Functions of Money
What is Functions of Money?
Money serves three functions: a medium of exchange, a unit of account, and a store of value.
As a medium of exchange it removes the need for barter's double coincidence of wants. As a unit of account it gives a common measure of value. As a store of value it preserves purchasing power over time, though inflation erodes this.
Functions of Money: a worked example
Suppose a tutor charges $30 an hour and a used bicycle sells for $150. As a unit of account, money reports that the bicycle costs $150 / $30 = 5 tutoring hours, a comparison that barter would force the two traders to negotiate case by case. As a medium of exchange, the tutor sells hours for dollars and buys the bicycle with dollars, so no double coincidence of wants is needed. As a store of value, suppose the tutor saves $600 in cash and prices then rise 20% over the year. That cash buys $600 / 1.20 = $500 worth of goods at the old prices, a $100 loss of purchasing power even though the number of dollars never changed.
The mistake students make with functions of money
Students often write that inflation stops money from working as a medium of exchange. Dollars still buy goods during moderate inflation, so exchange keeps functioning normally. Inflation attacks the store of value function, because cash held over time buys less later. The confusion is tempting since both functions involve prices. A second error is treating unit of account and store of value as one idea. Unit of account is about measuring prices today, while store of value is about carrying purchasing power into the future.
Functions of Money questions
What are the three functions of money?
Money works as a medium of exchange, a unit of account, and a store of value. Medium of exchange means sellers accept it for goods, which removes the need for a double coincidence of wants. Unit of account means prices are quoted in one common measure, so a $150 bicycle and a $30 tutoring hour can be compared directly. Store of value means purchasing power can be held and spent later, though inflation weakens that function.
Which function of money does inflation weaken?
Inflation weakens the store of value function. Cash held while prices climb buys fewer goods later, so $600 saved through a 20% price increase commands only $500 of the earlier purchases. The medium of exchange function survives moderate inflation because sellers still accept the currency, and the unit of account function survives because prices are still quoted in it. Only very rapid inflation damages all three at once.
Why does money remove the double coincidence of wants?
Barter requires each trader to want exactly what the other offers at the same moment, which is why a tutor with hours to sell and a need for a bicycle may find no match. Money splits that single trade into two, selling hours for dollars and then spending dollars on the bicycle. Any seller accepts the dollars, so the search for a perfectly matched partner disappears.
Related terms
Common comparisons
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