The functions of money

Money serves as (1) a medium of exchange, (2) a unit of account, and (3) a store of value. We examine each of these functions, beginning with medium of exchange.

A medium of exchange, or a transactions medium, is anything generally acceptable as a means of payment in the exchange of goods and services, in repaying debts, and in the exchange of assets, such as shares of common stock.

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The second function of money is to serve as a unit of account. A unit of account is a yardstick for measuring prices and values and a benchmark for comparing them. In principle, any commodity can serve as a unit of account. Having chosen the good, we can express the price of each of the rest of the goods in units of that good. Historically, societies designated a single item to serve as the unit of account, say, a kilogram of wheat. In this way, each good could be priced at so many kilograms of wheat per unit. In modern times, paper money is the unit of account. For example, the dollar is the unit of account in the United States. Knowing that a pound of peaches costs two dollars and a pound of apples costs one dollar enables us to compare their value. Thus, money becomes a standard of value.

Normally, the same item serves as the unit of account and the medium of exchange: the dollar in the United States; the yen in Japan; the mark in Germany. In abnormal times, however, societies divorce the two functions of money, often unofficially. For example, although the ruble is the unit of account in Russia, some Russians use foreign currencies, such as the dollar and the mark, as the unofficial medium of exchange. Many Russians, without access to foreign currencies, resort to barter. Invariably, the reason for the divorce of the medium of exchange from the unit of account is a deterioration of the currency as a store of value, which takes us to the third function of money.

A store of value is a reservoir of future purchasing power. Money is both a temporary and a permanent store of purchasing power. The function of money as a temporary store of purchasing power is an outgrowth of its function as a medium of exchange. If an item is to serve as a medium of exchange, people must hold that item to carry out their transactions. For example, consider an individual who earns $700 a week but plans to spend $560 on goods and services and save $140 every week. Usually this individual will not spend the entire $560 on payday. Instead, he may spend $90 on payday and hold $470 in the form of money to be spent over the course of the week. This $470 held in money is a temporary store of purchasing power.

People, however, hold more money than they need to carry out their transactions. Why? The answer is that money can also serve as a permanent store of purchasing power. Individuals who save forgo present consumption to have higher future consumption. The wealth of individuals is their accumulated savings. Money is one form in which individuals may keep their wealth; stocks, bonds, and real estate are other forms. Of course, when wealth is held in money, in the future it will not need to be exchanged to buy goods and services. The ability of money to serve as a store of value depends on its capacity to retain its purchasing power.

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