Objectives
List and explain four functions of money.
List and explain four requirements of money for a good to act as money.
Why do you want to learn this?
Many people think that the U.S. dollar is “backed by” gold. That is not the case. The U.S. dollar is backed by people’s confidence in it. The truth is that most currencies are backed by people’s confidence in their ability to perform the functions of money. As long as people believe that a good is money, it IS money.
Four functions of money
What is money? It sounds like the answer should be pretty simple---money is different denominations of coins and currency…end of story. But it is not that simple. Someone once said that money is as money does. In fact, that is pretty accurate. You learned much earlier, that money facilitates exchange by reducing transaction costs; it is a medium of exchange.
Money is also a unit of account. If someone wants to know the net worth of a company, they don't discover that the company owns five cows, two horses, four pigs, three automobiles, and seventeen computers more than it owes; they discover that its net worth is $200,000. We use money as a measuring rod to account for the value of things we can't add together.
Money is also used as a standard of deferred payment. Money allows us to "buy now and pay later.” While credit was possible in an economy with no money, it was an awkward situation. You agree to pay one cow, one year from now. Within that year the cow gets sick, loses a lot of weight, and quits giving milk. She may even die. Then you're in a pickle. You can be pretty sure that money won’t die. It might get a little sick (lose some of its value with inflation), but the borrower can attempt to compensate for that by paying a rate of interest.
Finally, money can be used as a store of value. Money enables people to save some of their income to buy things later on. In most cases, unless you're robbed, it will be there when you want it. So anything that performs these four functions--a medium of exchange, a unit of account, a standard of deferred payment, and a store of value, is money.
The Requirements of Money
Historically, many strange things have been used as money, including animal teeth, bark cloth, barley, beaver pelts, butter, cattle, chocolate, cigarettes, copper, corn, cowrie shells, feathers, fish, gold, stones, iron, liquor, oats, peas, pigs, rice, salt, silver, tobacco, whale teeth, and woodpecker skulls and even little pieces of paper!
Must money have any intrinsic value? No. Many people think that money must be a valuable commodity by itself-like gold. Do checks have any value by themselves? Do Federal Reserve Notes (dollar bills, 20s, etc.) have any value by themselves? No. Well, aren't they "backed" by gold? No. The only thing that gives our money value is the confidence the public places in it. People are willing to allow those little pieces of paper to perform the four functions of money. If they weren't willing to accept them as a medium of exchange, a store of value, a standard of deferred payment, or a unit of account, they would not be money. During the American Revolution, the Continental Congress printed "Continentals." These were money in some places and weren't in others, depending on whether they were acceptable or not. They certainly weren’t money in Tory strongholds!
Confidence is not the only requirement for money; money must also be scarce. If money did grow on trees, you could go pick it anytime you desired. There would be no control on the amount of money in circulation and its value would change every time you picked a new leaf. Returning to the American Revolution, Congress issued so many Continentals that they were relatively easy to get and so much less scarce than would be appropriate for an acceptable currency.
It is also important that money not change its quality. When people in the colonies used tobacco as money they had two problems: (1) the supply of money was determined by the weather, and (2) some bales of tobacco were worth more than others because they were of a higher quality. One bale would not necessarily buy the same amount of goods and services as another bale.
Money should also (within reasonable limits) maintain its purchasing power. This is particularly important when money functions as a standard of deferred payment. If you lend someone $20, you want to be pretty sure that $20 will buy as much when it is returned to you as when you loaned it.
The four requirements for money include the following:
People must have confidence in it.
It must be scarce.
It must be of an even quality.
It must maintain its value.
No money fulfills all these requirements perfectly. To the extent that a "money" does fulfill them, it helps to keep the economy running smoothly, facilitating many different economic transactions. Below are some of the things that have served as money.
Animal Teeth | Cattle | Cowrie shells | Paper pieces | Strings |
Bark Cloth | Cigarettes | Feathers | Peas | Tobacco |
Barley | Fur | Fish | People | Wampum |
Beads | Liquor | Metals | Salt | Whale teeth |
Butter | Corn | Oats | Stones | Woodpecker skulls |
Bottom Line
Money has four functions:
It is a medium of exchange; it facilitates exchange by reducing transactions costs
It is a unit of account
It is a standard of deferred payment
It is a store of value
Requirements of Money: It must
Instill confidence
Be scarce
Be of an even quality, and
maintain its value.
What are the four functions of money?
What are the four requirements for something to act as money?
Research the hyperinflation of the German Deutsch Mark during the Weimar Republic, the Argentinian Peso during the Peron era, or the Zimbabwean Dollar in more recent years.
What was the largest denomination of your selected currency?
Cite an example of a product whose price was exorbitant?