The Two Functions of Money

Money is often defined in terms of functions. If a thing functions as money, if it performs the functions of money, it is money. The better it performs those functions, the better money it is.

Let us examine the two functions that are basic to the definition of money. These functions are being a standard unit of account and being a medium of exchange.

When money serves as a standard unit of account it gives units in terms of which relative value can be expressed. The money values have meaning in comparing goods and services. The money values indicate the proportionate worth of all the goods and services to which they are applied. With traditional money, each person having money can determine for themselves the value they are willing to put on goods and services. The person with goods and services to trade also determines the value they will put on those goods and services. If the person with money is willing to give more money than the smallest amount the person with goods is willing to accept in trade then a trade can occur. The trade is between those two parties. They set the value of the object in making their trade. When a large number of such trades occur we can refer to the amount of money typically exchanged for the good or service as the market value.

Money also serves as a medium of exchange. Each trade can involve money going from one party to another while goods and/or services go the other way. Money can be traded for all things and all things can be traded for money.

The purpose of these two functions of money is to make sure that each person engaged in production or distribution will receive a fair (or at least adequate) share of the goods and services produced and distributed. The procedures given under "standard unit of account" and "medium of exchange" are not the only ways that the society can indicate the value of things nor the only way it can be sure that the things are distributed fairly among those that produce.

The term value can also refer to such things as usefulness or importance of a good or service. These kinds of value, though not the same as monetary value, are often closely associated with it. A thing that has great utility is more likely to have a greater monetary value than a thing with little usefulness, for example. We will consider both monetary values and other ways of assigning value in the following discussion.

Trades, in a primitive economy, concern only those parties doing the trading. Society does not need to control those trades. The trades do not seem to affect other people so society will not try to control those trades. As economies become more complex and technologically advanced, trades affect a wider variety of people more seriously. In industrial societies, trades can be a matter of economic life and death for the entire society, even though the trades are still treated as if they were between only the two parties. It is the nature of our money that it makes it possible for us to treat trades as if they occurred only between two parties (two groups when more than two people are involved). The concept of money does not require that its use be limited to two party exchanges.

In industrial society every adult is a specialist. As specialists they are dependent on each other. This means that if two specialists trade with each other, their trade will affect the others. However, the specialists' immediate gain from the trade will not be affected by the way their trade is going to affect others. Each specialist will view their trade as being only between the two parties when, in fact, the entire society is a party to the trade. The whole society benefits or suffers from each trade. Money is one means by which these trades affect other people.

Money is a thing of the imagination in industrial societies. A thing is money if people accept it as money. Counterfeit bills are money until they are found to be counterfeit. Even currency is not so much valuable for itself but for what it can buy.

If we look upon a medium of exchange as a device or tool to help people motivate each other to do things then we can see how a thing can be a medium of exchange without being traded by individuals. If a party knows that they will receive something they want (a reward) if they do a certain thing (work), they they will be motivated to do that work. The more they want the reward, the stronger will be their motivation to work. In a traditional economy, the worker is paid only by those the worker benefits. This is because they benefit only a few people at a time. Their work efforts do not have a general impact on the public. Thus it makes sense for those directly affected to set the pay for their work. In an industrial economy, it is difficult for a worker to benefit one person without benefiting others. Yet the worker's pay (rewards) will come from some individual party. Actually, the source of the reward does not matter to the worker so long as the worker believes that the reward will come and that it will come as a result of the work done. If each person works for rewards which come from everyone, then the individual worker will be "trading" with the society and not with individuals. One will be rewarded by and work for the society as a whole. The medium of exchange will then be the record of the society's promise to reward one for working. Since the record is of a trade between only two parties (the worker and the society) the "medium" need not "change hands." In fact, the work of each person is still being traded for the work of all the other workers but the medium of exchange does not go from one person to another.

If we look at a "standard unit of account" as strictly a bookkeeping device then we can see that the standard does not have to be a thing one can hold in one's hand. The standard does not have to have a physical existence other than as a number. Currency does have a physical existence. It can be a bookkeeping tool but it is not a thing which is necessary to bookkeeping. If John owes Sam three dollars, John owes Sam an amount of money, a value, not three pieces of paper which also happen to be called dollars. The debt is fairly repaid by giving three dollar bills only if those bills have three dollars of purchasing power. This becomes obvious when the public loses confidence in the government's paper money. In times past, paper money was refused as a means of repaying debts. The standard exists in the worth and not in the paper. Only goods and services have worth. Only goods and services are valued and desired as ends in themselves. Currency is not a standard unit of account unless it is of intrinsic value; i.e. unless it would have worth even if it were not being used as currency. Even then, one might more accurately say it was being used as a standard unit of account. The currency itself is not the standard.

If we examine the requirements for standard units of account and for media of exchange we see that there need only be a record kept of values. There need be no tangible thing to serve as a counter of the value (i.e. a currency).

