Wednesday, August 18, 2010

What Are the Functions of Money

What Are the Functions of Money
Thomas Allen

Money has four basic functions. They are a medium of exchange, standard of exchange value, store of value, and payment of debt.

As a medium of exchange or purchasing medium, money is used to buy goods and services. It is immediately available in its existing form to the buyer and immediately acceptable by the seller. Not only is money a means of payment; it is also the thing used as final payment for purchases. After a purchase has been made, money involves no continuing or further obligation. As a medium of exchange, money can transport value through space.

Fiat money is a failure as a medium of exchange. When a person buys something with fiat money, he pays with credit (the fiat notes). Buying goods and services with fiat money is more like nothing-for-something than something-for-something that occurs when commodity money is used. Fiat money is a poor semblance as a medium of exchange.

When a person buys with commodity money, he exchanges a real asset whose material value equals its monetary value for assets. Even if he buys with a form of credit money, such as a bank note or check, instead of commodity money itself, he still buys with a real asset. The credit money that he uses quickly converts into the underlying commodity. Fiat money can only convert into another obligation.

Besides being a medium of exchange, money also serves as the standard unit of exchange value, i.e., as a standard of prices and of account and debt. Money is the standard by which the value of various things is measured and compared. Thus, money is a measure value. As a standard of value, money can transport value through time. It enables people to estimate the present value of future acts.

With commodity money, the standard of value is objective. It is the value of the commodity in its nonmonetary use. With fiat money, it is an arbitrary arithmetical abstraction.

Being the standard of value, money is the common denominator by which value of things are compared. It is the measure. As a measure of value, money simplifies the comparison of contemporaneous values of goods and services. By comparing prices of various goods and services, a buyer can determine their relative value to each other. For example, if a haircut costs $15 and a hamburger costs $3, then a haircut has the value of five hamburgers. Money becomes the common denominator by which the values of things are reduced to their prices. Price is simply “the exchange value of an article in terms of the monetary unit.”[1] Price makes possibly the keeping of general accounts. Thus, as the standard of value, money becomes the unit of accounts.

However, for money to function properly as the common denominator by which values are compared, the monetary unit itself must have value. The monetary unit must have a specific definition and made of something that has value.[2] To measure value, it must be a unit of concrete value. For example, a silver dollar, the dollar mentioned in the U.S. Constitution, is 371.25 grains of fine silver or 412.5 grains of standard silver (nine-tenths fine). Money should contain material that is in itself valuable. It ought not be an abstraction. It must be able to move value from one place to another and from one time to another.

The value of paper fiat money becomes an abstraction. Initially, its value is based on the commodity money that it replaces. No paper fiat money spontaneously comes into existence without a relationship to a preexisting commodity or tangible asset.

As a standard of value, fiat money also fails. It is useless as a long-term accounting unit without adjustments. These adjustments are poor substitutes for sound money. Furthermore, “business profits are widely overstated because historically determined depreciation charges are inadequate in terms of current replacement costs. Likewise for inventory accounting and charges for goods sold.”[3]

Money is also a store of value, i.e., wealth can be held in the form of money. As a store of value, money must be able to retain its value when moved from one place to another and from one time to another. It transports value over time and space. Money serves “as a standard of deferred payments.”[4] It “stores up the value of future goods and services sold”[5] and bridges the present with the future. People expect today’s money to serve as payment ten to thirty years from now. Such expectations make long-term contracts practical. The expectation is that today’s money will retain its purchasing power over the long term. Also, as a store of value, money serves as insurance against the uncertainties of the future.

To serve as a store of value, money must be stable in value for an indefinite time. As a store of value, fiat money is a miserable failure. In the United States since 1933, the dollar had lost 93 percent of its purchasing power by 2005. Since its complete divorce from gold in 1971, it had lost 79 percent of its purchasing power by 2005.

On the other hand, gold has retained its value through the millennia. The ancient Babylonian and Hebrew gold shekel contained about 252 grains of gold or about as much gold as an American eagle (a $10 gold coin).[6] Those 252 grains of gold are still worth 252 grains today.

If a time traveler carried a $10 gold coin back two thousand years, he would have the buying power equivalent to about 58 days of wages of a common laborer. A common laborer’s wage at that time was about 17¢ per day.[7] Moreover, because a double eagle (a $20 gold coin) contains twice the gold of an eagle, it would have twice the buying power. If he carried a $100 and a $1 federal reserve note with him, he would get only what he could trade his bills for as a curiosity. He would find the $1 bill worth more than the $100 bill if the person with whom he is trading finds that the occult symbols on the back of a $1 bill have great value whereas a picture of Independence Hall on the back a $100 bill has none. Unlike commodity money, fiat money fails to maintain its value through time.

Nevertheless, the purchasing power of gold and silver does fluctuate. At times their purchasing power rises; at other times it declines. Gold and silver’s value tends to rise for about 10 to 20 years and fall for about 10 to 20 years. However, compared to fiat money, whose purchasing power usually trends downward, gold and silver are stable.

Money is not the only store of value. Commodities, financial assets, land, and collectibles can serve as a store of value. However, there is a cost to converting money into other assets and these assets into money. Money is merely the most liquid asset for a store of value as no conversion is needed.

Finally, money must be able to pay debt. It provides a means to pay debt.

When a person pays a debt, he either retires it or discharges it. If he pays with commodity money, such as a full-weight gold coin, he retires the debt. He has paid the debt with something that is no one else’s obligation.

If a person pays with paper money (gold certificates, bank notes, or government notes), check, or any other kind of money substitute (credit money or representative money), he merely discharges the debt. He has paid the debt with another obligation or debt. The debt is not retired until the paper money is converted into commodity money or the check transfer the commodity money to the creditor’s account.

Although the same substance can perform all four functions of money, it does not have to do so. Much convenience is often found in one substance performing all four functions. For example, a 10-pennyweight gold coin can be a medium of exchange, the standard by which value is measured, a store of value, and a payment for debt.

Under bimetallism, gold and silver were used as money with a legally fixed exchange rate or ratio between the two. In the United States, silver was the standard of value until 1862. In 1834 Congress changed the exchange rate or ratio between gold and silver. The new ratio reduced the value of gold in terms of silver. Thus, full-weight silver coins soon ceased circulating, and gold coins became the medium of exchange. Silver was the standard of value. Gold was the medium of exchange. Both were a store of value.

1. E.C. Harwood, Cause and Control of the Business Cycle (Great Barrington, Massachusetts: American Institute for Economic Research, 1974), p. 58.

2. J. Laurence Laughlin, The Elements of Political Economy (New York, New York: American Book Co., 1887), pp. 61, 68.

3. Ernest P. Welker, editor, Why Gold? (Great Barrington, Massachusetts: American Institute for Economic Research, 1978), p. 11.

4. Joseph French Johnson, Money and Currency: In Relation to Industry, Prices, and the Rate of Interest (Revised edition. Boston, Massachusetts: Ginn and Company, 1905), p. 15.

5. Charles Rist, History of Monetary and Credit Theory from John Law to the Present Day (1940; reprint. Translator Jane Degras. New York, New York: Augustus M. Kelly, 1966), p. 84.

6. Madeleine Miller and J. Lane Miller, Harper’s Bible Dictionary (New York, New York: Harper & Brothers Publishers, 1959), pp. 454-455.

7. John D. Davis, The Westminister Dictionary of the Bible (Revised by Henry Snyder Gehman. Philadelphia, Pennsylvania: The Westminster Press, 1944), p. 630.

Copyright © 2010 by Thomas Coley Allen.

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