Types of Money and its Functions

There have been many different types of money throughout human history, or many different things that have served the purpose of money, and in this article I will describe all the important features of this most coveted of possessions from an economics point of view.

The focus here is more on the modern measures of money, but for more information on the history of money and the different types of items that have been used as money, have a look at my report about Commodity Money.

Near money, sometimes referred to as quasi money, is also discussed here in relation to assets that can quickly and easily be turned into money i.e. assets that have a high degree of liquidity. These assets have particular relevance to the modern economy in terms of monetary policy and the short-term management of the business cycle.

Before getting into that, we first need to consider how we define money in terms of the functions that it performs, and by its inherent characteristics.

The Four Functions of Money

All types of money are distinguished first and foremost according to the four functions of money as originally described in the 1875 classic ‘Money and the Mechanisms of Exchange’ by W. S. Jevons.

The important point to keep in mind here is that the correct selection of the best money for use by society has massive implications for the economy, and therefore society’s standard of living.

As an example of the significance that this has in modern times, consider some relevant questions that our societies are now grappling with, should we:

  • Adopt a cryptocurrency as money?
  • Create a new gold standard system?
  • Adopt a full-reserve banking system?
  • Keep the current fiat system with fractional reserve banking?
  • Adopt a Central Bank Digital Currency?

All these possibilities and more are heavily influenced by how well any proposed money and its associated monetary system can perform the following four functions of money.

Function1 - A Medium of Exchange

This is the most important function of money because it literally transforms our entire economy from a barter system to a much more efficient system of transacting between buyers and sellers. Without money as a medium of exchange, it would be far more difficult to obtain goods in the marketplace.

For example, a bicycle salesman who wants to obtain a new computer would need to find a computer salesman who wants a new bicycle. Even worse, what if the bicycle salesman wants to obtain a bottle of water – how does he divide his bicycle into a portion just large enough to be equal in value to that bottle of water?

Clearly these problems would be a major impediment to achieving efficient commerce, and using money instead, as a medium of exchange to allow payment for goods, greatly simplifies matters. Money works as a medium of exchange because all buyers and sellers have trust in its value, and that it can be used to purchase any other good or service.

Function 2 - A Unit of Account

Sometimes referred to as a standard of value, a unit of account easily allows economic agents to compare prices of all different goods and services. For example, consider how difficult and imprecise this would be without money, where a cow might be worth 3 pigs and a pig might be worth 100 chickens. What is a calf worth, or an egg? What about an underweight, elderly pig?

We need some sort of common denominator that can be used to give prices for all these things, and all other goods and services in the same unit of account, and money does just that.

Without money as a unit of account, it would be impossible to keep track of the relative prices of all of the millions of different goods and services produced in an economy.

Function 3 - A Store of Value

The store of value function enables money to be saved without it losing any value in terms of its purchasing power. This allows people to hoard the money that they earn during times of plenty, so that it can be used in the future during times when their earnings are lower.

Clearly this is an important function, and one that gives security against unexpected temporary falls in income. Money performs this function of storing value better than hoarding goods directly, because many goods are perishable or will degrade over time. Even those goods that do not tarnish might still be unsuitable for hoarding, or incur expensive storage costs.

Storing value by saving money also creates the ability for money to be borrowed and invested in new business opportunities, thereby creating economic growth and prosperity in future.

Function 4 - A Standard of Value

This is sometimes referred to as a ‘standard of deferred payment’ because this function relates to money’s use over extended time-periods.

A great deal of commerce takes place over extended time-periods where buyers and sellers enter into contracts that specify future delivery and payment terms. Money may be borrowed or lent in order to conduct this sort of commerce, and in such cases a relevant interest charge will be applied.

Imagine how difficult this would be without money as a standard of value. Any borrower of a good would have to pay interest in terms of the borrowed good, but the lender might not need any more of the borrowed good, and might well wish to acquire some other good with his earnings. And what if, when repayment is made, the value of the borrowed good has fallen relative to the desired good? In that case the lender would lose out.

