The Functions of Money; The Kinds of Money: Study with Video Lessons, Practice Problems & Examples

Money serves three primary functions: as a medium of exchange, a unit of account, and a store of value. It facilitates trade by eliminating the double coincidence of wants found in barter systems. Money allows for standardized pricing, simplifying transactions. Additionally, it retains purchasing power over time, enabling deferred payments. There are two types of money: fiat money, which has value by government decree, and commodity money, which has intrinsic value, like gold. Understanding these concepts is crucial for grasping economic interactions and the role of money in the economy.

Definition of Money; Barter Economy; Double Coincidence of Wants

Alright. So let's get into everyone's favorite topic, money. So we're going to discuss the functions of money, the kinds of money, and why money is important. So let's start off with the definition of money. Money is a set of assets that people are generally willing to accept in exchange for goods and services. So when you work at your job, you're willing to accept money when you go and put in your labor. And when you go to the store to buy something, the store is willing to accept the money for whatever you want to buy, right? Money acts as that medium. So why is money useful? Well, it eliminates the need for a double coincidence of wants. This is an important term that they love to use in this class, double coincidence of wants. Because this double coincidence of wants is where both the buyer and the seller need to have something that the other one has. Alright? So let's go ahead and see what this means in a barter economy. The double coincidence of wants is important in a barter economy because they only trade goods for other goods in a barter economy. There's no money in a barter economy. So let's go through this example. We've got three people in this economy. We've got Brickmaster who's a builder and who would like to trade his extra clay for lumber. And then we have Sir Lumber, who's a carpenter, who would like to trade his extra lumber for wheat, right? So if these two tried to trade, if Brickmaster tried to trade his clay for lumber, but Sir Lumber only has lumber that he wants to trade for wheat, well, they're not going to make a trade, right? Because neither one has what the other one has. There's no double coincidence of wants. Sir Lumber would have to have a need for clay, right? But he only has a need for wheat. He doesn't have a need for clay. Finally, we have Admiral Wheat who's a farmer who would like to trade his extra wheat for lumber. So in this situation, who would trade? Well, we would be able to trade right here, right? There would be a trade between Sir Lumber and Admiral Wheat would be able to make a trade because they have what each other wants. But what about Brickmaster? He's kind of screwed here because all he has is clay and nobody wants his clay, and he needs lumber. Right? But what if he was able to sell his clay for money and then Sir Lumber would accept the money for lumber as well. You'd be able to get rid of this double coincidence of wants. So it's difficult to get what you want without the use of money, right? You need to have that double coincidence of wants in this situation. So let's go ahead and pause and let's talk about the functions of money.

Functions of Money

Alright. So let's discuss the 3 main functions of money. These are the 3 main functions of money right here. A medium of exchange, a unit of account, and a store of value. Okay? So let's start here with the medium of exchange. A medium of exchange means that the money can be used for trading goods rather than just for its own consumption, okay? So we don't actually consume US dollars, right? The US dollars are not consumed by anyone. They never get used up. They get traded away and they get traded just for other goods and services, right? They're just used to trade. So that's what the money does. It acts as this middleman between the goods that you want and the goods that you have.

Next, we have a unit of account. So this the money is a measure used to set prices and to help make calculations, right? It helps us to have a set price for things rather than many different prices for each item. So let's go through an example. Money allows us for one set price. For example, in US dollars. So if we have lumber, right? If we're selling one amount of lumber, it's worth $5. But without money, we would have to be able to value it with different types of goods. So one lumber could be worth, for example, 2 wheat or 3 bricks or 1 sheep, right? So all of these different calculations. Now, if we had 2 wheat, well, we know that's worth 1 lumber. How many bricks can we get with 2 wheat? It adds a whole bunch of layers of math that nobody wants to do. Money gets us to eliminate that complex calculation and we just say one lumber is $5. If you have $5, you can get that lumber. So, we would have set prices for the bricks, a set price for the wheat, and we would just get the money in the middle ground, okay?

Finally, we have the store of value. So we want to be able to have the ability to retain our purchasing power over time, right? Because you may give up your services now to get paid in money, but you don't really need anything right now. But maybe in the future, you might need something. So, you can trade your goods and services now, save the money, and use it later, right? Because it's going to retain that value. You don't have to immediately need something to make the trade. You can just get the money, hold the value, and then later on, get what you want. So this goes in with the idea of a standard for deferred payment. And this allows for trading of goods in advance where we can kind of have a loan, right? We can get a loan for something. We can receive something now like buy a car now and make payments in the future because the seller knows that the money that we pay them in the future is still going to hold the value that it has today. That's what good money would do is be able to have these three characteristics here.

