THE FUNCTIONS OF MONEY
Just what is money? There is an old saying that “money is what money does.” In a general sense, anything that performs the functions of money is money. Here are those functions:
• Medium of exchange First and foremost, money is a medium of exchange that is usable for buying and selling goods and services. A bakery worker does not want to be paid 200 bagels per week. Nor does the bakery owner want to receive, say, halibut in exchange for bagels. Money, however, is readily acceptable as payment. Money is a social invention with which resource suppliers and producers can be paid and that can be used to buy any of the full range of items available in the marketplace. As a medium of exchange, money allows society to escape the complications of barter. And because it provides a convenient way of exchanging goods, money enables society to gain the advantages of geographic and human specialization.
• Unit of account Money is also a unit of account. Society uses monetary units—dollars, in the United States—as a yardstick for measuring the relative worth of a wide variety of goods, services, and resources. Just as we measure distance in miles or kilometers, we gauge the value of goods in dollars.
With money as an acceptable unit of account, the price of each item need be stated only in terms of the monetary unit. We need not state the price of cows in terms of corn, crayons, and cranberries. Money aids rational decision making by enabling buyers and sellers to easily compare the prices of various goods, services, and resources. It also permits us to define debt obligations, determine taxes owed, and calculate the nation’s GDP.
• Store of value Money also serves as a store of value that enables people to transfer purchasing power from the present to the future. People normally do not spend all their incomes on the day they receive them. In order to buy things later, they store some of their wealth as money. The money you place in a safe or a checking account will still be available to you a few weeks or months from now. When inflation is nonexistent or mild, holding money is a reltively riskfree way to store your wealth for later use.
People can, of course, choose to hold some or all of their wealth in a wide variety of assets besides money. These include real estate, stocks, bonds, precious metals such as gold, and even collectible items like fine art or comic books. But a key advantage that money has over all other assets is that it has the most liquidity, or spendability
An asset’s liquidity is the ease with which it can be converted quickly into the most widely accepted and easily spent form of money, cash, with little or no loss of purchasing power. The more liquid an asset is, the more quickly it can be converted into cash and used for either purchases of goods and services or purchases of other assets.
Levels of liquidity vary radically. By definition, cash is perfectly liquid. By contrast, a house is highly illiquid for two reasons. First, it may take several months before a willing buyer can be found and a sale negotiated so that its value can be converted into cash. Second, there is a loss of purchasing power when the house is sold because numerous fees have to be paid to real estate agents and other individuals in order to complete the sale.
As we are about to discuss, our economy uses several different types of money including cash, coins, checking account deposits, savings account deposits, and even more exotic things like deposits in money market mutual funds. As we describe the various forms of money in detail, take the time to compare their relative levels of liquidity—both with each other and as compared to other assets like stocks, bonds, and real estate. Cash is perfectly liquid. Other forms of money are highly liquid, but less liquid than cash.
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