- Divisible, because prices of goods and services vary.
The Mystery of Fiat Money
Notice that paper currency has no intrinsic value. You can use a $20 bill to buy goods and services, but beyond that it has no value to you except, perhaps, as a bookmark. The Federal Reserve issues the paper currency of the United States, but the Fed is under no obligation to redeem it for gold or any other commodity.Money, such as paper currency, that has no value apart from its use as money is called fiat money. People accept paper currency in exchange for goods and services partly because the federal government has designated it to be legal tender, which means the government accepts paper currency in payment of taxes and requires that individuals and firms accept it in payment of debts. In reality, though, the more important reason paper currency circulates as a medium of exchange is the confidence of consumers and firms that if they accept paper currency they will be able to pass it along when they need to buy goods and services. Basically, it is a case of self-fulfilling expectations: You value something as money only if you believe that others will accept it from you as payment.
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