Money and itʼs function

The Functions of Money
The monetary economy is a significant improvement over the barter system, in which goods were exchanged directly for other goods.
Learning Objectives
Analyze how the characteristics of money make it an effective medium of exchange
Key Takeaways
Key Points

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  The barter system has a number of limitations, including the double coincidence of wants, the absence of a common measure of value, indivisibility of certain goods, difficulty of deferred payments, and difficulty of storing wealth.
  
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  Despite the numerous limitations, the barter system works well when currency is unstable or unavailable for conducting commerce.
  
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  Money is durable, divisible, portable, liquid, and resistant to counterfeiting.
  
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  Money serves as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment.
  

Key Terms

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  barter: An exchange goods or services without involving money.
  

Barter is a system of exchange in which goods or services are directly exchanged for other goods or services without using a medium of exchange, such as money. The reciprocal exchange is immediate and not delayed in time. It is usually bilateral, though it can be multilateral, and usually exists parallel to monetary systems in most developed countries, though to a very limited extent. The barter system has a number of limitations which make transactions very inefficient, including:


Barter: In a barter system, individuals possessing something of value could exchange it for something else of similar or greater value.

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  Double coincidence of wants: The needs of a seller of a commodity must match the needs of a buyer. If they do not, the transaction will not occur.
  
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  Absence of common measure of value: In a monetary economy, money plays the role of a measure of value of all goods, making it possible to measure the values of goods against each other. This is not possible in a barter economy.
  
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  Indivisibility of certain goods: If a person wants to buy a certain amount of another’s goods, but only has payment of one indivisible good which is worth more than what the person wants to obtain, a barter transaction cannot occur.
  
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  Difficulty of deferred payments: It is impossible to make payments in installments and difficult to make payments at a later point in time.
  
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  Difficulty storing wealth: If society relies exclusively on perishable goods, storing wealth for the future may be impractical.
  

Despite the long list of limitations, the barter system has some advantages. It can replace money as the method of exchange in times of monetary crisis, such as when a the currency is either unstable (e.g. hyperinflation or deflationary spiral) or simply unavailable for conducting commerce. It can also be useful when there is little information about the credit worthiness of trade partners or when there is a lack of trust.
The money system is a significant improvement over the barter system. It provides a way to quantify the value of goods and communicate it to others. Money has several defining characteristics. It is:

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  Durable.
  
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  Divisible.
  
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  Portable.
  
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  Liquid.
  
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  A unit of account.
  
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  Legal tender.
  
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  Resistant to counterfeiting.
  

Money serves four primary purposes. It is:

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  A medium of exchange: an object that is generally accepted as a form of payment.
  
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  A unit of account: a means of keeping track of how much something is worth.
  
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  A store of value: it can be held and exchanged later for goods and services at an approximate value.
  
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  A standard of deferred payments (this is not considered a defining purpose of money by all economists).
  

The use of money as a medium of exchange has removed the major difficulty of double coincidence of wants in the barter system. It separates the act of sale and purchase of goods and services and helps both parties in obtaining maximum satisfaction and profits independently.