Functions of Money

3.1 Functions of Money

Money is not a single-purpose tool; it performs several distinct roles that together make a modern economy possible. The textbook identifies three primary functions: medium of exchange, unit of account, and store of value. Each solves a specific problem that would otherwise cripple trade and saving.

Medium of Exchange

The most fundamental function of money is to serve as a medium of exchange. In a barter system, a person who has a surplus of rice and wants cloth must find someone who not only has cloth but also wants rice. This is called a double coincidence of wants. Finding such a person in a large economy is time-consuming and often impossible. The costs of searching, negotiating, and waiting are so high that many potential trades never happen.

Money eliminates this problem. Everyone accepts money in exchange for what they sell, and everyone uses money to buy what they need. The seller of rice takes money, not because they want money itself, but because they know they can later exchange that money for cloth, shoes, or anything else. Money is the universal intermediary — it breaks one difficult barter transaction into two easy cash transactions.

Unit of Account

Money also provides a common yardstick for measuring and comparing value. In a barter economy, the price of a pen might be expressed as 5 pencils, the price of a pencil as 0.2 pens, the price of a shirt as 20 pencils, and so on. With n goods, you would need n(n–1)/2 different exchange rates — a hopelessly confusing system.

Money solves this by expressing the value of everything in a single unit — rupees, dollars, or whatever the currency is. When we say a wristwatch costs Rs 500, we mean it can be exchanged for 500 units of money. This single number tells us its value relative to every other good whose price is also quoted in rupees.

The textbook gives a concrete example. If a pencil costs Rs 2 and a pen costs Rs 10, we can calculate the relative price of a pen in terms of pencils:

So one pen is worth five pencils. We can also invert this to find the value of money itself in terms of goods. One rupee is worth:

This leads to a crucial insight. If the prices of all commodities rise — that is, if there is a general increase in the price level — then the value of money in terms of any commodity must fall. A rupee that once bought half a pencil now buys less. The textbook calls this a deterioration in the purchasing power of money.

Store of Value

The third function of money is to serve as a store of value — a way to hold wealth from one period to another. The barter system makes this extremely difficult. Suppose you have a stock of surplus rice that you do not wish to consume today. You might regard it as an asset to be consumed or sold later. But rice is perishable; it rots. It also requires a lot of storage space. And when you finally want to exchange it for other goods, you must again search for someone who wants rice. These problems make rice a poor store of value.

Money solves all three problems. Money is not perishable — a rupee note today will still be a rupee note next year. Its storage costs are far lower than those of physical goods. And it is acceptable to anyone at any time. So you can sell your rice for money today, and use that money to buy whatever you need in the future.

However, for money to perform this function well, its value must be reasonably stable. If the price level rises sharply, the purchasing power of money erodes. A rupee saved today may buy only half as much next year. In that case, money becomes a poor store of value, and people will prefer to hold their wealth in other forms.

A Note on the Cashless Economy …