Money as a medium of exchange

To avoid the inconveniences associated with a barter economy, one of the goods can be used as a medium of exchange. This crude form of money used for exchange is then called commodity money. Bartering one good against money and then money against another good might at first glance further complicate transactions. At second glance, however, it becomes clear that the use of one good as a medium of exchange facilitates the whole process to a considerable extent, as the mutual coincidence of wants is no longer required for an exchange of goods and services to take place. It is obvious that one precondition for this particular good to fulfill the function of money is that it is accepted throughout the economy as a medium of exchange, because of tradition, informal convention or law. At the same time, it is obvious that goods serving as a medium of exchange should have some specific technical properties. In particular, goods serving as commodity money should be easy to carry, durable, divisible and their quality should be easy to verify. In a more economic sense, of course, money should be a rare good, as only rare goods have a positive value.

Money as a store of value

If the good used as money maintains its value over time, it can be held for longer periods. This is particularly useful because it allows the act of sale to be separated from the act of purchase. In this case, money fulfils the important function of a store of value. It is for these reasons that commodities that also serve as a store of value are preferable to commodities that only serve as a medium of exchange. Goods such as flowers or tomatoes, for instance, might in principle serve as a medium of exchange. However, they would not be useful as a store of value and would therefore probably not have been used as money. So if this function of money does not work properly (for instance if the good serving as money loses its value over time), people will make use of the value-storing function of other goods or assets or – in extreme cases – even go back to bartering.

Money as a unit of account

Of equal importance is the function of money as a unit of account. This can be illustrated by going back to our previous example. Even if the difficulty of the mutual coincidence of wants is overcome, people would still have to find the exact exchange ratio between bread and haircuts or between haircuts and shoes, for example. Such “exchange ratios” – the number of loaves of bread worth one haircut, for instance – are known as relative prices or terms of trade. In the market place, the relative price would have to be determined for each pair of goods and services and, of course, everybody involved in the exchange of goods would need all the information about the terms of trade between all goods. It is easy to show that, for two goods, there is only one relative price, while for three goods there are just three relative prices (namely bread against haircuts, haircuts against shoes and bread against shoes). The greater the number of goods being exchanged, the more difficult it becomes to gather information on all possible “exchange rates”. Consequently, collecting and remembering information on the terms of trade creates high costs for the participants in a barter economy, increasing disproportionately with the number of goods exchanged. These resources can be used more efficiently in other ways if one of the existing goods is used as a unit of account (a so-called “numeraire”). In this case, the value of all goods can be expressed in terms of this “numeraire” and the number of prices which consumers have to identify and remember can be reduced significantly. Therefore, if all prices were labeled in money terms, transactions would be much easier.

More generally speaking, not only can the prices of goods be expressed in money terms, but so too can the price of any asset. All economic agents in a currency area would then calculate things such as costs, prices, wages, income, etc. in the same units of money. As in the above mentioned functions of money, the less stable and reliable the value of money, the more difficult it is for money to fulfill this important function. A commonly accepted reliable unit of account thus forms a sound basis for price and cost calculations, thereby improving transparency and reliability.

Vocabulary list

1. a banknote – банкнота

2. a coin – монета

3. an asset – актив

4. liquid – ликвидный

5. ant. illiquid

6. to convert – обращать, переводить, конвертировать

7. n. conversion

8. a medium of exchange – средствообращения

9. a store of value – средство накопления

10. syn. a store of wealth

11. a unit of account – единицарасчета

12. barter – бартер, бартерный

13. v. to barter

14. acounterpart – контрагент, партнер в сделке

15. a mutual coincidence of wants – взаимноесовпадениепотребностей

16. commodity money – товарные деньги

17. convention – соглашение; обычай

18. exchange rate (ratio) – обменныйкурс

Notes:

1. atlowcost – с низкими издержками

2. aproperty – зд. характеристика, черта

3. a positive value – положительная стоимость

4. price and cost calculation – расчетценыистоимости

5. transparency – прозрачность

6. adeposit – банковский депозит

Ex 1. Suggest the Russian equivalents:

“money makes the world go round”; these assets are regarded as money; to be used for payment purposes; uncontested; to make a payment at a very low cost; money is what money does; division of labour; to imply substantial “transaction costs”;crude form of money; facilitate the whole process to a considerable extent; money should be easy to carry, durable, divisible; to allow the act of sale to be separated from the act of purchase; to lose value over time; terms of trade; to be expressed in money terms.