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.