The Functions of Money; The Kinds of Money: Videos & Practice Problems

Money serves several essential functions in an economy, acting as a medium of exchange, a unit of account, and a store of value. As a medium of exchange, money facilitates transactions by eliminating the need for a double coincidence of wants, which is a situation where both parties in a trade must have what the other desires. In a barter economy, this requirement complicates trade, as illustrated by the example of Brickmaster, Sir Lumber, and Admiral Wheat. Without money, Brickmaster struggles to trade his clay for lumber because Sir Lumber only wants to exchange lumber for wheat, creating a deadlock.

In contrast, when money is introduced, Brickmaster can sell his clay for money, which he can then use to purchase lumber from Sir Lumber. This process highlights the importance of money in simplifying transactions and enhancing economic efficiency. Money also serves as a unit of account, providing a standard measure of value that allows individuals to compare the worth of different goods and services easily. This function is crucial for pricing and budgeting.

Additionally, money acts as a store of value, enabling individuals to save and defer consumption until a later time. This characteristic ensures that money retains its value over time, allowing people to plan for future purchases. Overall, the functions of money are vital for the smooth operation of an economy, facilitating trade, providing a consistent measure of value, and allowing for savings and future planning.

Money serves three primary functions that are essential for facilitating economic transactions: it acts as a medium of exchange, a unit of account, and a store of value.

The first function, medium of exchange, allows money to be used for trading goods and services rather than being consumed itself. For instance, when you use US dollars, you are not consuming the currency; instead, you are using it to trade for other goods. This function positions money as a facilitator in transactions, acting as a middleman between what you want and what you have.

Next, money functions as a unit of account, which provides a standard measure for setting prices and making calculations. This simplifies transactions by establishing a consistent price for goods. For example, if lumber is priced at $5, it eliminates the need for complex barter systems where one would have to calculate the value of lumber in terms of other goods, such as wheat or bricks. By having a single price in dollars, it streamlines the buying and selling process, making it easier for consumers and sellers to understand the value of goods.

Lastly, money serves as a store of value, enabling individuals to retain their purchasing power over time. This means that you can earn money now and save it for future use, allowing for deferred payments. For example, you might buy a car today and make payments later, with the assurance that the money you pay in the future will hold the same value as it does today. This characteristic is crucial for financial planning and investment, as it allows individuals to manage their resources effectively.

While other assets like stocks, bonds, and real estate can also hold value, they do not function as money in the same way. These assets can be considered forms of wealth but lack the liquidity that money provides. Liquidity refers to how easily an asset can be converted into cash. For instance, stocks are generally more liquid than real estate, as they can be sold quickly on the market, whereas selling a house involves a lengthy process to find a buyer.

In summary, the three main functions of money—medium of exchange, unit of account, and store of value—are fundamental to its role in the economy, facilitating trade, simplifying pricing, and allowing for the preservation of wealth over time.

Understanding the two primary types of money—fiat money and commodity money—provides insight into their roles in the economy. Fiat money derives its value from government regulation and societal agreement, meaning it holds value simply because we collectively decide it does. For instance, the US dollar is a form of fiat money; outside of its function as currency, it has no intrinsic value, as it cannot be consumed or utilized for other purposes.

In contrast, commodity money possesses intrinsic value due to its physical properties and additional uses beyond serving as a medium of exchange. A prime example of commodity money is gold, which has been utilized for thousands of years not only as currency but also in various applications such as jewelry and electronics. This dual functionality is a key characteristic of commodity money, distinguishing it from fiat money, which lacks alternative uses.

In summary, the fundamental difference lies in the nature of their value: fiat money is valuable solely because of government endorsement, while commodity money has inherent value due to its additional applications in society.