The Function and Properties of Money

So why do you need money in the first place, and how is money chosen in the market?

The Function and Properties of Money

This is PART 3 of my series where I examine Bitcoin through the lens of Austrian economics. In his part, I explore the function and properties of money.

So why do you need money in the first place, and how is money chosen in the market?

Money has one core function: facilitating indirect exchange by functioning as a medium of indirect exchange. The three purposes are “medium of exchange,” “store of value,” and “unit of account.” The functions analyzed below are not separable and distinct utilities but rather derivative of the medium of exchange-utility because all uses of money aim to facilitate exchange in the market. For simplicity, these functions are separated to break down money as a exchange phenomenon.

Medium of exchange

Throughout time, money has been described differently by different economic thinkers in different eras. Although differently explained, most tend to converge on one core function: facilitating indirect exchange by acting as a commonly used medium of exchange. This is the core function of money, and all the other uses are derivatives of this use. Money is a medium of exchange because people will accept it for goods and services and then exchange it further for the goods and services they want. Money must be salable, and since the definition of salability is the degree of ease with which an individual can dispose of his goods for a good economic price and without delay, money must serve its purpose in the short term, i.e., it must be liquid.

Store of value

Money is a store of value because people are confident that it will keep its value over time. Thus, they are willing to save it for future exchanges. Their suitability often causes the increased salability of goods for hoarding, an important factor in their qualification for being media of exchange. This dynamic resulted in individuals storing their wealth in a good, gaining market recognition at the expense of other goods.

Menger calls money the most appropriate form for individuals to store their wealth. Thus, storing value should not be seen as a separate function of money since storing one’s wealth in a good that is money is simply deferring one’s exchange into the future based on time preference. The praxeology theory of human action can explain this time preference. This type of exchange can be described as intertemporal because this exchange is related to the past, the present, and the future.

The term “store of value” is used to store one’s wealth in a good to exchange it for another good. If the previous statement holds truth, storing one’s wealth in a good is not an inherent function but a byproduct of a deferred exchange. The store of value function emerges with sufficient salability across time, achieved with a good’s ability to preserve value with sufficiently low costs for exchange across time. Fitness for preservation is the wording Menger uses to describe a characteristic of a highly salable good, indicating that money satisfies the facilitation of temporal exchange cost-effectively. Mises also describes the uncertainty of the future as a core driver of demand for money. This explains why individuals store their value in a good that carries the least amount of risk (often money), and that can be liquidated quickly and cheaply: individuals tend to store their wealth in salable goods.

One might think that “store of value” and “medium of exchange” are separate functions, but they serve the same fundamental function: indirect exchange. Storing value is a preference for a later exchange instead of an immediate one. The “store of value” function is an indirect exchange with a time component.

Unit of account

The unit of account function is performing economic calculus. It does not directly satisfy the need for exchange, but it further improves it by acting as a measurement stick for economic calculation in the market. Money makes exchange simple: the price of a good or service is stated in monetary units, driving potential buyers to know precisely how much value is wanted in return. Menger also argues that a measure of price, i.e., unit of account can also be an attribute of a non-monetary good; he concludes that the function of a measure of price is a byproduct of money, which derives its “moneyness” from being a medium of exchange in the present (direct payment) or future (store of value). Although money cannot measure value, it is reasonable to call it a measure of price: it is the most useful good in which other goods can be evaluated directly without an unnecessary roundabout procedure.

Markets and money are fundamentally social coordination tools that help the division of labor. Being a unit of account, money enables economic calculation, allowing individuals participating in the market economy to alter the anticipated course of events to help them better satisfy their wants. Profit-seeking entrepreneurs use the money to readjust production and investment to satisfy demand optimally.

When examining the different functions of money, one can conclude that the sole function of money is to facilitate the exchange of value. Storing wealth in a monetary good and using this monetary good for immediate payments are different sides of the same coin, and the only difference is the holding period. Concepts of a “store of value” and a “unit of account” are tied to deferred exchange of value. It might be helpful to end this topic by reinforcing the idea that money is always a medium of exchange but outlining specific separate functions via compartmentalization is helpful for the reader to grasp these ideas and examine them more clearly.

Properties of money

Salability is the core property that defines what is used as money in the free market. Salability is a characteristic of a good that deals with the economic costs related to disposing or acquiring it. As we have established before, salability can be described as a characteristic that lowers the economic costs for exchanging them, i.e., reduces the adversity in reaching their goals. As people become increasingly aware of the differences in the salability of goods, they become ever more inclined to accept exchange opportunities.

