We are all familiar with money. It is part of our everyday lives. We use it to buy food, clothing, shelter, and entertainment. Money impacts all aspects of our lives one way or another, but how does it work? Money is defined as a medium of exchange. This is a basic definition of money that tells part of the story. In order to understand how money works, you must know that it has three functions. We mentioned one earlier, which is that it is a medium of exchange. The other two functions are that it is an item that keeps account and stores value. We will go into deeper details of what these three functions mean. In explaining these functions of money, you will have a better understanding of how money works.

MEDIUM OF EXCHANGE

One of the functions of money is that it is used as a medium of exchange. In other words, we use it to pay for goods and services, and it is also an established way to settle debt. Living in a society where money is the main medium of exchange, we can grow to take its convenience for granted. Comparing the use of money to a barter system will help highlight many benefits of money as a medium of exchange.

The Barter System

A barter system is when goods and services are traded between parties. Money is not included in the barter system. In order for a trade to be successful, both parties must have a need for each other’s goods and services. Also, there must be a similar value in the goods and services being traded. In a barter system, a farmer and a fisherman will trade their goods for a need of the other individual’s goods. Ten fish may be equal to a dozen apples and a dozen oranges if so agreed upon by both the fisherman and the farmer.

Barter vs. Money

Comparing the use of money to the barter system, we can observe that transaction costs are much lower when using money. Transaction cost is the time it takes to exchange goods and services. If a fisherman wanted a dozen apples and oranges, it would take more time to find a farmer who has the amount he wants and is also willing to exchange it for the fish he has. The fisherman may find a farmer with a dozen apples and oranges but also discover that the farmer does not want to exchange them for fish. This only adds to the transaction cost, making it greater. If money were to be used instead of barter, then the fisherman could sell the fish he catches for money and then use that money to buy a dozen apples and oranges. Having a low transaction cost makes money a convenient means of exchange.

KEEPS ACCOUNT

The second function of money is to be an item of account. In other words, money is used to measure value. A watch is used to measure time, and a tape measure is used to measure distance. Imagine how inconvenient it would be to determine the value of goods and services without using money. The value of an item is also its price.

Barter vs. Money–Grocery Store

We are accustomed to seeing price tags on items and deducing that what we see is the worth and cost of the item. Picture a grocery store that doesn’t use money but instead uses a barter system. Think of Walmart if Walmart was using the barter system. Instead of seeing $3.99 for a loaf of bread, you see all the possible combinations of items within the economy that can be used to trade for a loaf of bread. Depending on the number of items in the economy, a price tag can be very long.

A loaf of bread price tag could have a list of items of the same value, a list of items of lesser value combined to equal the loaf of bread, and a list of items that have a higher value than the loaf of bread in the portion of the loaf of bread value. So a toaster that is valued more than a loaf of bread could be listed on a loaf of bread price tag as 1/10 of a loaf of bread. Now the dilemma is, how do you trade 1/10 of a toaster for a loaf of bread? If you are confused by all of that, just be grateful we are not using the barter system. 

We see here that a barter system makes it very hard to make change. A barter system in today’s grocery store would be a nightmare. That is why money is a great measure of value in an economy with many items. 

STORE OF VALUE

The third function of money is to store value. Money’s function as a store of value gives users the opportunity to delay their purchasing to a later time or whenever they want. In comparison to a barter system, you can only use the trading power of your item when another person desires it. This can be very inconvenient and time-consuming in an economy if parties’ desires do not match quickly and easily.

Many people prefer money over other assets due to its liquidity. Liquidity is how easy it is for an item to be converted into a medium of exchange. Since money is already a medium of exchange, it is very liquid. A house may be a better store of value due to the fact that its value usually increases. Not the same is true for money, which loses purchasing power due to the increasing of the prices of items. This phenomenon is also known as inflation. Nonetheless, a house is not a medium of exchange and will have to go through a process to convert it to a medium of exchange. If a person needs cash in a few days and their only asset is a house, it is very difficult to sell a house that fast and get cash from its sale.

CRITERIA TO EFFECTIVELY FUNCTION AS MONEY

We now know that for something to be money, it must be a medium of exchange, a unit of account, and be able to be a store of value. Throughout history we have seen money take many different forms, such as the use of shells, beads, livestock, gold, paper, and more recently electronic currencies. As you can see, anything can be used as money, but not everything can effectively and efficiently carry out the functions of money. 

Durability

For something to work effectively as money, it must meet a number of criteria. One of the criteria is that it must be durable. If a society decides to use apples as a form of currency, it would be very bothersome due to the short shelf life of fruits. It would take too much to preserve such a perishable form of currency. The integrity of an apple as a medium of exchange would not be able to make it through more than a few transactions. The more transactions it is a part of, the faster it will deteriorate.

Easy To Carry

The second criterion for an item to work effectively as money is that it must be easy to carry. Gold, silver, and other precious metals were once used as currency by ancient society. Carrying around a sack of gold or silver can be very inconvenient for the average person in daily activity. Also, it can be a safety issue if a person needs to make a large purchase. There is no surprise that certificates were created in place to represent the physical gold a person has.

Broadly Acceptable

The third criterion an item must meet to be effectively used as money is that it must be broadly accepted. An item may be easy to carry and be durable, but if no one or only a few accept it, it will be very difficult to use. This is one of the challenges Bitcoin faces. Only a selective few accept bitcoin as an appropriate use of payment. As time goes by, we are seeing it becoming more widely accepted.

Easily Standardized

The fourth criterion an item must meet to be effectively used as money is that it must be easily standardized. In the United States currency system, coins are denoted in 1 cent, 5 cents, 10 cents, and 25 cents. Bills are denominated in $1, $5, $10, $20, $50, and $100. Imagine how difficult it would be if there was a $13.87 bill or a $3.87 coin. This would make counting and making change more difficult. A simple and easy form of standardization makes for ease of use. 

Be Divisible

The final criterion is that an item must be able to be divisible in order to make change. Going back to the early example of a modern grocery store that uses a barter system. We use a loaf of bread and a toaster as an example. Even though we decided that the toaster is worth more than a loaf of bread, it was impossible to make change to compensate for the extra value that a toaster has over the loaf of bread. In a barter system in this situation, a person would be given the option to get several more items to equate to the full value of the toaster. An item or a system that doesn’t allow the making of change provides many inconveniences.

FINAL THOUGHT

From the inception of civilization, humans have created some form of medium of exchange to deal with the economic activity among each other. When activity was simple and the population was much smaller than it is today, trade and barter were enough to satisfy the needs of commerce. As the population grew and economic activity became more complex, so did the medium of exchange. We know that money is used to buy goods and services and also used to measure and store value. These are some of the ways money is being used today. As society’s needs become greater and more complex, so will the function of its money.

If you only understand money as a way to purchase things, you are missing out on all of its capabilities. As technology improves, so will the medium of exchange’s ability to meet the criteria mentioned above. We will see safer transactions in commerce. Wealth will be easier to create and transfer among generations. Since its invention, money has been complex in its operation and will continue to be so for generations to come.