Money as a unit of account

Of equal importance is the function of money as a unit of account. This can be illustrated by going back to our previous example. Even if the difficulty of the mutual coincidence of wants is overcome, people would still have to find the exact exchange ratio between bread and haircuts or between haircuts and shoes, for example. Such “exchange ratios” – the number of loaves of bread worth one haircut, for instance – are known as relative prices or terms of trade. In the market place, the relative price would have to be determined for each pair of goods and services and, of course, everybody involved in the exchange of goods would need all the information about the terms of trade between all goods. It is easy to show that, for two goods, there is only one relative price, while for three goods there are just three relative prices (namely bread against haircuts, haircuts against shoes and bread against shoes). The greater the number of goods being exchanged, the more difficult it becomes to gather information on all possible “exchange rates”. Consequently, collecting and remembering information on the terms of trade creates high costs for the participants in a barter economy, increasing disproportionately with the number of goods exchanged. These resources can be used more efficiently in other ways if one of the existing goods is used as a unit of account (a so-called “numeraire”). In this case, the value of all goods can be expressed in terms of this “numeraire” and the number of prices which consumers have to identify and remember can be reduced significantly. Therefore, if all prices were labeled in money terms, transactions would be much easier.

More generally speaking, not only can the prices of goods be expressed in money terms, but so too can the price of any asset. All economic agents in a currency area would then calculate things such as costs, prices, wages, income, etc. in the same units of money. As in the above mentioned functions of money, the less stable and reliable the value of money, the more difficult it is for money to fulfill this important function. A commonly accepted reliable unit of account thus forms a sound basis for price and cost calculations, thereby improving transparency and reliability.