Now that we have made the point about what a good standard unit of account does not have to be let us examine what it does have to be. The standard must be expressible in the units of a ratio scale. (That is, the set of categories has to have order from least value to most value, the differences in adjacent categories being the same for all pairs of adjacent categories, and there is a category which indicates none of the variable.) These units can have any name (dollars, pounds, inches, hours) and are categories. The number of units of account assigned to a thing must be knowable. The standard serves best if the number of units of account for a thing (a good or service) does not change unless the value of the thing changes. That is, so long as the value of a thing does not change its price should not change. More simply, the price should not change for reasons that have nothing to do with the item for sale. One of the most important aspects of any standard unit of account is the ways in which particular things are assigned categories of the standard (given a price). There must be some means of being able to tell which category of value goes with each thing. Both physical object money and the improved money have ways of determining the values of particular goods and services.

The value of a thing to a society can be determined in several ways depending upon how one thinks of value. Value can refer to how much a thing is desired. "He would give anything to possess her." Value can refer to relative worth based on cost of production. "You owe me $100.00 based on time and materials." Value can refer to the fair market value in money of an item. "The going rate for that is $4.25 per bushel." Value can refer to the utility of an item. "Without barbed wire and the windmill the prairie would never have been settled." Prices can be assigned or set based on any or all of these possible ways of looking at value. Some ways are more useful or practical than others from the point of view of the economic system of a society. The way(s) used by a society to set prices will have significant consequences for how well its economy functions. Let us examine each of these ways of setting prices.`

One way is to find the degree of desire to have (own) the thing. This would require some sort of psychological measurement of subjective states of individuals. Such a measure would be difficult to meaningfully translate into an aggregate measure for the society as a whole. This is probably the least practical means of setting a price.

A second basis for setting prices derives from the "cost" of producing the thing or otherwise obtaining it. This point of view of value can be objectively measured in terms of physical materials and human labor used in its production. It can also include such things as the effects on the environment of the production process or the number of people likely to die in its production. This is the cost to the economy in resources rather than the price of the components added together. This kind of cost is relatively constant so long as the technology of production is unchanged. In theory the calculation is straightforward. In practice when businesses perform such calculations they make certain assumptions and express the results in terms of the expected price to purchase those resources. "It will cost $3.00 per widget to make them." The resultant cost is the price in money for the company, not the cost for the society in resources. For example, if a rancher is calculating the cost of producing a steer for market and has available government owned range land, he may ignore the cost of the grass the steers will eat on that land since he does not have to pay any money for it.

A third way to set prices is through the most common market value when many of the things are sold. This assigning of value is a strictly monetary process. The result may vary from time to time and reflects the psychological state and the results of many individuals' expectations and feelings. This technique adjusts relatively quickly to changing circumstances and has historically provided one of the economically most useful means of assigning prices when it has been allowed to function in a free market. Unfortunately both governments and businesses have a powerful motivation to prevent the operation of the free market. Both businesses and governments want to control prices for themselves rather than depending on the invisible hand of the market. The result is that only rarely in history has a free market lasted for any great length of time. Despite the attempts to control prices, however, prices have persisted in changing in ways that have frustrated both businesses and governments.

A fourth basis for setting prices is to find the degree of usefulness of the thing to the society. This technique can require considerable knowledge of the economy for any good degree of reliability and consistency. Different people will at different times may give quite different ratings of the degree of usefulness of many goods and services. One can produce estimates of an item's contribution to the economy by itemizing the processes in which it is used and the cost of replacing the item. One can also estimate such a contribution for an item which does not yet exist. This last estimation is frequently performed by businesses when trying to project the market for a new product.

These four ways of assigning a specific valuation to a particular good or service are not independent of each other. The second, third, and fourth, in particular, one would expect to generate correlated results. However, this is the case only when the economy if functioning well. In times of economic disruption the correlation is reduced.

For physical object money the third point of view is emphasised. Prices set by the market will usually be influenced by the other three factors if there is plenty of money and its flow is unrestricted. If the money flow is restricted or in short supply, then other factors do not affect the market value in the same way. In some rare cases they do not affect it at all. If there is no money available or no trading then there is no market value until trade and/or the availability of money resumes. Since money is usually changing in supply and restrictions, the market value often changes even though the item itself remains unchanged. The supply of a good or service also influences the market value of an item even if the desire, "cost," and usefulness of the item are unchanged. With these changes the market value is sometimes but a poor indicator of the price that would be assigned using the other means of assigning a price. There are several rather spectacular historical examples of the market value of a thing being quite different from its utility or cost of production or degree people desired it for itself. The tulip bulb boom in Holland is one such case.

There are many who would say that the market value of an item is the only true basis for setting a price. This position assumes that the price of an item is somehow independent of human beings. It assumes that such a price is somehow more valid or correct than any other. It seems to give some mystical significance to the market as a mechanism for setting prices. But price, like value, is a human invention and creation. Price, like value, is subjective in many ways. None of the ways of setting price discussed here are purely objective no matter how much counting and computing may be involved. At root there is always a subjective element which affects the price set. Therefore, in judging whether the price set for an item is appropriate, one must always clearly specify the criteria by which one will judge the suitability of that price. One should not merely say that if the price differs from the market price it is somehow wrong or inferior. One should provide some criterion by which to make such a judgment.

