What Are the Three Functions of Money?

Money is central to modern economies. Before money, societies relied on bartering, a system where goods and services were exchanged directly. This method was cumbersome, often requiring a “double coincidence of wants,” meaning both parties had to desire what the other offered. Money emerged as a solution to these inefficiencies, streamlining exchanges and providing a universal medium for valuing assets and services.

Medium of Exchange

Money functions as a medium of exchange, an intermediary instrument for the purchase or trade of goods and services. This eliminates the need for direct bartering, making transactions more efficient. Instead of searching for someone who wants your specific product and has what you need, you can exchange your goods or services for money, then use that money to acquire desired items from anyone who accepts it.

For money to effectively serve as a medium of exchange, it must possess several characteristics. It needs to be widely accepted by individuals and businesses as a form of payment. Money should also be portable, allowing for easy transportation and transfer, and divisible, so it can be broken into smaller units for transactions of varying values. Durability is important, ensuring money withstands repeated use without significant degradation. U.S. coins and Federal Reserve notes are designed to be durable and are legally recognized as valid for payments for debts, taxes, and dues according to 31 U.S.C. 5103. While federal law states that U.S. currency is legal tender, private businesses retain the discretion to set their own policies regarding cash acceptance for goods or services, unless state laws dictate otherwise.

Store of Value

Money functions as a store of value, enabling individuals to hold wealth or purchasing power over time. This means money earned today can be saved and used to purchase goods and services at a later date, effectively deferring consumption. The ability to store value allows for financial planning, saving for future expenses, or accumulating wealth.

Money is a convenient store of value due to its high liquidity and general acceptability. However, its effectiveness can be influenced by economic factors. Inflation, which represents a general increase in prices and a decrease in the purchasing power of money, can erode the value of stored money over time. For example, if inflation is 5% annually, a dollar saved today will buy approximately 5% less goods or services a year from now. Other assets, such as real estate or stocks, can also serve as stores of value and may offer potential for higher returns, but they come with less liquidity and greater risk compared to holding cash.

Unit of Account

Money serves as a unit of account, providing a common standard by which the value of goods, services, and debts can be measured and compared. This function simplifies economic calculations, as all items can be priced in a single, consistent metric. Instead of determining the value of a car in terms of bushels of wheat or hours of labor, its value is expressed in a universally understood monetary amount.

This standardized measurement allows for clear communication of economic values. Businesses can easily price their products, calculate revenues, expenses, and profits. For individuals, the unit of account function aids in budgeting, comparing prices, and understanding the cost of living. It underpins the structure of financial statements, where all assets, liabilities, and equity are quantified in monetary terms, providing a comprehensive overview of an entity’s financial position.