Hello! Welcome to your third lesson.
In our last session, we distinguished between microeconomics (the study of individual economic actors) and macroeconomics (the study of the economy as a whole). We framed them as the two essential lenses you'll use as an investor to analyze both the company and the environment it operates in.
Today, we will examine a concept that is fundamental to both of those fields and is the lifeblood of any modern economy: money. You might think of money simply as the cash in your wallet or the balance in your bank account, but in economics, its definition is based on the jobs it performs.
This lesson will describe the three basic functions of money: medium of exchange, unit of account, and store of value. Understanding these functions is the first step toward understanding more complex topics like inflation, interest rates, and banking, all of which directly impact the stock market.
1. The World Before Money: The Problem of Barter
To understand why money is so important, it's helpful to imagine a world without it. In such a world, people would have to rely on barter—the direct exchange of goods and services.
This sounds simple, but it's highly inefficient. For a trade to occur, there must be a "double coincidence of wants," where each person happens to have exactly what the other wants. The following video does an excellent job of illustrating this problem and introducing the functions money serves to solve it.
Functions of money | Financial sector | AP Macroeconomics | Khan Academy
This video from Khan Academy, 'Functions of money', provides a clear explanation of why barter economies are inefficient and how money's functions solve these problems.
Please watch the entire video (it's about 6 minutes long). Pay close attention to the 'double coincidence of wants' example and how the narrator introduces each of the three functions as a solution to a specific problem.
2. The Three Functions of Money
As the video explained, money is defined by the roles it plays in an economy. Let's break down these three core functions.
Function 1: Medium of Exchange
This is the most intuitive function. Money acts as an intermediary that we all agree to accept in exchange for goods and services.
- Without money, the lawyer who wants a chair has to find a chair-maker who needs legal advice.
- With money, the lawyer can sell their services to anyone for cash, and then use that cash to buy a chair from any chair-maker.
Money eliminates the need for the "double coincidence of wants," making trade vastly more efficient and allowing for complex economies where people can specialize in very specific jobs.
Function 2: Unit of Account
Money provides a common measure of value, or a "yardstick," that we can use to price goods and services.
- In a barter economy, you'd have to remember a huge number of relative prices: how many apples is a chair worth? How many hours of legal service is an apple worth?
- With money, everything can be priced in a single unit (e.g., Sri Lankan Rupees). A chair is LKR 15,000, an apple is LKR 100. This makes it easy to compare values and make rational economic decisions.
From your IT perspective, this is like having a standardized data format. Instead of every application using its own proprietary data structure that requires a custom converter for every interaction, a standard like JSON or XML allows all systems to communicate and understand value using a common language.
Function 3: Store of Value
Money allows you to transfer purchasing power from the present to the future. You can earn money today and spend it tomorrow, next week, or next year.
- In a barter economy, it's difficult to save. If your wealth is in a perishable good like bananas, you must trade them away before they spoil.
- Money, while not always a perfect store of value due to inflation (which we'll cover soon), is far more durable and convenient for saving wealth over time.
This diagram provides a simple visual summary of these three functions in action.
3. A Formal Definition and a Fourth Function
To round out your understanding, the following reading provides a concise, formal definition of these concepts. It also introduces a closely related fourth function: standard of deferred payment, which is crucial for understanding loans and debt.
27.1 Defining Money by Its Functions
This section from the OpenStax 'Principles of Economics' textbook formally defines the functions of money.
Please read the section titled 'Functions for Money.' It's a short section that clearly defines 'medium of exchange,' 'store of value,' and 'unit of account.' Also, take note of the fourth function it introduces, 'standard of deferred payment,' which means money can be used to settle debts in the future.
The idea of a standard of deferred payment is simply an extension of the other three functions over time. Because money is an accepted medium of exchange, a common unit of account, and a reliable store of value, it can be used to create contracts for future payments, like a loan to buy a car or a bond issued by a company.
Conclusion
In this lesson, we moved beyond the physical form of money to understand its essential economic roles.
Key Takeaways:
- Money solves the "double coincidence of wants" problem inherent in barter economies.
- It serves three primary functions:
- Medium of Exchange: An accepted intermediary for trade.
- Unit of Account: A common measure to value goods and services.
- Store of Value: A means of saving purchasing power for the future.
- These functions also allow money to act as a standard of deferred payment, enabling credit and debt.
Now that we have a solid definition of what money does, we can move on to a critical question for any investor: who controls the creation and supply of money? In our next lesson, we will explore the role of central banks and how their main policy tool—interest rates—affects the entire economy.