Money allows such lending and borrowing to occur in a much more useful and predictable manner, which makes this sort of commerce much easier to conduct.

The Characteristics of Money

Having outlined the four functions of money, it should come as no surprise that different types of money in the past have performed these functions to varying standards, and that there have been times when several types of money have been used at the same time to satisfy different functions. Ideally, however, a single type of money would be used for all situations.

The ideal money must possess the following characteristics in order to satisfy all the demands placed upon it to a satisfactory level:

  • Utility & Value – This refers to the intrinsic value and usefulness of the item being used as money. For example, gold and other precious metals have value in and of themselves regardless of the value bestowed upon them from being a medium of exchange. Historically, all types of money that lack intrinsic value have failed at some point.
  • Portability – The ideal money must be portable in order that it can easily circulate throughout the economy, and around the world, as need be. In modern times, payment by credit/debit cards entails no physical movement of money at all. There have been recent experiences with failed fixed exchange rate systems where central banks have been forced to sell their gold stocks to foreigners in order to defend their national currency from speculators, but these events are rare. 
  • Indestructability – This is so that the money will not degrade or tarnish, or lose value due to wear and tear as time passes. Paper money certainly does tarnish, but old notes are constantly withdrawn from circulation and replaced by new notes in order to negate this problem.
  • Homogeneity – The money must be uniform and constant, meaning that each unit is fungible i.e. that it can be exchanged for other identical units at no cost. For example, one dollar is worth exactly the same as another dollar regardless of its age or other specifics.
  • Divisibility – In order to easily enable small transactions as well as large, money needs to be divisible into small, low value units.
  • Stability of Value – In order to promote confidence and avoid inflation or deflation, the value of the money must be stable over time. A natural requirement for this is that it must have a relatively limited supply so that it cannot be significantly expanded or contracted in the short run.
  • Cognizability – In order to promote trust, and prevent duplication or counterfeiting, money needs to be easily recognizable and verifiable.

It should be noted here that, if you haven’t already guessed, there is no one universally agreed upon best money, let alone an ideal money.

All possible types of money currently available to us have shortcomings on one or more of the characteristics listed above, our challenge is to find the best entity that we can use as money from the choices that we have.

Unfortunately, different people have different ideas about what this should be.

Fiat & The Five Types of Money

The monetary base of a modern economy is made up of some or all of the following types of money (note that these definitions are not exclusive, meaning that there is some significant overlap):

  • Fiat Money – this is the legal tender that we use today i.e. cash like dollars, pounds, euros etc. It is not backed by anything other than the government's promises to maintain its value i.e. it is not linked to any precious commodity such as gold or silver, and as such it only has value due to the people’s acceptance of it as a means of exchange. Its main weakness is its susceptibility to debasement via inflation. Inflation can easily occur because there is no limit on government (or central bank) money-printing.
  • Commodity Money – for most of human history we have used one commodity or another (usually a precious metal) to perform the role of money. Central banks still hold large gold reserves as a way of supporting their currencies on the international money markets, but commodities themselves are rarely used for day-to-day transactions in modern economies.
  • Representative Money – the transition from commodity money to fiat money occurred via representative money i.e. where notes and coins were issued for day to day use but were convertible into the underlying commodity (usually gold) at a fixed rate. Most modern currencies like pounds and dollars are named according to the weight that they were originally transferable at e.g. the pound sterling was once convertible into one pound in weight of sterling silver.
  • Fiduciary Money – this is money that is based on an element of trust between the payer and payee. For example, a check/cheque or a banker’s draft, or a promissory note, may be accepted as payment for certain items, but they all take a period of time to clear before the payee receives any money.
  • Commercial Bank Money – This forms the bulk of what we call the monetary base. It is the money held in bank accounts by the customers of the commercial banking sector. It is the sum total of all deposits in current accounts, sometimes called demand-deposits.

This list may need amendment soon to include Central Bank Digital Currency, and possibly even some cryptocurrencies, but for now these items do not form a part of the monetary base. 

