Learn It 4.1.2: All About Money

Functions of Money

The defining characteristics of money are that:

  1. It serves as a medium of exchange.
  2. It serves as a store of value.
  3. It serves as a unit of account.

Medium of Exchange

Money solves the inefficiency of the barter system. First, money serves as a medium of exchange, which means that money acts as an intermediary, or link, between the buyer and the seller. Instead of exchanging haircuts for shoes, the hairstylist now exchanges haircuts for money. This money can then be used to buy shoes or anything else. To serve as a medium of exchange, money must be very widely accepted as a method of payment in the markets for goods, labor, and financial capital.

In addition, a medium of exchange needs to have the following properties:

  1. It must be divisible—that is, easily divided into usable quantities or fractions. A $5 bill, for example, is equal to five $1 bills. If something costs $3, you don’t have to tear up a $5 bill; you can pay with three $1 bills.
  2. It must be portable—easy to carry. Money can’t be too heavy or bulky.
  3. It must be durable. Money can’t fall apart or wear out after a few uses.
  4. It must be difficult to counterfeit. Money wouldn’t have much value if people can make their own.

Store of Value

sneakers in boxes on shelves
Figure 1. Money is a better store of value than sneakers.

Next, money must serve as a store of value. Consider the barter between the hairstylist and shoemaker again. The shoemaker risks having their shoes go out of style, especially if they keep them in a warehouse for future use—their value will decrease with each season. Shoes are not a good store of value. Holding money is a much easier way of storing value. You know that you don’t need to spend it immediately because it will still hold its value the next day or the next year. This function of money doesn’t require that money is a perfect store of value. In an economy with ordinary inflation, money loses some buying power, but it retains most of its value.

Unit of Account

Third, money serves as a unit of account, which means that it’s the standard by which other values are measured. For example, a hairstylist may charge $30 to style someone’s hair. That $30 can buy two shirts or one pair of shoes. Money acts as a common denominator, an accounting method that simplifies thinking about alternatives.

So money serves all of these functions: medium of exchange, store of value, and unit of account.