We shall return to the previously used example of the shoemaker, who goes to the marketplace to exchange shoes tailored specially for overgrown people. Although he might encounter buyers after some time willing to pay the price he wants for them, it is unarguably clear that for a merchant selling corn, it will be much easier to find people he can trade with to acquire the goods he wants. In this case, corn’s higher salability can be attributed to its consumption utility and divisibility. On the other hand, the market for overgrown people’s shoes can be quite limited.

Salability can be examined mainly in three dimensions: salability across space, across scales, and across time. Salability (liquidity) is impossible to measure as most aspects of salability deal with the future making it possible only to estimate one’s best but subjective ability. Salability is also never a fixed constant; it changes based on an economy's technological and economic situation. In one economy, one good is used as money; in another economy, in a different historical period, different money is preferred. While salability is a psychological phenomenon, certain characteristics are valued by humans. These characteristics and why they matter are examined in PART 2.

Salability through space

Salability is affected by the ease of transporting or carrying a good across long-distance. This is known as portability; the cost of transferring a good and moving the ownership influence a good’s salability across space. Goods that tend to be portable have better salability across space and thus are more likely to accrue monetary value. Digital money can be salable in this regard as it is easy to transport but can incur other costs such as the cost of international transactions.

Another essential quality of good money is its fungibility, also called homogeneity or uniformity. Monetary units should not differ and should be accepted at the same price. If money is not fungible, there is a risk of certain money units trading at a discount or a premium.

Salability through scales

Salability across scales refers to the cost of using a good in exchanges of different values. A good can be conveniently divided into smaller units or grouped into larger units. Easily divisible goods can be used more effectively as media of exchange. The more subunits one can get by dividing a good while not destroying the value for the whole volume, the better the salability across scales.

Divisibility can also be measured by the cost of dividing a unit into subunits. The ability to adjust the value of a good to reflect on the exchange value of another good accurately creates more opportunities to use a good in diverse types of exchanges.

Salability through time

Most goods used as media of exchange were nonperishable, making it possible to exchange across time effectively. This dimension of salability can be measured by how well a good preserves its value across time. This is tied to the durability of goods because durable goods over time are likely to preserve their value better and have lower preservation costs.

Another essential factor to consider when thinking about salability across time is scarcity, which is the relationship between the supply of a good and the demand for it. The key aspect of scarcity is the dilution resistance of existing stock. Creating more units of money inflates the supply, thus pushing the money’s value per unit down. Part of this aspect is how well money can resist political limitations imposed on it being transferred from one period of time to another. This can be characterized as a good’s censorship resistance through time. There is a possibility of a temporal (long-term) exchange being censored either by direct confiscation or through periods in a non-direct way via the previously mentioned dilution of stock (inflation). If an entity can increase the supply of a good, ceteris paribus, the value of this good per unit decreases, decreasing salability through time. To decrease stock dilution, the production cost of these units should not be too low.

Acceptability

Acceptability and recognizability are essential characteristics for persuading others to trade with you. If it takes a long time to investigate whether something is a salable good, it increases the time needed to execute a trade, thus increasing economic sacrifice. Thus, familiarity lowers the costs of exchange. All previously mentioned intrinsic characteristics do not matter if nobody is willing to accept your good in exchange.

Another essential factor for salability is the permanence and distribution of demand. Ideally, a good is demanded by individuals far away from each other and by individuals in different periods. Also, salability is affected by the development of the market, and particularly, the level of speculation present in the market; speculation can expedite the monetization process of a good.

Good money tends to be relatively salable across all dimensions. The greater the number and intensity of a good's previously mentioned characteristics, the more likely it will become used in indirect exchange. Less salable goods are disposed of for goods that exhibit higher salability, even if they are not desired for consumption. Higher salability results in economic actors’ increased knowledge and confidence that this good can be resold easily for lower transaction costs. Information about a good’s salability assurances spreads throughout the economy resulting in goods emerging as media of exchange.

Definition of money

There is no praxeological difference between a medium of exchange and money. The difference comes down merely to how the word “money” is defined and how individuals perceive it. Menger defines money as the “universal medium of exchange,” meaning everyone should accept it. At the same time, Mises more reasonably maintains it must be “generally accepted and commonly used,” leaving some room for interpretation. Menger explains that the difference between money and media of exchange that is not yet considered money is the degree of salability. Since this is a measurement question, it is impossible to make a praxeological separation between the two.

To be money, according to the Austrian definition, a good would not only need to function as temporal exchange (store of value) but also in the short term, since money is the most salable good (liquid), i.e., it needs to be easy and fast to dispose or acquire it without much economic sacrifice.