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The Essential Functions of Money
Business Essentials · Chapter 23: Money and the Federal ReserveSection 23.1 · lesson 97 of 10512 min · free with a free account
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In this lesson
Money is defined by what it does, not what it is made of.
- State the 3 functions and 6 characteristics of money
- Trace commodity, representative, and fiat money
- Describe how the money supply is measured
- Separate money from the ways we pay with it
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Everything said in the video, section by section (1,693 words). Read along, or search it.
Money and the Federal Reserve
The Essential Functions of Money
What do a seashell, a gold coin, and a number in a bank's computer have in common? Under the right conditions, each one is money. This is educational content about money and payment systems. It isn't financial, investment, tax, or legal advice. It describes how these mechanisms work, rather than recommending any action. We'll define money by its three functions, and the six characteristics that support them. We'll trace its history, from commodity money to the fiat money we use today. We'll see how the money supply is measured, and why most of it isn't cash at all. And we'll separate money itself from the cards and apps we use to move it.
The Key Idea
Money Is What Money Does
Here's the key idea of this whole section. Money is best defined by what it does, rather than by what it's made of. Anything performing the three functions we're about to see is money. It could be a metal coin, a paper note, or an entry in a bank's electronic ledger. Why define it this way? Try defining money by its physical form, and you run into trouble. You'd struggle to explain why a seashell worked as money in one historical setting. And why a bank deposit works as money today. A definition based on function explains both cases, with exactly the same criteria.
Function 1
A Medium of Exchange
The first function is a medium of exchange. Money is accepted in transactions. That removes the need for something called a coincidence of wants. Under barter, each party has to want exactly what the other has to offer. Picture a baker who wants shoes. Under barter, she must find a shoemaker who happens to want bread, on that particular day. Money removes that requirement entirely. The baker sells bread for money to anyone, and uses that money to buy shoes from anyone else. So what happens when this function fails? Exchange itself breaks down. People fall back on barter, or on improvised substitutes. Historically, that failure has been most visible during periods of severe currency collapse.
Functions 2 And 3
A Unit of Account and a Store of Value
The second function is a unit of account. Money gives a common measure of value. So goods as different as a haircut and a truck can be compared on one scale. This function usually fails during extremely rapid price increases. Prices change so fast that the unit stops being a meaningful basis for comparison. Businesses may then price in a more stable foreign currency, even while still accepting the local one. The third function is a store of value. Money lets you hold purchasing power over time. You can sell today, and buy later, without your money eroding significantly. This is the function inflation attacks, as we saw earlier with the Consumer Price Index. As prices rise, a given amount of money buys progressively less. And severe or unpredictable inflation can undermine confidence in holding money at all. People then turn to alternative stores of value instead.
Table 23.1.1
When Each Function Fails
This table sets the three functions side by side, with what fails when each one is performed badly. As a medium of exchange, money lets people trade without a coincidence of wants. When it fails, communities have reverted to barter, or even cigarette-based exchange, during severe currency collapse. As a unit of account, money lets very different goods be compared. When it fails, businesses price in a stable foreign currency while the local currency's value collapses. As a store of value, money holds purchasing power for later. When it fails, rapid, sustained inflation erodes savings held in a weakening currency. Here's the subtle part. A currency can perform one function reasonably well, while failing badly at another. That's especially likely during severe inflation. So a business needs to know which function is failing. The right response, like pricing in a more stable unit, fixes a specific failure. Not money's role in general.
Characteristics
6 Characteristics, and the 1 That Matters Most
Six characteristics help something work well as money. Durability means it survives repeated handling without degrading. Portability means it can be carried and transferred conveniently. Divisibility means it can be broken into smaller units, for transactions of different sizes. Uniformity means every unit of a denomination is identical, so none needs to be individually inspected. Limited supply means it can't be produced without constraint. Something infinitely available couldn't hold value. And acceptability means people are willing to receive it, for goods, services, or debts. Of the six, acceptability is the one that actually matters most. Money works through a self-reinforcing expectation. People accept it because they expect others to accept it from them in turn. The other five support acceptability. They aren't independent requirements. Something that wasn't durable or portable would struggle to become widely accepted in the first place. But in the end, it's acceptability, not any physical property, that makes something money in practice.
