What is Money?

Introduction

Throughout human history, money has taken different forms in different cultures—from salt, stones, and beads to gold, silver, and copper coins and most recently, virtual currency. Whatever form it takes, money needs to be widely accepted by both buyers and sellers in order to be useful.

Before Money: Bartering

Economies without money typically engage in the barter system. Barter—literally trading one good or service for another—is inefficient for trying to coordinate the trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide.

For example, if a barber wants a pair of shoes, he must find a shoemaker who has a pair of shoes in the correct size and who is willing to exchange the shoes for a certain number of haircuts. Such a trade could to be difficult to arrange.

The barter system also doesn’t allow people to easily enter into future contracts for the purchase of many goods and services. For example, if goods are perishable, it may be difficult to exchange them for other goods in the future.

Characteristics of Money

Money solves the problems created by the barter system. First, money serves as a medium of exchange, which means that money acts as an intermediary between the buyer and the seller. To serve as a medium of exchange, money must be very widely accepted as a method of payment in the markets for goods, labor, and financial capital.

Money also needs to have the following properties:

It must be divisible—that is, easily divided into usable quantities or fractions. A $5 bill, for example, is equal to five $1 bills. If something costs $3, you don’t have to tear up a $5 bill; you can pay with three $1 bills.
It must be portable—easy to carry; it can’t be too heavy or bulky.
It must be durable. It can’t fall apart or wear out after a few uses.
It must be difficult to counterfeit. It won’t have much value if people can make their own.

Second, money must serve as a store of value. Holding money is a way of storing value. You know that you don’t need to spend it immediately, because it will still hold its value the next day or the next year. This function of money doesn’t require that money is a perfect store of value. In an economy with inflation, money loses some buying power each year, but it remains money.

Third, money serves as a unit of account, which means that it’s the ruler by which values are measured. Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs.