8. Functions of Money

Money is usually said to embody three different functions. While these different monetary functions are common knowledge, it can be speculated whether these functions contradict each other and can hardly be subsumed within one good or thing.

8. Functions of Money
Monetary graph
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Functions of Money

Functions of Money

In textbooks, three different functions are commonly attributed to money: -Money as a means of payment (medium of exchange function) -Money as a store of value (store of value function) -Money as a measure of value (unit of account function)

Statics versus Dynamics

Statics versus Dynamics

How something attains these three functions is only a secondary topic in neoclassical economics. Money, so the impression, simply seems to be there. In many cases, money is also interpreted as a veil that lies over the economy and has no meaning on its own. Also, the origins of money are hardly ever discussed, because it is a dynamic, emerging phenomenon. There is no place for such a phenomenon in the neoclassical (the most dominant school of thought within the economic sciences) framework of mainstream economics. Rather, it is about states of equilibrium and static quantities. Money is therefore assumed to be one of these static quantities.

First and Foremost a Medium of Exchange

First and Foremost a Medium of Exchange

Other schools of economics, most notably the Vienna School of Economics, focus much more on money as an emergent phenomenon. But even within the Austrian School, there is an intense debate about the correct sequence of these monetary functions in the emergence of money. The most widespread view is that of the great economist Ludwig von Mises. According to him, the most important function is that of a medium of exchange. Von Mises even wrote: "Money is a medium of exchange. (...) That is the only function of money; it is a medium of exchange, a generally used medium of exchange, nothing else." The other two functions, store of value and unit of account, are, according to von Mises, merely subcategories of the actual medium of exchange function of money.

First Store of Value, Second Means of Payment

First Store of Value, Second Means of Payment

Other thinkers within the Austrian School disagree with von Mises, citing in particular William Stanley Jevons, an economist whose thinking is close to that of the Viennese School, but who is not himself one of them. According to these other thinkers, the function of the medium of exchange is secondary to the store of value function. Thus, what was gradually discovered as a monetary resource by emerging market forces would first and foremost be regarded as valuable collector's items with ornamental purposes. This valuable collector's item would be hoarded, which is why this item would gradually acquire a value-storing function. Only with advanced monetization (consolidation of the value retention function) would the medium of exchange function and finally the store of value function be realized. Only after the exchange value has stabilized because enough people have discovered this thing's potential to store value, the opportunity costs to use this good as a means of exchange would no longer be too high.

Harmony or Contradiction?

Harmony or Contradiction?

Thus, there is no agreement on the order and sequence of these three functions. Almost universally is the conviction according to which money, i.e. a thing which is supposed to be money, must unite the three functions mentioned. Money should therefore by definition always be a medium of exchange, a store of value, and a unit of calculation. But the question arises whether this generally accepted view is correct and whether there is not an inherent contradiction between these functions?

Flexible Lubricant or Stable Value?

Flexible Lubricant or Stable Value?

Thus the question arises whether money, which is to serve as a lubricant for the economy, can at the same time be a reliable basis for its calculation? Whoever regards money as a lubricant for the economic engine, implies that the supply of this very money must be kept elastic. Changes on the supply side however distort this money's condition as a neutral value yardstick, which again thwarts money as a calculation basis. In the same way, the store of value function and the medium of exchange function seem to contradict each other in essence. If money is hoarded, which is the natural consequence of the store of value function, money is withdrawn from the economic cycle that is not turned around or exchanged. However, money that is to be used entirely as a medium of exchange and is therefore made available in any quantity so that every possible exchange is possible, is not suitable for storing value long-term.

Short and long-term

Short and long-term

Money, which is primarily intended to be a medium of exchange, is necessarily a bad store of value because in most cases interventions must be accepted to ensure that this money circulates. Money, which, on the other hand, due to its characteristics is excellently suited as a store of value, is more likely to be hoarded rather than exchanged because the opportunity costs for not hoarding it are too high. Nonetheless, today's economists believe that these three functions can be united in one resource alone. Today, fiat currencies are stable in price, but not in value. Because of their price stability, they are suitable as a medium of exchange and unit of account in the short term. In the long term, however, they are neither suitable as a measure of value nor as a store of value. Gold and bitcoin, on the other hand, are predestined as a measure of value and store of value in the long term. In the short term, however, they are always calculated against US dollars, which is why their volatility is often perceived as too high.

Stability: an Illusion?

Stability: an Illusion?

With greater market depth and liquidity, volatility in gold and bitcoin decreases. However, increasing demand for money for gold or bitcoin must always be reflected in their prices, as the supply is limited in absolute terms for bitcoin and in relative terms for gold. However, price stability is always a question of one's frame of reference. There is never one price, but always the price expressed in another commodity. Expressed in dollars, bitcoin may seem volatile. Expressed in bitcoin, it is the dollar that is subject to fluctuations. Perfect stability is an illusion in a dynamic world like ours. At the expense of the store of value function, this illusion of price stability is created with fiat currencies. Whether this illusion is necessary for money to be accepted as a generally accepted medium of exchange has not yet been conclusively clarified. In contrast to fiat currencies, the money supply is absolutely limited with bitcoin, so only the demand parameter can change. Against this backdrop, the argument can be made that ultimately everything should be priced against bitcoin as the cryptoassets is the hardest money we have.

Bearer of Information

Bearer of Information

Occasionally, the importance of money as a basis for calculation is also underestimated. Money is also a "store of information" and not just a "store of value". By means of money, a society communicates with each other and over time. Prices play a special role in this context. They reflect condensed knowledge. However, their significance is by no means limited to the mere display of payment amounts. A freely formed price is the documentation of decisions made by people responsible for scarce resources. Thus, prices are concrete, completed and thus past exchange relationships in which our decisions (and thus also preferences) are expressed in interaction with decisions of others. As a common denominator, generally accepted money sets and defines what the different prices (read exchange relations) are in relation to one another and thus enables efficient economic activity.

A World without Money?

A World without Money?

Money is primarily there to save us humans transaction and computing costs. It is a kind of cognitive relief for our brain since it allows us to offset all the different exchange relations against a single common denominator. A world without money would thus mean and add up to additional cognitive costs for humans, which would turn out to be a backlog. But what about machines? They are not subject to the same restrictions as humans are. For machines, a world without money would be conceivable, since they have the "cognitive" abilities for high-frequency bartering. So if we really one day live in a machine-to-machine economy in the future, in which acts of exchange would be carried out quasi instantaneously by machines and robots, we humans would be dependent on machines that translate the exchange relations to us so we can keep on benefiting from an ongoing economy.

Money as the Ultimate Extinguisher of Debt

Money as the Ultimate Extinguisher of Debt

A final function that is often neglected today is that of debt extinguishment. Money should ultimately always be debt extinguishing because after all, money is often also debt. In order to prevent the debt from growing continuously, in an optimal monetary system the base money should extinguish debts. This way an ultimate debt can be canceled and will not simply move from one debtor to another within a hierarchy of money. In our fiat currency system, central bank money represents base money. It is actually the central bank's liability and is "backed" by government bonds. In this sense, central bank money is the obligation of the central bank and thus ultimately no instrument of debt extinguishment in the true sense of the word. The situation is different with gold and bitcoin, which are nobody's liability because there is no counterparty, different from central bank money.