How would you explain the concept of money to a 5-year-old? Take a moment to think about it.
Surprisingly difficult, isn’t it? We use money everyday, but when we really think about being able to define it, the task is harder than one might expect.
Personally, I have yet to come up with a good idea of explaining money to a 5-year-old. If you got something good, I am all ears (hint: hit reply and share!). In the meantime, let’s take a closer look at how money is formally defined.
When you search the web for the definition of money, you’ll typically find that people explain money as both serving a set of functions and having a set of properties.
Functions of money
Function #1: Medium of exchange
The primary purpose of money is to serve as a medium of exchange to facilitate transactions. Without money, the only way to exchange goods would be through direct exchange (i.e. bartering.)
Bartering is an incredibly inefficient way to exchange goods because it relies upon someone having something of equal value to offer in exchange for a coveted good. It can be extremely difficult to settle on an “even exchange”, however.
For example, let’s say that you want me to tutor you on cryptocurrency. In return, you offer a few papayas from the papaya tree in your backyard. If I like papayas, this trade will work because I’ll be happy to eat the fruit and you’ll be happy to receive tutoring. But what if I was allergic to papayas? Moreover, what happens when it’s not papaya season? Or what if you have a bad harvest year? You would have to go hunting for another good to trade or we couldn’t work together. In other words, exchanging goods in a barter system can only happen if there is a double coincidence of wants between two transacting parties.
Another scenario to take into consideration is trust. For example, what if you decide to keep the brightest and freshest papayas for yourself, while offering me the smallest and oldest papayas in exchange for tutoring sessions? How can I trust that you’re not ripping me off? To solve this issue, we might need a middleman to help facilitate the trade.
Because of issues like this, the costs of relying on a barter system increase much faster than the growth in the number of goods traded. Barter might work in one-off scenarios, but it doesn’t work at a larger scale.
Money eliminates these problems by serving as a medium of exchange that can be used to trade goods and services regardless of whether the buyer and seller desires each other’s goods and/or services.
Function #2: Unit of account
Money also serves an agreed-upon measure of the value of goods and services.
For example, if something costs $30 USD, then the unit of account is USD and we know that we need 30 of them to buy the thing we want.
Function #3: Store of value
For something to be a type of money, it must also maintain its value over time. In other words, it must be a “store of value”. The way to prove this is to disprove the opposite being true.
Let’s assume we live in the Land of Mystery. In the Land of Mystery, the currency they use is called Mystery Dollars. Let’s say you allocate 30 Mystery Dollars each day to spend on food and groceries. Today, 30 Mystery Dollars can buy you 6 eggs, 8oz of steak or salmon, a carton of milk, 100 grams of butter, and 2 cups of rice. But a week later, your 30 Mystery Dollars depreciates in value by 50%. Now you can only buy 3 eggs, 4oz of steak or salmon, half a carton of milk, 50 grams of butter, and 1 cup of rice with your 30 Mystery Dollars. You wouldn’t want to use Mystery Dollars anymore because you might risk going into starvation one day if they continue to depreciate in value.
Therefore, in order for something to be a good form of money, it must be a good store of value. This means if I hold onto that money today, it will maintain its value until tomorrow, next week, or even next year.
Function #4: Standard of deferred payment
Finally, money also needs to be a widely accepted way to value a debt obligation. Debt is a very important use of money because it allows people to acquire goods and services now and pay for them in the future. Without debt, we’d have a very constrained and limited economy. Money must serve as a functional way to give value to debt.
Properties of money
The 6 properties of money are durability, portability, divisibility, uniformity, limited supply, and acceptability. To explain this concept, let’s compare two different forms of money to see how well they rank in these properties:
A $20 bill
Can we use money over and over again to settle many transactions?
A cow is quite durable, but since it is a living thing, it’s always at risk of getting sick or dying. A $20 bill, on the other hand, is much more durable than a cow because it doesn’t get sick or die. Moreover, it can be easily replaced even if the bill becomes worn out.
How easily can you carry the money from one place to another?
While a whole cow would be annoying to carry around every time we want to go to the store to buy something, a $20 dollar can be easily put in your pocket.
Can we divide the money easily so that we can buy different products of different value?
A $20 bill can be broken into smaller bills, such as $10s, $5s, $1s, quarters, dimes, nickels, and/or pennies. Using these smaller denominations, we can buy more products than what we can buy with a cow that cannot be so easily divided. Sure, we can slaughter the cow and sell parts of it, but that’s not nearly as easy as using denominations of a currency.
Is every unit of the money the same?
Cows come in different sizes, shapes, and breeds. Each one has a different value. Therefore, cows are not a very uniform form of money. On the other hand, $20 bills are all the same size and shape. Therefore, a $20 bill is much more uniform than a cow.
Do many different people accept the money as having value?
For something to be money, it must be accepted by a large enough set of suppliers in order to be exchanged for goods and services. While cows are certainly valuable, some people may not accept cows as money. In contrast, a $20 bill is accepted as payment wherever you go in the US.
Does the money have a limited supply, thereby giving it value?
Cows are fairly limited in supply. We can’t just produce cows out of thin air. Nonetheless, if we used cows as money, farmers would do their best to increase the supply of cows, which would eventually decrease their value. On the other hand, the supply of $20 bills is regulated by the Federal Reserve, whose job it is to control the supply of money such that it retains its value over time.
The 6 above properties are not required to be met 100% for something to be money. However, they provide a good method of measurement into how efficient a form of money is. Throughout history, there have been various sources of money that did not meet one or more of the criteria above.
For example, there was a small island in Micronesia called Yap. The people of this island, the Yapanese, were once known to have used rai stones as money.
Rai stones were huge discs of limestones. Some of them even weighed up to several tons!
Obviously, Rai stones don’t meet a lot of criteria we defined above. For example, they are not very portable, divisible, or uniform. So how was it possible for the Yapanese to use rai stones as money?
Well, even though the stones were not very portable, the Yapanese used them as money purely through social agreement. In other words, they would transfer a rai stone from one person to another purely through oral agreement. The names of the previous owners were passed down to the new owner. In this way, the use of rai stones as a monetary system is probably the earliest example we have of a distributed ledger, similar to blockchains!
Additionally, the value of stone was not based solely on its size and aesthetics, but also its history. If many people died when a specific stone was transported or if a famous sailor brought it in, the value of the rai stone increased. Therefore, even though the rai stones were not uniform, they still worked as money (albeit inefficiently because the Yapanese would have to keep track of the value of each stone separately.)
In reality, anything can serve as money so long as there is a stable social consensus about its value. However, the criteria we defined above helps us figure out what makes for a good form of money that can be used to settle many different types of transactions among different types of people.
Now I hope you understand the formal definition of money. You should now understand the functions it must serve (Medium of exchange, Unit of account, Store of value, and Standard of deferred payment) as well as the properties we use to rank its efficiency (Durability, Portability, Divisibility, Uniformity, Generally Accepted, Scarcity).
In the next post, we’ll dive into the history of money and how it evolved. This will be a fun topic, so get excited! 🙂