Functions of money | Financial sector | AP Macroeconomics | Khan Academy

Hello everyone, Grant here.

So I'd like to talk to you today about the various functions of money. Functions of money now. Money, of course, is something that we all use every day, and we kind of have a general feel for what it is. But it's interesting to step back and actually contemplate what is money, what gives it its value, what is it that we use it for? Why is it that you can use some things for money throughout history? You know, people have used not just gold and silver but things like salt or cigarettes as money, and why other things can't be used.

Economists generally divide the functions of money, the things that it does for us, into three different categories. Sometimes people will add a fourth in there; I won't get to that in this video, I'll talk about it in a different one. But there's kind of three main ones that people usually talk about.

So if you were an economist just kind of philosophizing about what the functions of money are, you might start by thinking, "Well, what does the world look like without money?" For example, let's say that you were a lawyer, and you provide legal counsel to people. This is the service that you provide, and this is the way that you add value to the economy. Let's say it's the case that you're refurnishing and you want a chair. Well, what that would require is that you find someone who happens to produce chairs. You find some person out there, and his way of adding value to society is to produce chairs. This is what he does, and he is specialized at it, and he's very good.

Now, the issue here, because money doesn't exist, you basically have to trade with him. You have to barter in some way, and this is what's called a barter economy. In order to do that, given that you've specialized in law, which is the thing that you provide and add value with, you kind of have to hope that he wants legal services. That he happens to be in a situation where he wants the thing that you provide, which, in this case, is legal services.

If that was true, if you had that good fortune, then you would be able to trade some legal services over to him, and he would trade you some number of chairs, and all would be well. But of course, this feels kind of rare, especially given how specialized you are, and this idea where you want something, and he wants something, and those line up with each other actually has a name. This is called the double coincidence of wants. Double coincidence, and it's worth writing down because people kind of reference this when we're talking about barter economies of wants.

By barter economy, I just mean, you know, this kind of setup but scaled up to the scale of society where everybody's trading based on their specialty and what someone else needs. Of course, in a world of money, this seems absurd because in reality, what you do is you would be over here, and sure, you would provide your legal services. You would kind of provide legal services to someone as your way of adding value, but it would be to just anyone who wants it, not based on what they produce.

In response, in exchange for that, they give you cash. They just give you, you know, money, something you can then use that everybody accepts for whatever it is that you want. So in this case, you know, if you want a chair, then you bring it over to the guy who produces chairs, and that's what he gives you, you know, a chair.

Insofar as money serves this function, where it is kind of the universal thing to trade, it's called a medium of exchange. And what that means is anytime that you want to exchange for something, this is the common thing of value that you use to actually trade with the world. But that's not the only thing money does.

That's a really big part that kind of allows the entire economy to exist and it allows you to specialize in something like legal services. But what else does money do? What else would be harder to do in a world without money?

Let's say you produced, as a lawyer, you know, producing legal services a little bit more than you actually wanted to consume, and you're hoping to kind of save up some value so that maybe later on you can buy a house or you can pay for your kids' education or something like that. You want to actually start storing value and saving it up. Well, in the barter economy, you would have to find something, since money doesn't exist, you would have to find something of value and start storing that. Maybe, you know, chairs might hold their value, so you're hoping to store them. Or maybe you have to buy land or something that you think will store it, but there's not kind of a good de facto medium that you can do it for.

So, in this sense, since that's something that we usually do with money, it's also called a good store of value. So this is considered kind of a second use of money, store of value, distinct from medium of exchange. Because the idea of needing something to trade with is pretty different from wanting to kind of save value.

For this third function, think back to this case where you're hoping to barter legal services for chairs. I mean, once you start getting into the specifics, you can start asking the question, "Well, actually how many hours, right?" Like how many hours of legal services corresponds to one chair? And if you want to buy something different, you know, you're going grocery shopping, how many hours of legal services corresponds to buying one apple?

Similarly, the chair guy, he has to go off and every time he's going to buy an apple, he has to think, "How many chairs correspond to an apple?" Trying to relate values like this starts getting really complicated unless you just have some kind of actual unit to deal with—something that you can use to actually measure value of everything like a yardstick for value. And, of course, in the real economy, we just give everything a dollar value, or a euro value, or a peso value depending on where you are.

But you give it a value that corresponds to the currency, to the money that you're dealing with. So people will say that money serves as a unit of value. A unit of value, and basically that means that it gives you the starting number. It gives you the meaning of the number one, so that you can say, "Well, if this is worth one dollar, then what is worth three dollars?" Or maybe an hour of this lawyer's time is worth a hundred dollars, and one of these chairs is worth fifty dollars, and you can start actually comparing the values of various different goods that way.

I actually think this is a pretty interesting one. This is the kind of thing that would be easy to underappreciate until you realize how important it is to have something like this. In the next video or two, I'm going to talk about a certain historical case of hyperinflation in Brazil, where basically what happens is money loses some of these functions, and you can see just how much a society actually breaks down if what is supposed to be money stops serving these functions.

So with that, I will see you next video.