The word ‘money’ can be used in many different ways, but it has a very specific meaning to economists. Economists define money as anything that is generally accepted as payment for goods or services or in the repayment of debts. Just saying that money is currency is not a good enough definition for economists. Economists make a distinction between money in the form of currency, demand deposits, and other items that are used to make purchases, and wealth the total collection of pieces of property that serve to store value. Income is a flow of earnings per unit of time. Money, by contrast, is a stock, it is a certain amount at a given point in time. “If someone tells you that he has an income of $1,000, you cannot tell whether he earns a lot or a little without knowing whether this $1,000 is earned per year, per month, or even per day. But if someone tells you that she has $1,000 in her pocket, you know exactly how much this is. Whether money is shells or rocks or gold or paper, it has three primary functions in any economy: as a medium of exchange, as a unit of account, and as a store of value. Of the three functions, its function as a medium of exchange is what distinguishes money from other assets such as stocks, bonds, and houses”.
Money used as a medium of exchange furthers economic efficiency by reducing the time spent in exchanging goods and services. It also helps efficiency by allowing people to concentrate on what they do best. “Money is therefore essential in an economy. It is a lubricant that allows the economy to run more smoothly by lowering transaction costs, thereby encouraging specialization and division of labor. The need for money is so strong that almost every society beyond the most primitive invents it”. For something to operate productively as money, it has to meet multiple benchmarks: “1) It must be easily standardized, making it simple to ascertain its value; 2) it must be widely accepted; 3) it must be divisible, so that it is easy to ‘make change’; 4) it must be easy to carry; and 5) it must not deteriorate quickly”. Objects that have fulfilled these benchmarks have taken many abnormal forms throughout human history, “ranging from wampum (strings of beads) used by Native Americans; to tobacco and whiskey, used by the early American colonists; to cigarettes, used in prisoner-of-war camps during World War II”. The various forms of money that have emerged over the years are as much a testament to the inventiveness of the human race as are the developments of tools and language.
The second role of money is to provide a unit of account, that is, money is used to measure worth in an economy. “Imagine how hard it would be in a barter economy to shop at a supermarket with 1,000 different items on its shelves and be faced with deciding whether chicken or fish is a better buy if the price of a pound of chicken were quoted as 4 pounds of butter and the price of a pound of fish as 8 pounds of tomatoes”. The answer to the problem is to present money into the economy and have all prices set in terms of units of that money. We can see that using money as a unit of account lowers transaction costs in an economy by reducing the number of prices that need to be considered. The benefits of this function of money grow as the economy becomes more complex.
Money also functions as a store of value; it is a repository of purchasing power available over time. A store of value is used to retain purchasing power from the time income is obtained until the time it is spent. This function of money is useful because most people do not want to spend their income right when they receive it, but would rather wait until they have the time or the want to shop. “Any asset—whether money, stocks, bonds, land, houses, art, or jewelry—can be used to store wealth. Many such assets have advantages over money as a store of value: They often pay the owner a higher interest rate than money, experience price appreciation, and deliver services such as providing a roof over one’s head”. What is the point of holding any money at all if assets are a more beneficial store of money? The answer to this question relates to the important economic concept of liquidity, which is the relative ease and speed with which an asset can be turned into a medium of exchange. Money is the most liquid asset of all because it is the medium of exchange. Other assets involve transaction costs when they are converted into money. How good a store of value money, is depends on the price level. “During times of inflation, when the price level is increasing rapidly, money loses value rapidly, and people become more unwilling to hold their wealth in this form. This is especially true during periods of extreme inflation, known as hyperinflation, in which the inflation rate exceeds 50% per month”.
We can obtain a better picture of the functions of money and the forms it has taken over time by looking at the evolution of the payments system, the method of conducting transactions in the economy. The payments system has been evolving over centuries, and with it the form of money. Precious metals were the primary means of payment and the main form of money at one point. Later, paper assets such as checks and currency became the main form of money to be used in the payments system. It helps to know how the payment system evolved to gain an understanding of where the system is heading. “For any object to function as money, it must be universally acceptable; everyone must be willing to take it in payment for goods and services. Money made up of precious metals or another valuable commodity is called commodity money, and from ancient times until several hundred years ago, commodity money functioned as the medium of exchange in all but the most primitive societies”. The biggest problem with a payments system based on precious metals is that such a form of money is very heavy and is hard to transport from one place to another. After precious metals, the next development in the payments system was paper currency. Paper currency has the advantage of being much lighter than coins or precious metal, but it can be accepted as a medium of exchange only if there is some trust in the authorities who issue it and if printing has reached a sufficiently advanced stage that counterfeiting is extremely difficult. Countries have the ability to change the currency they use whenever they want since currency has become a legal arrangement. “Major drawbacks of paper currency and coins are that they are easily stolen and can be expensive to transport in large amounts because of their bulk”. To stop this from happening, the next way the payment system evolved was by creating checks within the development of modern banking.
A check is an instruction from you to your bank to transfer money from your account to someone else’s account when he or she deposits the check. Checks allow transactions to take place without the need to carry around large amounts of currency. The introduction of checks was a major innovation that improved the efficiency of the payments system. The use of checks thus reduces the transportation costs associated with the payments system and improves economic efficiency. Another advantage of checks is that they can be written for any amount up to the balance in the account, making transactions for large amounts much easier. Checks are also advantageous in that loss from theft is greatly reduced and because they provide convenient receipts for purchases. There are two big problems that appear when you have a payments system based around checks. “First, it takes time to get checks from one place to another, a particularly serious problem if you are paying someone in a different location who needs to be paid quickly. If your need for cash is urgent, this feature of paying by check can be frustrating. Second, the paper shuffling required to process checks is costly”.
“The development of inexpensive computers and the spread of the Internet now make it cheap to pay bills electronically. Banks now provide websites at which you just log on, make a few clicks, and thereby transmit your payment electronically. Estimated cost savings when a bill is paid electronically rather than by a check exceed one dollar per transaction. Electronic payments technology can substitute not only for checks but also for cash, in the form of electronic money (or e-money)—money that exists only in electronic form. The first form of e-money was the debit card. Debit cards enable consumers to purchase goods and services by electronically transferring funds directly from their bank accounts to a merchant’s account. Most banks issue debit cards”.
Economists need an accurate definition that tells them which assets should be included to measure money. The problem of measuring money has recently become especially crucial because extensive financial innovation has produced new types of assets that might properly belong in a measure of money.