A medium of exchange

The use of money as a medium of exchange is as fundamental to the development of economic systems as the invention of the wheel was for transport. Unless there is some commodity (money) that people are prepared to accept both for the sale of their own output, and to purchase that of others, transactions are limited to barter, the direct exchange of goods for goods. Barter is an extremely clumsy and inefficient way of doing business. Not only must I find a seller who is offering the goods that I want, but that particular seller who will accept whatever it is I can produce in exchange. This is referred to as a double coincidence of wants.

Store of value

To act as an efficient medium of exchange, money must also function as a store of value. Barter requires that goods must be exchanged for each other at the same time. With money, the act of purchase can be separated from the act of sale. Money then acts as a temporary means of holding purchasing power.

When the overall price level is stable, or even falling, money can be more than a temporary store of value. The opportunity cost of holding money is low and even negative when prices drop, so people may decide to hold a proportion of their wealth in the form of money, the medium of exchange, rather than as other financial or real assets, such as building society shares, or property. However, even in periods of quite rapid inflation people continue to hold money in order to carry out transactions, because of the great convenience it allows.

Unit of account, standard for deferred payment.

Money also acts as a measuring unit to assess the relative values of different commodities. This is distinct from its function of a medium of exchange, because a unit of account could in principle be used merely to assign prices rather than act as a means of payment. For example the guinea is used as a unit of account in many of London’s prestigious auction rooms, yet there is no such thing as guinea note or coin for actual use in transactions.

Money also performs this measurement function over time when it becomes a standard of deferred payment. If I wish to borrow a given sum now, an interest will be added to it so that I know how much I will have to repay in the future. Contracts can also be made for delivery of goods in the future. Inflation erodes the usefulness of money in this role.

Comprehension:

1. What are three basic functions of money?

2. Why is barter a clumsy way of doing business?

3. In what case can money be more than a temporary store of value?

4. Why do people continue to hold money even in the period of rapid inflation?

5. What is ‘deferred payment’?

True-false questions:

Anything can act as money if it is generally accepted by people as money.	
In all advanced economies the greater part of money supply consists of notes and coins.	
Barter is an efficient way of doing business.	
When the price level is stable, money can be more than a temporary store of value.	
Inflation erodes the usefulness of money.