Functions of Money
Try to imagine an economy without money. Without money,
it would be almost impossible to carry out the usual day
to day
business of life. For instance, if you wanted to buy a
hamburger without
cash, you would have to give the restaurant something else
in return.
Perhaps you could wash the dishes, or sweep the floor.
Either way, the
ability to pay for goods and services with money greatly
simplifies consumer life and eliminates the necessity of
bartering goods and services for other goods and
services.
What exactly does money do? Sure, you can buy things with
it and save
it, but how does it function within the economy? There
are
four basic functions of money:
By understanding each of these functions, it is possible
to see how important money is to the economy.
The most obvious function of money is as a medium of
exchange. When
you hand the waiter a five-dollar bill in exchange for
your hamburger,
you are using money as a medium of exchange. You might
have a hard time paying for your hamburger with five
dollars worth of
apples, but if you did, the apples would serve as a medium
of exchange
as well. To simplify, a medium of exchange is something
that buyers give
to sellers in exchange for goods and services. Perhaps
money's most compelling advantage is that it is a commonly
recognized and universally accepted
medium of exchange. This allows anyone with money to walk
into any restaurant with the confidence that the waiter or
clerk will take your cash in
exchange for goods or services. This would likely not be
the case with
a basket full of apples.
The second function of money, as a unit of account, is
rather obvious,
but you may never have considered it before. When you
walk into a
restaurant, the menu tells you that a hamburger costs $5
and a steak
costs $15. You know what this means and are able to
compare these
prices. If, on the other hand, apples and oranges were
used as units
of account, comparison between the costs of goods
and services would be much more difficult. Imagine trying
to determine
what costs more, a hamburger costing 25 apples or a steak
costing 30
oranges. As a unit of account, money serves as the common
base of
comparison that people use to present prices and record
debts. Without
a common unit of account, these tasks would be much more
difficult.
The third function of money, as a store of value, is one
that we all
know well. When you work, you are paid a
wage. The
portion of
that wage that you do not spend gets saved. By saving
money, you are
able to spend some now and some later. In this way, money
serves as a
store of value, allowing you to trade current
consumption for future
consumption. Imagine if you were paid in bananas. Any
bananas that you
did not eat or trade immediately would rot, rendering you
unable
to enjoy the fruits of your labor at a later time.
The fourth and final function of money, as a means of
liquidity, is
important for an economy to move beyond a simple system of
bartering.
Imagine that you have 30 apples, and you really want a
steak. You walk
to the local restaurant and ask the waiter if you can
trade 30 apples
for a steak. He informs you that they have plenty of
apples, but could
use some oranges. Frustrated and hungry, you walk out of
the
restaurant. In this example, apples lacked liquidity
since they could
not easily be traded for what you wanted. Liquidity
describes the ease
with which an item can be traded for something that you
want, or into
the common
currency within an economy. Money is the
most liquid asset
because it is universally recognized and accepted as the
common
currency. In this way, money gives consumers the freedom
to
trade goods and services easily without having to barter.
Types of Money
Money comes in a number of different forms. In the
preceding section,
we saw apples and oranges used as money. When something
with intrinsic value, like precious metals, is used as
money, it is called
commodity money. It is
interesting to think about
the enormous variety of goods that can serve as commodity
money.
Basically, anything that can fulfill the four functions of
money, to so
some degree, can be used as commodity money.
Barter economies depend on commodity money. When
something lacking intrinsic value is used as money, it is
called
fiat money. This system
only works if a government backs the fiat money and
regulates its
production. In most countries, the cash or currency is a
form of fiat
money. The advent of fiat money is a great convenience in
many ways--
imagine trying to carry a week's pay in apples and
oranges.
