Money Definition and Function

What is money? What are some of the functions and characteristics of money? Why are the pieces of paper in your pocket called money?

You'll be able to answer all these questions after reading this article.

Definition of Money

The definition of money refers to any asset that you can use to exchange goods and services. That is to say that anything that the other party will accept as payment, and give you a good or service in return, is money.

The definition of money has evolved with time, and today, it is not what it has once been. However, the principle and its use of it have remained the same.

Fig 1. -US Dollars

Hence, we can say that the definition of money depends on the type of transaction you're performing. Although there are cases where you can exchange a good in return for another good, in most cases, the money as we know it today is the currency in circulation.

Usually, the most common types of money are the currency in circulation, which refers to the cash and coins in the hands of the general public, and any checkable deposits. You have checkable deposits if you have a bank account from which you write checks that the receiver then cashes out. These two types of money, currency and checkable deposits, are the most liquid forms of money. The more liquid the money is, the easier it is to perform transactions.

Now, the money supply is what we call the total value of money in the economy. It contains not only the most liquid forms of money but also financial assets and other types of money that are less liquid than cash or checkable deposits. There is more than one way to measure the money supply.

Importance of Money

The importance of money comes from its ability to provide efficient transactions in an economy. It is a means of exchange. Money is one of the most important tools in an economy as it allows transactions. In the absence of money, the transactions would become inefficient, and the economy will not be able to produce.

Money narrows it down to just one item that can be used in order to purchase any good or service that we want or need.

Additionally, money allows for international trade to happen. The exchange of goods and other services from different countries is enabled by money, which is a means of exchange.

Characteristics of Money

The four main characteristics of money are durability, divisibility, transportability, and non-counterfeit as seen in Figure 2.

Characteristics of Money: Durability

Refers to the physical ability of money to withstand damage, decomposition, or change of any sort. Money should and must be able to retain its durability.

Characteristics of Money: Divisibility

This refers to money's ability to be divided into smaller parts while all the smaller parts have value. $100 equals two $50 notes, and both have the same value.

Characteristics of Money: Transportability

Transportability is money's ability to be easily carried around, which makes it possible for individuals to perform transactions when they go out.

Characteristics of Money: Non-counterfeit

Money can't be easily counterfeited. People need to trust that money is not likely to be counterfeit. Otherwise, all of our money would quickly lose value, and vendors would not want to accept it for payment purposes.

Functions of Money

Functions of money are:

• the medium of exchange;
• store of value;
• unit of account.

These are illustrated in Figure 3 below. Any asset that has all of the following functions is considered to serve as money.

Functions of Money: Medium of exchange

A medium of exchange is an intermediate tool used to enable the sale, purchase, or transfer of products between parties. For a system to operate as a medium of exchange, it must represent a standard of value. Further, all parties involved in the transactions must accept it. In contemporary economies, the most common means of trade is cash.

Functions of Money: Store of value

Store of value refers to the ability of an asset to hold its purchasing power over time. For one asset to be considered money, it has to have value over time. If you have an asset that will decrease in value in a short time, it can't be considered money. For it to be considered money, it must have value for a long period, meaning that you can still buy goods and services with it.

Imagine having money that today can get you ten apples, but no one accepts it the following day, and your purchasing power disappears into thin air.

Functions of Money: Unit of account

Another essential function of money is the unit of account. This means that the money can be measured based on goods and services it can buy. This means it can be used to set prices for goods and services that people want to consume.

You have housing rental rates that are expressed in terms of dollars; the goods at your local grocery store are also described in terms of dollars—basically, anything in the economy.

Exchange means as a Function of Money

We previously introduced the concept of money as a medium of exchange.

Money allows anybody who has it to engage in the market on an equal basis with everyone else. A bid is successfully made when a customer uses the money to acquire an item or service that has been advertised at a certain price. This brings order and the ability to predict in the marketplace.

Producers know what they are going to produce and how much they will charge, and consumers can plan their budgets with confidence around predictable and stable pricing structures. The entire transaction is facilitated by money which serves as means of exchange.

If money, as represented by a currency, ceases to be viable as a medium of trade or if its monetary units can no longer be reliably valued, consumers will lose their capacity to effectively and efficiently perform transactions in the economy.

Imagine how hard it would be to exchange using goods. Finding someone who not only has what you're looking for but also demands what you are willing to trade.

Usually, you have the domestic currency of a country serving as a medium of exchange. However, in cases when severe recessions/depressions are hitting a country's economy, they may switch to alternative currencies and use them as a medium of exchange. That is because, in times of crisis, currencies lose value quickly, and the purchasing power drops.

There were other alternatives to the currency that were used as a medium of exchange in times of economic crisis throughout history. One typical example of an alternative medium of exchange includes the use of cigarettes in prisoner-camp during World War II. Prisoners were exchanging cigarettes for goods and services.

Store of value as a Function of Money

Essentially, any item, money, or commodity that can be consistently turned into another asset, currency, or commodity at a later period may be used as a store of value. An item's eligibility as a store of value is determined by its ability to be stored, retrieved, and traded while retaining its buying power under any given circumstances.

Risk aversion is the basic idea of a store of value, and prices will be maintained as long as there is a continuous demand for the underlying object.

Stores of value also include interest-bearing assets, which qualify as such since they provide income while simultaneously retaining their worth. A commodity, on the other hand, such as milk, is a poor store of value since it is perishable and will expire in due course, rendering it useless.

Throughout much of history, many commodities served as money in various forms. Initially, trade agents relied on assets and commodities, such as gold, as means of exchange because of their inherent worth, durability, and mobility, as opposed to currency.

Generally speaking, money is regarded as a store of value in the monetary system, where it may be utilized to store and transfer capital. Money's ability to act as a store of value makes it easier to move buying power over a period of time.

Because cash has the ability to transmit buying power from one time to another, it is an excellent means of storing value.

For example, when individuals keep money in their pockets until they wish to trade it for products or services, the value of the money remains stable.