History
Commodity, Representative, Fiat
Money has taken three broad historical forms. Commodity money has value independent of its use as money. Gold or silver is valuable as a material, whether or not anyone is using it to trade. Representative money is a claim on a commodity held elsewhere. Think of a paper certificate, redeemable for a stated quantity of gold. It combines the portability of paper with value ultimately backed by a commodity. Fiat money has no intrinsic value, and no commodity backing. Its value comes from confidence, and from legal status. A government declares it legal tender, which means it must be accepted for debts. And people accept it because they trust others will keep accepting it, and that its value will stay reasonably stable. Most modern currencies, including the U.S. dollar, are fiat money. This is a historical pattern, not a judgment about which form is superior. Each has worked in different contexts.
Figure 23.1.1
Measuring the Money Supply
How much money is there? The answer depends on where you draw the boundary. That's why the money supply is measured with more than one definition. A narrow measure includes currency in circulation, meaning physical cash held by the public. It also includes the most liquid deposits, like checking-type accounts that can be spent immediately. Broader measures add less liquid categories, such as savings accounts and small time deposits. The broadest measures go further, adding larger or less liquid deposits, and institutional instruments. Each broader measure contains everything inside it, plus categories that are progressively less liquid. So the measures overlap heavily, but they can still move somewhat differently from one another. And no measure is simply more accurate than another. A question about immediate spending power calls for a narrow measure. A question about broader resources that could be converted into spending calls for a wider one.
Money Versus Payment
Most Money Isn't Cash
Here's a point that's easy to overlook. Most money in a modern economy isn't physical currency. The cash in your wallet, or in a business's register, is a small fraction of the money supply by most measures. The great majority exists as entries in bank ledgers, amounts depositors are entitled to withdraw or transfer. That makes it important to separate money itself from the payment methods used to move it. Cash is physical currency, and itself a form of money. Deposits and transfers move money that exists as ledger entries, from one account to another. A debit card isn't money. It's an access mechanism, telling a bank to transfer money already on deposit. A credit card isn't money either. It's a payment method built on top of a credit relationship. Mobile payment apps are likewise access mechanisms, moving underlying deposits or credit. So when a business says customers pay by card, it's describing how money moves. Once the money arrives, it's a bank deposit, however it got there.
Newer Ideas
Digital Currencies and Velocity
Two newer ideas round out the picture. Digital currencies are under active development and discussion. A central bank digital currency would be money issued directly by a central bank, in digital form. That's distinct from privately created digital currencies, which exist independently of any central bank. Whether, when, or in what form these become widely used is still a matter of policy discussion. It isn't a settled fact, and this course offers no view on their future adoption or value. The second idea is the velocity of money. Conceptually, it's how often a unit of money changes hands, on average, over a period. For a given money supply, faster circulation means more total transactions can be supported. That links to how much spending, and so how much upward pressure on prices, a quantity of money can generate.
For A Business
2 Points That Matter Going Forward
For a business, two points from this section matter most going forward. First, money is a claim whose value depends on confidence. Whether it's cash or a bank deposit, its worth rests on a shared expectation that others will accept and value it. It doesn't rest on any physical backing. Second, the money supply is managed. It isn't fixed by nature. The rest of this chapter shows how. Next comes deposit creation. After that, the Federal Reserve, and the tools it uses. And that sets up a question. If deposits make up most of the money supply, and banks create and record deposits, where do deposits actually come from?
Case Vignette
Pricing in a Steadier Unit
Teodoro runs an import business. This is a composite case, constructed for instruction. His country's local currency has been losing value rapidly and unpredictably. For years, he priced everything in local currency, adjusting as costs rose. But the changes have become too frequent for customers and suppliers to plan around. Disputes over what a quoted price means, by the time payment is due, have become routine. So Teodoro starts quoting and recording prices in a more stable foreign currency. He still accepts local currency, converted at the day's rate when payment is made. Customers and suppliers find this far easier. A price quoted today still means roughly the same thing next week. He can't simply stop accepting local currency. His customers hold it, and his local obligations are due in it. His reasoning separates the functions of money. The local currency hasn't failed as a medium of exchange. It still moves between parties in transactions. But it has largely failed as a unit of account, because it's no longer a stable reference for prices. So he keeps using it for what it still does well, and fixes only the function that broke.
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