Functions and Definitions of Money

1. Why Do We Need Money? The Problem with Barter

Before we define what money is, it's helpful to understand what the world looks like without it. In a barter economy, people trade goods and services directly. This sounds simple, but it has a major flaw.

For a trade to occur, there must be a "double coincidence of wants." This means not only do you have to find someone who has what you want, but that person must also want what you have to offer.

To see why this is so inefficient, let's watch a short video that explains this problem and introduces how money solves it.

As you can see, a barter system is incredibly cumbersome and limits economic activity. Money overcomes this by acting as an intermediary that everyone agrees to accept in exchange for goods and services.

2. The Four Functions of Money

For something to be considered "money," it must reliably perform several key functions. While the CFA curriculum primarily emphasizes three, a fourth is also commonly cited and is useful for a complete understanding, especially in the context of financial markets.

Let's watch a video that concisely outlines these functions.

Let's break these down further.

1. Medium of Exchange: This is money's most important function. It is the asset people use to buy goods and services. By acting as a universally accepted intermediary, it eliminates the "double coincidence of wants" and allows for the complex transactions that underpin a modern economy.

2. Unit of Account: Money provides a common measure of value. Instead of quoting the price of a car in terms of bananas or haircuts, we use a single, consistent unit (e.g., dollars, euros, yen). This "yardstick" function simplifies pricing, allows for easy comparison of value, and makes economic calculation and accounting possible.

3. Store of Value: Money allows you to transfer purchasing power from the present to the future. You can hold onto money today and spend it tomorrow, next week, or next year. While other assets like stocks or real estate also serve as a store of value, money is unique in its liquidity—the ease with which it can be converted into a medium of exchange. However, it's an imperfect store of value; inflation can erode its purchasing power over time.

4. Standard of Deferred Payment: This function is closely related to the others but is particularly important for finance. It means that money is an accepted way to settle a debt. When you take out a loan, the contract specifies repayment in monetary units. This function facilitates borrowing and lending, which are crucial for investment and economic growth.

3. Definitions of Money

Now that we understand the functions of money, let's turn to how it is defined and measured.

Commodity vs. Fiat Money

First, it's important to distinguish between two fundamental types of money.

• Commodity Money: This is money that has value outside of its use as money. Examples from history include gold, silver, salt, and even cattle. These items have intrinsic value.
• Fiat Money: This is money that has no intrinsic value and is not backed by a physical commodity. Its value comes from a government decree (a "fiat") that it is legal tender. Modern paper currency and coins are fiat money. Our entire financial system is built on trust in the stability and acceptance of this fiat money.

The EconplusDal video you watched earlier also explains this distinction well (from 02:40 to 03:57).

Measuring the Money Supply: M1 and M2

Because different assets have varying degrees of liquidity, economists use several different definitions, or "monetary aggregates," to measure the total amount of money in an economy. For the CFA exam, you need to be familiar with two key measures: M1 and M2.

To summarize the key points from the reading:

• M1 (Narrow Money): This includes the most liquid forms of money that are immediately available for transactions.
  • Currency in circulation (notes and coins).
  • Checkable deposits (demand deposits).
  • Traveler's checks.
• M2 (Broader Money): This includes everything in M1 plus assets that are slightly less liquid but can be quickly converted into cash. These assets primarily serve the "store of value" function.
  • Everything in M1.
  • Savings deposits.
  • Time deposits (under a certain amount, e.g., $100,000).
  • Money market mutual funds.

The relationship between M1 and M2 can be visualized easily.

4. Practice Application

Let's apply what you've learned with a CFA-style question. Read the question below and choose the best answer.

Question:

Money should be able to provide terms in which:

I. prices are quoted;
II. debts are recorded;
III. purchasing power is transferred from the present to the future; or
IV. goods are purchased.

A. I & II only
B. I, III & IV only
C. I, II, III & IV

Solution

The correct answer is C.

Let's link each statement to a function of money:

• I & II ("prices are quoted" and "debts are recorded") relate to the Unit of Account function.
• III ("purchasing power is transferred") relates to the Store of Value function.
• IV ("goods are purchased") relates to the Medium of Exchange function.

Since money performs all these functions, all four statements are correct.

Conclusion

In this lesson, we established a solid foundation for understanding money. We moved from the "why" (solving the barter problem) to the "what" (the four key functions) and the "how" (the formal definitions and measures).

Key Takeaways:

• Money's primary purpose is to act as a medium of exchange, eliminating the "double coincidence of wants" required in a barter economy.
• It also serves as a unit of account, a store of value, and a standard of deferred payment.
• Modern economies use fiat money, which is money by government decree, not because of intrinsic value.
• The money supply is measured in aggregates based on liquidity. M1 is narrow money (for transactions), and M2 is a broader measure that includes M1 plus savings-type accounts.

Preview of the Next Lesson:

Now that you know what money is, you might be wondering where it comes from. It's not just printed by the government. In our next lesson, we will explore the fascinating process of money creation through fractional reserve banking. You will learn how commercial banks create money "out of thin air" when they make loans and how to calculate the potential expansion of the money supply using the money multiplier.