Now, I want to make a note here when we talk about money is that there are other things that hold wealth, right? That can store value, but they're not exactly money. So things like stocks, bonds, and real estate, right? They hold a value in it. You buy a house, it's not like that house is just going to become worthless, so to speak, right? It's still going to hold value. But it's not like you can go to the store and buy your groceries and say, hey, I own a house. Do you want to take, you know, 1% of the house for this batch of groceries? It doesn't work like that. It doesn't function as money in the same way as it holds wealth, right? So we talk about this idea of liquidity which is how easily an asset can be converted into cash, right? So a liquid asset means that you could sell the asset quickly and have the cash on hand. So maybe something like stocks. Stocks are pretty liquid because there's always, let's say you own some Apple stock. Well, you could go on to the market. You could check on Google what it's worth and you could sell the stock almost immediately using an exchange, right? So stock would be said to be pretty liquid. Real estate is very much less liquid, right? You need to find a buyer. It takes a long process to actually sell a house compared to selling a piece of stock.

Alright? So those are the functions of money. Remember those 3. We've got our medium of exchange, our unit of account, and our store of value. Cool? Let's pause here and let's talk about the different kind

Kinds of Money

Alright. So now let's discuss the 2 different kinds of money. We've got fiat money and commodity money. Okay? So fiat money. Well, fiat money just has value just because we say it has value, okay? The only value is because we say it has that value. So it's usually mandated by a government to say that this is the currency of our nation, so this currency has value. But think about it. If the US dollar, outside of its uses as money, has no value, right? There's you can't eat it. You can't eat dollars for consumption or anything. There's nothing really you can do with the dollars other than buy something. Okay? So they have no other use. That's the big deal with fiat versus commodity. Fiat money has no other use. Okay? But commodity money has other uses. So commodity money has value and other uses but is also used as money. The very common commodity money is gold. Gold is a great example of commodity money. It's been used as a medium of exchange for millennia, right? It's been a long time that it's been used for, for money but it has many other uses as well, right? We use it in jewelry. It has uses in electronics and of course, when you have gold teeth, you need to have some gold for that as well, right? So commodity money has other uses than just being traded as money, just like gold does here, okay? So fiat money, no other uses. Commodity money has other uses. Cool? Let's go ahead and move on.

Here’s what students ask on this topic:

What are the three main functions of money?

The three main functions of money are: 1) Medium of Exchange: Money facilitates trade by acting as an intermediary in transactions, eliminating the need for a double coincidence of wants. 2) Unit of Account: Money provides a standard measure of value, allowing for consistent pricing and easier comparison of goods and services. 3) Store of Value: Money retains purchasing power over time, enabling individuals to save and defer spending to the future. These functions are essential for efficient economic interactions and stability.

What is the difference between fiat money and commodity money?

Fiat money has value because a government decrees it as legal tender, and it has no intrinsic value outside its use as money. Examples include paper currency and coins. Commodity money, on the other hand, has intrinsic value due to its other uses. A common example is gold, which can be used in jewelry, electronics, and dental applications, in addition to being a medium of exchange. Understanding these differences helps in grasping how various forms of money function in the economy.

Why is money considered a medium of exchange?

Money is considered a medium of exchange because it is widely accepted in transactions for goods and services. It eliminates the need for a double coincidence of wants, which is a requirement in barter systems where both parties must have what the other wants. By acting as an intermediary, money simplifies trade, making it more efficient and allowing for a broader range of economic activities.

How does money function as a store of value?

Money functions as a store of value by retaining its purchasing power over time. This allows individuals to save money and use it for future transactions. Unlike perishable goods, money does not degrade, making it a reliable means to preserve wealth. This characteristic is crucial for enabling deferred payments and long-term financial planning.

What is the double coincidence of wants, and how does money solve this problem?

The double coincidence of wants refers to the situation in a barter system where two parties each have something the other wants. This requirement makes trade cumbersome and inefficient. Money solves this problem by acting as a universally accepted medium of exchange, allowing individuals to trade goods and services without needing to find a direct match for their wants. This greatly facilitates economic transactions and market efficiency.