Three Functions of Money

Updated Jan 3, 2023

For many people, money is equal to bills and coins. However, even though this is not wrong, it is only one part of the equation. Generally speaking, money is a set of assets that are commonly used and accepted as payment for goods and services in an economy. This suggests that anything can be considered money, as long as it fulfills certain criteria (i.e., the functions of money).

To really understand what money is, we must therefore look at the relevant functions it performs within the economy. To keep things simple, we will focus on the three most important ones here: money as a medium of exchange, a store of value, and a unit of account.

1. Medium of exchange

Money can be used in exchange for goods and services. This reduces transaction costs by a huge margin because people no longer need to barter. In other words, you can just walk into a store and buy a pair of jeans (or whatever you need) in exchange for your money. This only works as long as the seller is confident, that he will be able to use the currency he receives to buy goods or services of equal value later on.

2. Store of value

Money can serve as a store of value. That means, it can be used to transfer buying power into the future. If you sell your car, for instance, you can keep the money for a while and use it to buy a new car later in the future. For that reason, money needs to be durable and must not lose its value over time.
Please note that this may not be perfectly accurate in reality, as money can actually lose some of its value due to inflation. However, we consider this effect negligible for now (but we will cover it later).

3. Unit of account

Money is also a measure of economic value. Every good you can buy in a shopping center has a price tag on it. Thanks to that we can easily compare the value of completely different goods. To give an example, you may want to buy some ice cream for 2$ and a shirt for 20$. By comparing the prices you know that the ice cream is worth about 1/10 of a shirt. Using money as a unit of account is very convenient because it allows us to compare virtually everything.

Summary

Money is a set of assets that are generally used and accepted as a medium of exchange for goods and services in an economy. Apart from its function as a medium of exchange, money also serves as a store of value and a unit of account. Everything that fulfills these three functions can be considered money.