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:
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The first is as a medium of exchange.
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The second is as a unit of account.
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The third is as a store of value.
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The fourth is as liquidity.
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.