Cryptocurrencies could conceivably be considered as ‘near-money’ because they are easily convertible into money in the same way that other financial assets are. However, they are not currently included in any official monetary aggregate measure.

Is Cryptocurrency Money?

Before any cryptocurrency can be officially termed 'money', it will need to be able to perform the four functions of money, so the real question is whether or not there is one that does this.

Right off the bat we should immediately see that no cryptocurrency is accepted as a means of payment in any large developed country. There may be some companies within those countries that state they will accept Bitcoin, Tesla has stated this on previous occasions, but on closer inspection what they mean is that they will accept an equivalent value of Bitcoin to a specified national currency denominated payment.

This is quite different, and does not count as a medium of exchange. Only if the price of the company’s product is denominated in a given amount of cryptocurrency would this be an example of medium of exchange, and that is not really possible since the company’s costs will be denominated in the official legal tender (meaning that fluctuations in the value of the crypto would make profit margins impossible to forecast with any degree of accuracy).

Furthermore, the common claim that cryptocurrencies can act as a store of value is quite incorrect. The whole point of a store of value is to act as a safe stable place to preserve wealth in uncertain times. Cryptocurrency prices have been anything but safe and stable, they have been extremely volatile.

For the same line of reasoning, cryptocurrency cannot perform as a standard of deferred payment, or even as a unit of account.

Now, none of this is to say that no cryptocurrency can ever become money, but I think you can see that to do this it would need to be adopted in full by a country as a replacement for their existing currency.

Central Bank Digital Currency (CBDC)

If news reports are correct, CBDCs look set to be introduced as a form of money in the near future. Whilst CBDCs do share some common technological features with cryptocurrencies, it would be more accurate to consider them simply as a digital version of the existing fiat currency. A ‘Fed Coin’ would be just a digital dollar, and therefore its value can be debased over time just as with fiat currency.

The key point is that all the criticisms of fiat currency with regard to its susceptibility to being over-expanded and debased via inflation would also apply to CBDCs. Only if the CBDC could be backed by a commodity such as gold would it be resistant to debasement.

The main difference that the CBDCs under development have with existing fiat currency is that they will give far more power to our governments to control our spending, and many people might reasonably argue that this will lead to wholesale abuse of that power. Our privacy will be severely compromised by CBDCs, because the technology used will be able to track our every purchase.

Only time will tell what the consequences of this are.

Monetary Aggregates

The central banks of each developed country track various monetary aggregates in order to build up a picture of how the total money supply in the economy is changing over time. You may have heard of these aggregates being referred to as:

  • M1 – This is a ‘narrow’ definition of the money supply and is a good estimate of the total amount of the five types of money discussed above. It includes notes and coins as well as money deposited in current accounts with the commercial banks.
  • M2 – This 'broad' measure of money goes beyond actual money and also includes ‘near money’ i.e. financial assets that can quickly be converted into money. This includes savings deposits, time deposits, and ‘Money Market Funds’. M2 is usually much bigger than M1, but in times of severe economic uncertainty, e.g. post-pandemic times, investors start to move very large amounts of their funds into M1 in order that their money can be more liquid and ready to move again in an instant should circumstances require it.
  • M3 – This measure of money is even broader than M2 and includes larger time-deposits as well as repurchase agreements i.e. very short-term loans that the banks borrow from non-bank entities. Eurodollars i.e. interest earning dollar deposits held overseas are also included here.
  • L – The broadest measure of all includes treasury bonds, long-term government bonds and commercial bonds. Whilst NOT currently included, it is here that cryptocurrency holdings could arguably belong.

These descriptions of the monetary aggregates give a usable idea of the types of money that they account for, but they are fairly loose and subject to change. For anyone interested in the precise definitions and figures, have a look at the: Federal Reserve Money Stock Measures.

For details on the importance of ‘L’, the broadest money measure, and how monetary policy is used to control the level of economic output, have a look at my article about the LM Curve.

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