Functions of money

What is money? If we have to define money today, we first think of banknotes and coins. These assets are regarded as money since they are liquid. This means that they are accepted and are available to be used for payment purposes at any time. While it is uncontested that banknotes and coins fulfill this purpose, nowadays a number of other forms of assets exist which are very liquid and can be easily converted into cash or used to make a payment at very low cost. This applies, for instance, to overnight deposits and some other forms of deposits held with banks. Consequently, these instruments are included in those definitions of money often referred to as “broad money”.

The various forms of money have changed substantially over time. Paper money and bank deposits did not always exist. It would therefore be useful to define money in more general terms. Money can be thought of as a very special good that fulfills some basic functions. In particular, it should serve as a medium of exchange, a store of value and a unit of account. Therefore, it is often stated that money is what money does.

In order to better illustrate these functions, consider how people had to conduct their transactions before the existence of money. Without money, people were forced to exchange goods or services directly for other goods or services through bartering. Although such a “barter economy” allows for some division of labour, there are practical limitations and any exchange of goods implies substantial so-called “transaction costs”. The most apparent problem with a barter economy is that people have to find a counterpart who wants exactly the same good or service that they are offering and who is offering what they want in return. In other words: a successful barter transaction requires a mutual coincidence of wants to exist. A baker who, for instance, wanted a haircut in exchange for some loaves of bread would have to find a hairdresser willing to accept those loaves of bread in exchange for a haircut. However, if the hairdresser needed a pair of shoes instead, he would have to wait until a shoe-shop owner wanted to get a haircut in exchange. Such a barter economy would therefore imply substantial costs related to searching for the appropriate counterpart and waiting and stockpiling.