Suppose you want to sell your 10-year-old Honda and buy a new Ferrari. A prospect has said he wants it and offers you an unopened carton of Kent cigarettes as full payment. Would you take it? Probably not. After all, you don't smoke, and you can be sure the Ferrari dealer will not accept a carton, or even 1,000 cartons, of cigarettes in exchange for that gleaming, red 488 GTB.
While this situation may sound preposterous, it actually existed at one time. In the 1980s, the Communist Party in Romania declared that Kent cigarettes were an acceptable medium of exchange. Fortunately, that idea didn't last too long, and other forms of money took its place.
So, what is money, and what are the characteristics of money? The University of California Santa Barbara says the three basic functions of money are to serve as a medium of exchange, a unit of account and as a store of value.
Money Establishes a Medium of Exchange
People are always in the process of buying and selling something, and they need a way to facilitate these activities. Something has to be a form of payment, a constant of exchange. The University of Minnesota says that money serves that purpose.
Consider what would happen if money did not exist. Every exchange would be a barter, a swap of goods. A buyer might give up two pigs for a sofa and a chair. A retailer might want a chicken in exchange for a pair of shoes.
But what if the chicken were sick and couldn't lay eggs? Then the retailer got the bad end of the deal.
Money steps in to eliminate these risks. It becomes a commonly used medium of exchange that everyone understands and accepts. Money is standardized, divisible, portable and does not physically deteriorate.
Money Creates a Unit of Account
The problem is obvious. Every transaction would be uncertain and fraught with risk without a common method to measure the value of the exchange. If someone asked you how much you paid for a radio, you would not say you paid with five apple pies. You would say, for example, that you paid $75 for the radio.
Money establishes a unit of account. It is a consistent way to measure the value of goods and services, and people will accept it as a medium of exchange. Money eliminates the need to barter for things.
Money is a Store of Value
Money holds its value over time. Suppose you found a $20 bill in your pocket that was left over a year ago. You would be happy because it's still worth $20. That little piece of paper had a value that had been "stored." This is an example of the durability of money.
Other things besides money can act as a store of value. Office buildings, stocks, bonds and works of art are also a means of storing value. But money has a distinct advantage; it is liquid.
Real estate, stock and collectibles can be exchanged for other goods, but as Forbes explains, they must first be converted into money. Sometimes, depending on the market, that's not easy to do. These items with a store of value all have some degree of illiquidity.
Money is liquid and can be exchanged instantly for other goods and services.
The one problem with using money as a store of value is inflation. While some investments, like real estate, may appreciate in value over time, money will lose some of its value because of inflation.
Civilizations have progressed over centuries to arrive at the systems of money that we have today. Nations have their own currencies that can be easily converted for exchanges into another country's goods and services. You don't need a chicken to pay for a cup of coffee at Starbucks. A crisp, $20 bill will do.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, PocketSense, Bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.