This definition immediately highlights the fact that when we think of what money is, we usually tend to refer to currency (paper bills and coins), but however it is only one type of money, in fact, there are also other means of payment that fit the definition of money, like checks that are accepted as payment for purchases, checking account deposits, or even other items such as savings deposits that, if they can be quickly converted into currency or checking account deposits, they can function as money.

Another common mistake that people make is that of referring to money as wealth or income, both of which are not correct. In fact, wealth is the total collection of pieces of property that serve to store value, which of course includes money, but also other assets such as stocks, bonds, art, land, etc.

The concept of income, on the other hand, is the flow of earnings per unit of time, while money is a stock, it is a certain amount at a given point in time. Therefore, by saying that “John has an income of $5,000”, without knowing whether that amount is earned per year, or month, it is impossible to tell whether he earns a lot or a little, while if you say that “John has $5,000 in his bank account”, you know exactly how much it is.

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Functions of money

Anyway, no matter the form that money takes, whether we are talking about paper money, gold, or checking account deposits, it has three primary functions, it is a medium of exchange, a unit of account, and a store of value.

Medium of exchange

In almost all market transactions that happen in the economy, money works as a medium of exchange, which means that it is used by economic actors to pay for goods and services.

The lower time spent in exchanging goods and services that is a consequence of the characteristic of money as a medium of exchange promotes economic efficiency and lowers the “transaction costs”. In fact, in an economy where the money is not used, like in a barter economy, transaction costs that are generated by the time spent trying to exchange goods or services, are high and relevant.

With barter, a system that has been used mainly in primitive societies, goods and services are exchanged directly for other goods and services, which means that if for example Fred the baker wants to buy a pair of shoes, he will have to find a shoemaker that needs bread and that is willing to exchange a pair of shoes for a certain quantity of bread that in the opinion of Fred seams equal.

A process like this is complex, difficult, and time-consuming, in fact, it is not surprising that economies to become more complex and grow, have spontaneously adopted different mediums of exchange.

These new forms of money were introduced by using commodities that had to meet several different criteria in order to be considered as means of exchange, criteria which are still valid: They must be easily standardized, in order to make it simpler to ascertain its value, they need to be widely accepted, easy to carry, and not quickly deteriorate. Therefore, people started to use goods like shells, tobacco, strings of beads, etc. for this purpose.

As shown in the previous example, money promotes economic efficiency by eliminating much of the time spent exchanging goods and services, and by allowing people to specialize in what they do best.

Unit of account

Another key function of money is that of providing a unit of account, which means that money, in an economy, is used to measure value. In fact, nowadays we take for granted the fact that the prices of all goods and services on the market are quoted in terms of the currency that we use (euro, dollars, etc.), and this not only makes life a lot easier, but it also allows economies to grow and to become more complex.

In fact, using money as a unit of account is another factor that helps to lower transaction costs, because it reduces the number of prices that need to be considered and the relationships between different goods or services.

In order to better understand the importance of the fact that money is a unit of account let’s suppose, for the sake of simplicity, that we are in a barter economy and that there are just three goods available (say, bread, milk, and eggs) on the market. This means that we need to know only three prices to tell us how to exchange one for another: the price of milk in terms of eggs (which means, how many eggs you have to pay for one bottle of milk), the price of bread in terms of eggs, and the price of milk in terms of bread.

In this situation, making exchanges is not that complicated, however, if we want the economy to grow and we want to start introducing new goods on the market we start to see some problems, in fact with 10 goods, we would need to know 45 prices in order to exchange one good or service for another, then with 100 goods, we would need to know 4,950 prices, and so on.

This is the reason why the adoption of money as a unit of account makes life a lot easier and enables the economy to grow because money makes it possible to compare prices of an infinite number of goods and services, eliminating transaction costs.

Store of value

Then, money functions as a store of value, which means that it is a repository of purchasing power that is available over time and is used to save purchasing power from the time income is received until the time it is spent on the market.

This function of money is very useful both to individuals and to companies because it allows them to not have to spend their income immediately when they earn it. However, it is not unique as a store of value, and in some cases, it is neither the best, in fact, any asset, like stocks, bonds, houses, art, etc. carry out the function of storing value, and they may also be better in certain situations, like when there is hyperinflation, a situation where the inflation rates grow very fast and money, especially currency, loses a lot of value.

Moreover, these assets often pay higher interest rate than money to their owners, and they experience appreciation, but money in certain cases is preferred with respect to other assets as a store of value because of its liquidity, which is the relative ease and speed with which an asset can be converted into a medium of exchange.

Liquidity is highly desirable, and money is the most liquid asset of all because it is the medium of exchange, therefore, because it is the most liquid asset, even if it is not the most attractive store of value, people are still willing to hold it.

This article was originally published by Nicolò Patti on medium