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Money Functions

To properly understand how the money supply is measured by the federal monetary authorities, one needs to understand the functions of money. There are:

- medium of exchange;
- measure or standard of value;
- standard of deferred payment; and
- store of value.

Medium of Exchange

The definition of money itself refers primarily to the medium of exchange as its key characteristic. Certainly, money in the form of currency or checks serves this function. One can appreciate the contribution of money in facilitating exchanges if one looks into consequences of having to do without money — that is, to depend on a bartering system.

Use of money as a medium of exchange thus reduces waste and inefficiency by eliminating much of the time spent in exchanging goods and services. As a result, money also promotes specialization, with different individuals specializing in different trades or professions without having to worry about how to trade their services or output to assemble all the items that their incomes can afford. The need for money is so strong that all societies, except those that are extremely primitive, invent some form of money.

Money has taken the form of strings of beads (used by American Indians), cigarettes (used in prisoner-of-war camps), silver and gold coins (used by Romans), rings money by Celtic peoples, shell money on Ancient Solomon Islands and traveler's checks used by modern tourists.

Measure or Standard of Value

Money also serves as a standard of value, sometimes called the unit of account. It is the second important function of money is to serve as a unit of account – just as we measure weight in pounds or height in inches, the values of goods and services are expressed in terms of money.

As the number of commodities increases, the complexity of the barter system multiplies immensely. For example, with 1000 items, nearly half a million prices will be needed in the barter system. Most supermarkets have many more than 1000 items – a total nightmare even for a mathematically inclined shopper. Money thus performs an important function as a unit of account by reducing the transactions costs due to a much smaller number of prices that have to be considered.

Standard of Deferred Payment

As a Standard of Deferred Payment, money permits the passage through time in the opposite direction from that of the store of value. It permits the person to enjoy the fruits of his labor before performing this labor. That is, money in the form of credit permits a person to acquire goods and services now and to pay for them later.

Store of Value

Money also functions as a Store of Value, although not in all circumstances. Serving as a store of value means that wealth can be held in terms of money for future use – to be spent on items or to be passed on to heirs. Money is not the only asset that functions as a store of value. Many assets, such as stocks, bonds, real estate, and gold, can also be used as a store of value.

Money has a minor advantage over competing assets in one respect – it is already in the form that can be spent, while the others first have to be converted into money before being spent. In this sense, money is the most liquid of all assets that can be used to store wealth – stocks and bonds are less liquid than money, but more liquid than real estate.

However, Money as a Store of Value has 2 Major Disadvantages:

- First, other assets may yield returns that are far greater than money – say, one individual earns 20% a year on stocks and only 3% on his checking account. Thus, wealth will multiply faster when held in assets other than money.

- Secondly, during periods of rapid inflation, money may not serve as an useful store of wealth. The decline in the usefulness of money as a store of wealth depends on the rate of inflation. Inflation erodes the purchasing power of money. If price levels double in a year, the stored money will buy only half as much the next year.

There are real world examples in history where money became worthless rather quickly. Germany after World War I provides an example of an extreme inflationary environment – the inflation rate sometimes exceeded 1000% per month. If a worker did not spend his or her income in the morning, it lost much of its value by the evening.

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