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The chapter on Production Possibilities and Trade imagines two people, Alicia and Boris, making and trading mugs and bowls. Other chapters assume that goods and services are exchanged for money. In those chapters, money may be viewed as a good that is traded for other goods. If there are markets for other goods, is there a market for money? Yes, there is. This chapter explains how the market for money works.
You probably identify money either with bills and coins or with a bank account balance. Economists have a broader understanding of money.
The Functions of Money
Money has three basic functions:
- It is a medium of exchange.
- It is a unit of account.
- It is a store of value.
Let’s consider each in turn.
If you want to buy a hamburger, you have to give the restaurant something in return. In theory, you could wash the dishes or sweep the floor. Or you could hand over some other food product, such as a basket of apples. If the transaction required negotiation (“What do you have?”—“Well, I have some apples”—“Oh, I could use those,” etc.), you would be engaging in barter. (That is what Alicia and Boris are doing with their mugs and bowls.) But if it were standard practice to hand vendors apples in exchange for other goods and services (a small basket for a burger, several wagonfuls for an automobile), then apples would be money. It is of course more convenient to carry cash, which is physically compact and doesn’t spoil when left in a drawer. But whether it’s apples or cash, money is a medium of exchange—something whose acceptance as payment for goods and services is standardized. Anyone with money in their pocket or purse can walk into any restaurant with the confidence that the waiter or clerk will accept the cash in exchange for a burger. The reason the restaurant will happily take the money is that the owners know they can spend it on something else.
The second function of money 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 $10 and a steak costs $18. 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 is one 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.
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, be it food or 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 is desirable in its own right and can fulfill the three functions of money can be used as commodity money.
Something lacking intrinsic value, like paper notes, can be used as a stand-in for a commodity. There was a time when a U.S. dollar bill was by law exchangeable for a fixed amount of gold. (Starting in 1934, the amount was 1/35 of an ounce.) This made the dollar commodity-backed money. Paper money only works if a government regulates its production. The advent of paper money is a great convenience in many ways—imagine trying to carry a week's pay in apples and oranges. But paper money is easy to counterfeit precisely because it’s inherently worthless: a counterfeiter’s production costs are minimal. That is why the government has to regulate production.
Once people have gotten used to using paper money, however, there really isn’t any reason why it has to be backed by a commodity. If the legal link to the commodity is taken away, commodity-backed money becomes fiat money. In most countries today, the cash or currency is a form of fiat money. (The U.S. dollar became a fiat currency in 1971.)
It turns out, though, that money need not have a physical form at all. As the Monetary Policy chapter explains, the amount of money in circulation is much larger than the number of bills and coins being passed around. The details of how that works don’t matter for this chapter, however. Here, we will think of money simply as fiat money “dollars” and not worry about the form they take.
