How to Define Money: A Simple Guide for Beginners

We all know what money is, but how might we define money? The generally accepted academic definition of money usually says that money needs to fulfil three functions: A medium of exchange, a store of value, and a unit of account. But what does this really mean?

How to define money

How to define money: Medium of Exchange

Medium of exchange means it is a payment mechanism—you can use it to pay someone for something, or to extinguish a debt or financial obligation. To be a good medium of exchange, it does not need to be universally accepted (nothing is), but it should be widely accepted in the context for which it is being used.

Store of value means that in the near term (however you define this) your money will be worth the same as it is today. To be a good store of value, you need to be reasonably confident that your money will buy you the same amount of goods and services tomorrow, next month, or next year. When this breaks down, the money’s value is quickly eroded, a process often referred to as hyperinflation. Individuals quickly develop alternative ways to denominate value and undertake transactions, for example bartering or using a ‘hard’ or more successful and stable currency.

Unit of account

Unit of account means it is something that you can use to compare the value of two items, or to count the total value of your assets. If you record the value of all your possessions, you need some unit to price them in, to get a total. Usually that is your home currency (GBP or USD or whatever), but you could in theory use any unit.

The last time I counted, I had 0.2 Lamborghinis worth of gadgets in my study. To be a good unit of account, the money needs to have a well-accepted or understood price against assets, otherwise it is hard to figure out the total value across all your assets and, if you need to do so, to convince others of that value.

While some believe that ‘good money’ should fulfil all these functions, others think that the three functions can be fulfilled by different instruments. For example, there is no real reason why something used as a medium of exchange (i.e., something that can be used to immediately settle a debt) must also be a long-term store of value.

How to define money: Forms of Money

Is Today’s Money Good Money?

It is debatable how well the forms of money we generally regard as ‘good money’ stack up against these properties. The US dollar is arguably the most prominent form of money we have today, and can be considered the best, at least for the time being. But how good is it? The dollar is generally acceptable for payment, certainly in the USA, and even in other countries, so it is an excellent medium of exchange in those contexts (but less so in Singapore). And it is an excellent unit of account, because many assets are priced in dollars, including global commodities such as crude oil and gold.

How to define money: Physical Currency

But how has it fared as a store of value? According to the St Louis Fed, the purchasing power of the USD from a consumer’s perspective has fallen by over 96% since the Federal Reserve System was created in 1913.

Given that purchasing power of the USD over time has decreased significantly, it has been a poor store of value over the long term. Indeed, people don’t tend to keep banknotes under their mattress for decades, because they know cash is not a good store of value. And if they did, they would find that the purchasing power has decreased, or worse, that the banknotes have been pulled out of circulation and are no longer accepted in shops.

In fact, the dollar, as with almost all government currencies, consistently loses value by design, driven by policy. We can predict, more or less, that the USD will lose its purchasing power by a few percentage points each year. This is known as price inflation (as opposed to currency inflation which is an increase in the number of dollars in circulation).

Consumer Price Inflation

Price inflation is measured by CPI (Consumer Price Inflation)—an index measuring the changes in the price of a theoretical basket of goods that are reportedly chosen to represent typical urban household spending.

The makeup of the basket changes over time, and policymakers are not beyond employing various tricks with that basket to bend the rate of inflation to figures they find more convenient.

So perhaps ‘store of value’ is a not a good medium or long-term function of money, and perhaps the economists and textbooks do not have it quite of money, and perhaps the economists and textbooks do not have it quite right. We certainly need all three ‘functions of money,’ but perhaps not in the same instrument.

Perhaps money fulfils one need (immediate settlement of obligations), whereas the longer-term store of value need can be better achieved through other assets. In terms of the ‘store of value’ function of money, it is more the short-term predictability of value, or spending power, that is relevant: I need to know that a dollar tomorrow or next month can buy me the same thing as a dollar today and will settle immediate debts. But for long term preservation of value, perhaps housing or land or other assets may be more reliable.

How to define money: Digital Currency

How do cryptocurrencies and Digital Currency are fare against the standard definitions of money?

Bitcoin as a Medium of Exchange As a medium of exchange,

Bitcoin has some interesting characteristics. It is the very first digital asset of value that can be transferred over the internet without any specific third party having to approve the transaction or being able to deny it. It is also an asset that is transferred from one owner to another rather than moving via a series of third-party debits and credits, for example, through one or more banks. In this respect it is genuinely novel.

This is worth repeating: Bitcoin is the very first digital asset of value that can be transferred over the internet without any specific third party having to approve the transaction or being able to deny it.

Can you make payments with bitcoins? Yes, absolutely—anytime, anywhere. Is it fast? Sometimes depending on several factors. At a settlement speed varying between seconds and hours, it is certainly faster than some traditional payment methods, but slower than others.

Different cryptocurrencies settle transactions at different speeds.

Is Bitcoin widely accepted? Well, among its community it is widely accepted, and some prefer using it to traditional payment mechanisms.

But by a global standard, no, it is not widely accepted. Could this change?

Could more and more people and businesses accept bitcoins or other cryptocurrencies? Perhaps not in large stable economies, but possibly in unstable smaller economies. There are several factors to consider when deciding if bitcoins should be used in preference to the domestic currency or existing alternatives.

What about merchant adoption? Every now and again, you might read that a merchant now accepts bitcoins or other cryptocurrencies as payment. What is going on? Doesn’t these mean bitcoins are improving as a medium of exchange? Well, yes and no.

Most of the companies who say that they accept Bitcoin as payment don’t actually accept bitcoins or hold them on their balance sheets. Instead, they use cryptocurrency payment processors that act as an intermediary by quoting a price to the customer in bitcoins (based on current prices of bitcoins to dollars on various cryptocurrency exchanges), accepting the bitcoins from the customer, then wiring an equivalent amount of conventional currency (fiat in the jargon) the boring way into the merchant’s bank account.

Here is how it works:

1. The customer fills their shopping cart with items, then clicks ‘check out’.

2. They are presented with the total value of the goods in local currency. ‘How would you like to pay?’

3. Customer selects ‘Bitcoin’.

4. They are then shown the number of bitcoins that they need to pay.

The payment processor calculates this number by using the current exchange rate between Bitcoin and local currency, found on one or more cryptocurrency exchanges.

5. The customer then has a short amount of time to accept the price before the price of Bitcoin changes and the payment processor must re-price the basket. The pricing refresh time can be as short as 30 seconds due to Bitcoin’s volatility. 30 seconds!

Bitpay is a good example of this kind of cryptocurrency payment processor. In 2013-2015 several merchants announced that they now accepted Bitcoin. This was good cheap press for merchants, and many companies did this: Microsoft, Dell, and even—my favorite— Richard Branson for Virgin Galactic trips. Just think—in 2013 you could buy a trip into space and pay in bitcoins! However, since then, many merchants have quietly dropped Bitcoin as a method of payment.

So, in these cases where a merchant says they accept Bitcoin as payment, bitcoins are a medium of exchange from the customer’s perspective. But these cases are rare, and currently it is not currently a widely used medium of exchange. In July 2017, investment bank Morgan Stanley produced a report on Bitcoin merchant adoption that found that, in 2016, only five of the top 500 online merchants accepted Bitcoin and, in 2017, that number had dropped to three.

Importance of Money