When the market value of goods and services changes significantly without a corresponding change in the other means of setting price (utility and cost to produce) there will be economic problems. The greater the difference between market value price, cost to produce, and utility, the greater will be the economic problems. (Remember that "cost to produce" in this context is the goods and services necessary not the price of those things.)

Desire is not indicated by market value unless each purchase is at the maximum the buyer is willing to pay. Even then there will be others who would purchase the item if it cost less and some who would buy even if it cost more. The market value is not even a good indicator for a society. The overall desire for a thing by the members of a society is a distribution of values ranging from disinterest or antipathy to obsession. The market value indicator is some point along the distribution curve. In as much as market value is a product of demand, it reflects only the curve above that value and then gives only an estimate of how many are above that value. The shape of the desire curve below the market value is not determined. Fortunately the curve is probably rather regular in most cases, perhaps even a "normal" curve. Market value just cannot be a reliable, fair means of indicating the desire of individuals or of the society as a whole. But, of course, this does not mean that fair market value is a bad means of setting prices.

The cost of producing an item is related to market price to a degree. Items that are expensive to produce tend to draw the highest prices. However, market value is set after production. Producers take the risk of producing an item even though they have no way to be sure that it can be sold at a high enough price to cover the costs of production. Sometimes they are lucky and the price rises far above production costs. Once produced, the cost of an item is fixed except for storage and maintenance costs. Yet the market value can change rapidly. It can even take on a negative value. Also, the market value for many products declines as an item ages even though its cost to the producer continues to rise.

The degree of usefulness (contribution to the society's well-being) is also but poorly indicated. Many things have a high market value and yet harm society. (Heroin is an example.) The actual use of an item cannot be known accurately at the time its price is set by the market. But then the market is not intended nor expected to establish the usefulness of an item. The individuals involved may be using their estimation of how useful an item may be to themselves as one of the considerations in deciding how much they are willing to pay for the item. The individual sellers may be estimating the usefulness of the item as part of their calculation of how much they can expect to receive for the item. But in neither case is that the only consideration.

The market value will usually give an approximation of the other means of setting value. It is this fact that enables it to survive as a basis of the economy of much of the world. However, market value for some items does sometimes get completely out of line with other measures of value. At these times the economy is badly hurt. An economy can cope with small discrepancies but when there is a gross difference it can wreck the economy for years. It would be worth more little errors if the big errors could be avoided. It is partly in the attempt to prevent these large errors that government controls over prices are instituted (thus increasing the little errors).

The improved money ignores the market value in setting prices because there is no market, in the traditional sense, for luxury goods and services. Individuals do not set their own prices in terms of money. Individuals do barter but they do not use new money in doing so. Only trades between individual and society use new money. The relatively few trades that take place between individuals can be conducted by barter since they are not important to the economy. The improved money even gives a new dimension to barter in that a person can use their money to buy something that they know the other person is willing to trade for.

"Benefit to society" is the standard used by the payers in setting the amounts they will pay for various jobs. This is a combination of "usefulness" and "desire" from the society's point of view. It also includes the cost to society of the production. In effect, the improved money uses all the points of view on value except the market price.

An economist might argue that the "most common market price" was the best possible indicator of the "value" of a thing. This argument can be refuted by pointing out that the market price is paid before a thing is consumed whereas the improved money is paid after a thing is consumed. Almost everyone would agree that hindsight is better than foresight. The value of an object is much more readily determined after it is used than before it is used. One who goes to the movies, eats in a restaurant, or buys a car discovers that. Thus with the old money one must predict the value of a thing while the payers can wait until a thing is used and then say what its value was.

The improved money has an additional advantage in that the payers are motivated to pay a fair price in wages and to set fair prices for luxuries. The old money system has competition to determine the level of prices and wages. Unless there is complete balance the competition will not result in a stalemate at fair price and wage levels. The result of these factors is that in the old money system there is small ability to set values correctly and no incentive for the individual to even try to set a fair value.

Not only is the improved money less likely to make errors in assigning value it is also far less likely to have the really large error that can so disrupt an economy. There are several reasons for this. One is that prices are nearly constant with the improved money. There are fewer opportunities to set prices and therefore less chance to make a mistake. A second reason is that only luxury items have prices. This, too, reduces opportunity for error. Errors in paying are less likely because the payers have no vested interest in either high or low pay. They will not make a bad situation worse in order to gain a personal advantage. They cannot benefit from a bad situation. Errors in paying will be made, or course, but they can be rather easily corrected because the payers have a good feedback mechanism in the computer and in the public they are so close to. The computer system records all transactions, production, and distribution. Data from this system are available to the payers even on a real time basis. The payers are scattered through the society at all levels and interact with almost everyone. Their rewards are in that interaction. They are very sensitive to, and concerned by, dissatisfaction in their friends. This social feedback is quickly noted by the payers. The feedback in economic and social areas provides a quick check on errors in assigning values to work. Large errors do not have the opportunity or time to develop with the improved money.

The improved money is able to be a much more accurate means of assigning value and is much less likely to be grossly wrong.

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