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What Is Money and What Are Its Functions?

Money is something you've been familiar with throughout your life. In fact, you may already consider yourself an expert on the subject. You regularly use money to measure the value of things you own. You also have some of it in your pocket and in bank accounts. It might surprise you to learn that there's a great deal of disagreement among economists about what money is and how to measure it. Money serves a number of functions, and any definition of money must consider all of its functions.

The four major functions of money are as a medium of exchange, a standard of value, a standard of deferred payment, and a store of value.

A Medium of Exchange. As a generally accepted medium of exchange, money rules out the need for barter, the direct exchange of one item for another. Barter is a very inconvenient means of trading because it requires the double coincidence of wants. A seller with a good or service to offer must search for a buyer who has exactly what the seller desires. For example, if a baker wants meat, he must search for a person who sells meat and wants bread under a barter system. Because money is generally accepted as payment for may purchase, a baker who sells bread for money can use the money to buy meat or anything else he wants.

A Standard of Value. Money provides a unit of account that serves as a standard to measure value. The value of an item is a measure of what a person will sacrifice to obtain it. How much is a two-week vacation in Hawaii worth to you? If you're like most people, you'll probably respond to such a question by valuing the vacation in dollars - way $2,000 - rather than in terms of other things (like your car). Whether or not you're conscious of it, you're constantly valuing items in dollars. As a standard of value, money allows the addition of values of many different items as automobiles, repairs, and all other goods and services. The concept of GNP is useless without a standard of value such as the dollar.

A standard of Deferred Payment. Many contracts involve promises to pay sums of money in the future. The unit of account for deferred payment of debts is also money. If you borrow money to buy a car, the loan contract specifies how much you must pay back every month and the number of months required to satisfy your obligation. However, money serves its function as a standard of deferred payment only if its purchasing power remains fairly constant over time. If the price level rises, the future purchasing power of money over time will go down. Similarly, a decrease in the price level will increase the future purchasing power of money.

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