The Function of Money

THE FUNCTION OF MONEY

A usual thing in economics is money. When we say that a person has a lot of money, we usually mean that he or she is wealthy. By contrast, economists use the term “money” in a more specialized way. To an economist, money does not refer to all wealth but only to one type of it: money is the stock of assets that can be readily used to make transactions. Roughly speaking, the dollars in the hands of the public make up the nation’s stock of money. Money has three purposes: it is a store of value, a unit of account, and a medium of exchange. As a store of value, money is a way to transfer purchasing power from the present to the future. If I work today and earn $100, I can hold the money and spend it tomorrow, next week, or next month. Of course, money is an imperfect store of value: if prices are rising, the amount you can buy with any given quantity of money is falling. Even so, people hold money because they can trade it for goods and services at some time in the future. As a unit of account, money provides the terms in which prices are quoted and debts are recorded. Microeconomics teaches us that resources are allocated according to relative prices the prices of goods relative to other goods yet stores post their prices in dollars and cents. A car dealer tells you that a car costs $20,000, not 400 shirts (even though it may amount to the same thing). Similarly, most debts require the debtor to deliver a specified number of dollars in the future, not a specified amount of some commodity. Money is the yardstick with which we measure economic transactions.

As a medium of exchange, money is what we use to buy goods and services. “This note is legal tender for all debts, public and private” is printed on the U.S. dollar. When we walk into stores, we are confident that the shopkeepers will accept our money in exchange for the items they are selling. The ease with which an asset can be converted into the medium of exchange and used to buy other things goods and services are sometimes called the asset’s liquidity. Because money is the medium of exchange, it is the economy’s most liquid asset. To better understand the functions of money, try to imagine an economy without it: a barter economy. In such a world, trade requires the double coincidence of wants the unlikely happenstance of two people each having a good that the other wants at the right time and place to make an exchange. A barter economy permits only simple transactions. Money makes more indirect transactions possible. A professor uses her salary to buy books; the book publisher uses its revenue from the sale of books to buy paper; the paper company uses its revenue from the sale of paper to pay the lumberjack; the lumberjack uses his income to send his child to college; and the college uses its tuition receipts to pay the salary of the professor. In a complex, modern economy, trade is usually indirect and requires the use of money.

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