Money is primarily a medium of exchange or means of exchange. It is a way for a person to trade what he has for what he wants. Ideal money has three critical characteristics: it acts as a medium of exchange; it is an economic good; and it is a means of economic calculation.
To properly understand money as a medium of exchange one must first go back to the first methods of trade. Before money was invented one would have to engage in direct barter. A farmer who produced grain – but wanted shoes for his family – would have to find someone who, a) had shoes and, b) wanted grain. You can imagine the difficulty involved in finding that perfect someone who had what the farmer wanted and wanted what the farmer had.
a) money has to be a token currency(otherwise it would give rise to barter and not to monetary exchanges);
b) money has to be accepted as a means of final settlement of the transaction (otherwise it would be credit and not money);
c) money must not grant privileges of seignorage to any agent making a payment.
The Functions of Money
Money serves three basic functions. By definition, it is a medium of exchange. It also serves as a unit of account and as a store of value.
A Medium of Exchange
The exchange of goods and services in markets is among the most universal activities of human life. To facilitate these exchanges, people settle on something that will serve as a medium of exchange—they select something to be money.
We can understand the significance of a medium of exchange by considering its absence. Because no one item serves as a medium of exchange in a barter economy, potential buyers must find things that individual sellers will accept. A buyer might find a seller who will trade a pair of shoes for two chickens. A moment’s contemplation of the difficulty of life in a barter economy will demonstrate why human societies invariably select something—sometimes more than one thing—to serve as a medium of exchange, just as prisoners in federal penitentiaries accepted mackerel.
A Unit of Account
Money serves as a unit of account, which is a consistent means of measuring the value of things. We use money in this fashion because it is also a medium of exchange. When we report the value of a good or service in units of money, we are reporting what another person is likely to have to pay to obtain that good or service.Ask someone in the United States what he or she paid for something, and that person will respond by quoting a price stated in dollars: “I paid $75 for this radio,” or “I paid $15 for this pizza.”
A Store of Value
The third function of money is to serve as a store of value, that is, an item that holds value over time. Consider a $20 bill that you accidentally left in a coat pocket a year ago. When you find it, you will be pleased. That is because you know the bill still has value. Value has, in effect, been “stored” in that little piece of paper. Because money acts as a store of value, it can be used as a standard for future payments. When you borrow money, for example, you typically sign a contract pledging to make a series of future payments to settle the debt. These payments will be made using money, because money acts as a store of value.
Money, of course, is not the only thing that stores value. Houses, office buildings, land, works of art, and many other commodities serve as a means of storing wealth and value. Money differs from these other stores of value by being readily exchangeable for other commodities. Its role as a medium of exchange makes it a convenient store of value.
As bonus, a true monetary economy is inconsistent with the presence of a commodity money. A commodity money is by definition a kind of money that any producer can produce for himself. But an economy using as money a commodity coming out of a regular process of production, cannot be distinguished from a barter economy. A true monetary economy must therefore be using a token money, which is nowadays a paper currency.
