When we first learn about money and banking in high school or university, we are all taught that money has three functions: medium of exchange, unit of account, and store of value. Maybe it’s time for educators to throw out this triumvirate. It’s not very accurate.
We need a simple and teachable device to take the triumvirate’s place. I propose the money Venn diagram.
Before I explain the money Venn diagram, let’s revisit the textbook triumvirate.
When something is a medium of exchange, what is meant is that it is generally acceptable in trade. You can use it to buy stuff at the grocery store, or purchase stocks on the stock market, or get things online.
The quality of being a medium of exchange is really more of a gradient than a matter of either/or. Banknotes, for instance, are good at brick and mortar shops, but useless online. Your debit card works great at shops, but forget trying to buy shares with it. But both are sufficiently widely accepted to qualify as a medium of exchange.
Because cryptocurrencies like Bitcoin and Litecoin aren’t widely accepted, they don’t make it across the line to qualify as a medium of exchange. Neither do Walmart or Target gift cards. Cigarettes don’t qualify either, but that wasn’t the case in 1950 when Milton Friedman used them to buy gas:
Milton Friedman describes the time he used cigarettes as money. (I get this from his book "Money Mischief".) pic.twitter.com/1NSjY9vZNX
— John Paul Koning (@jp_koning) November 6, 2020
The unit of account function of money refers to the fact that our economic conversations and calculations are couched in terms of a given monetary unit, whether that be the $, ¥, or £. In Canada and the US, prices are expressed in grocery aisles with dollars, our salaries use dollar units, and our debts are denominated in dollars. We don’t express prices in terms of government bonds, or Microsoft shares, or cigarettes or bitcoins. These things don’t function as a unit of account.
Thirdly, when money acts as a store of value we mean that it preserves value over time and space. Whereas the first two functions are quite useful, the store of value isn’t. Every asset functions as a store of value: houses, diamonds, banknotes, deposits, bitcoins, LSD tabs, lentils, cars, spices. And so it is meaningless to cast store of value as a unique function of money. Monetary economists such as Nick Rowe and George Selgin have proposed, and I concur, that we just chuck store of value from the definition of money.
But we are still left with two useful definitions for money, unit of account and medium of exchange. Which gets us to the money circle.
Note that the two circles in the diagram, medium of exchange and unit of account, don’t perfectly overlap. About 99% of the time the things we use as media of exchange are also the things we use as a unit of account. So the contents of our wallets or our bank accounts, dollar banknotes and dollar deposits are functionally equivalent to the $ units displayed in signs in grocery aisles.
But for the remaining 1% of the time, the unit of account and medium of exchange are separated. The idea of a separation is tough to get one’s head around. Luckily we’ve got a nice example. In Chile the prices of many things, particularly real estate, are expressed in terms of the Unidad de Fomento. But no Unidad de Fomento notes or coins circulate in Chile. It is a purely abstract unit of account.
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| Apartments for sale in Chile, priced in Unidad de Fomento |
If a Chilean wants to buy an apartment that is priced at 840 Unidad de Fomento, she must use a separate medium of exchange, the Chilean peso, to make the payment. The peso is issued by Chile’s central bank, the Banco Central de Chile, in both paper and account form.
How many pesos must she pay? Every day the Banco Central de Chile publishes the exchange rate between the Unidad de Fomento and the peso. Right now one Unidad de Fomento is equal to 28,969 pesos. If an apartment were priced at 840 Unidad de Fomento, a Chilean would have to hand over 24 million Chilean pesos today.
Why has Chile separated its unit of account from its medium of exchange? I have discussed the issue at length. But the short answer is that it was a trick the government used to help cope with high inflation in the 1960s. Chilean inflation has been well under control for decades now. The practice of using the Unidad de Fomento as a unit-of-account has continued nonetheless.
You can see why it’s rare for these two functions to be separated. It’s awkward to do conversions every time one wants to pay for something. For the sake of ease, we tend to evolve towards systems where the medium of exchange and unit of account are united. But these exceptions are still important enough that we need a Venn diagram.
To sum up, money isn’t best thought of as a medium of exchange, unit of account, and store of value. Let’s just think of it as just a medium of exchange and a unit of account. For the most part these circles overlap, and the two functions are united. But this isn’t always the case.
[My article was originally published at AIER's Sound Money Project in 2020 under the title A Simpler and More Accurate Way to Teach Money to Students]
I concur with the part that value over time and space is not exclusive to money only. If I may add, 'Preserving' value over time and having value at a certain point in time, however, are two different things. Of all the assets that you mentioned, notes or cash is the most sought after in terms of exchange, and the most liquid, which is what makes it so desired and in demand. It meets the immediate as well as medium to long-term needs, and in uncertain times like COVID-19, the demand for cash skyrockets, underscoring its value as a bulwark against uncertainty.
ReplyDeleteYep, banknotes are great condensers of value over time and space. But LSD is actually one of the best for this. Check out the chart here:
Deletehttps://jpkoning.blogspot.com/2017/12/store-of-value.html
Fine. But what do we gain by ditching the 'store of value' function?
ReplyDeleteA more accurate definition of money.
DeleteMoney is what we all buy and sell with. All the other features are incidental. George Selgin went to great length on this:
ReplyDeletehttps://www.cato.org/blog/three-pronged-blunder-or-what-money-what-it-isnt/
George and me are on the same page on this.
DeleteWriting a contract using the wrong unit of account can have disastrous results, as people who borrowed money in dollars have sometimes discovered after a currency crash. If we think of a loan as a store of value, its valuation depends on how accounting units behave over time.
ReplyDeleteThat's exactly why the Chileans developed the Unidad de Fomento unit of account that I describe in the second half of my post. It's much safer for a creditor to denominate a loan in UF than in Chilean pesos.
DeleteThis post exemplifies the issue I have with your research. You're very good at collecting and grouping data. But you are completely uninterested in causal relationships. Why are people using this or that for a store of value? You don't seem to be curious about that at all. But without at least having a hypothesis about causality, there is no rational basis for predicting the future. You can answer the questions "What happened in the past" and "What is happening in the present", but don't know why, and can't answer the question "What will happen in the future" or "What effect will such and such action have in the future".
ReplyDeleteSo are you saying that one of the defining features of money, one that makes it distinct from all other non-monies, is that it is a store of value?
DeleteThere are multiple issues with your post, and they are all the consequence of analysing phenomena quantitatively rather than through human action.
DeleteThe first problem is that what you describe as "money" is not an economic good, it's not a category of human action. You're simply defining the question away. In "Money, Method and the Market Process", Mises writes: "The demand for money of individuals, as well as the entire economy, is determined by the desire to maintain a cash balance and not by the aggregate of transactions to be carried out during a certain time period." In other words, "demand" for transacting and for accounting is not a demand for money and therefore can't be defining attributes of money. At best they are the symptoms, or consequences, of money, rather than prerequisites.
The second problem is the term "store of value". Your definition as "preserves value over time and space" is again a description of symptoms, again not a category of action. I propose that store of value is the equivalent of saving, which is the result of the desire to delay consumption (which is a category of action). This allows us to differentiate saving from investing (which you don't). Now, you write that other assets serve as a store of value. Let's posit that we don't mean this to include "investing". What does this mean? It means that people recognise that fiat money is a bad store of value, and are looking for alternatives, and since there is no uniformly best alternative, there are multiple stores of value.
Combining these two together, we arrive at issue number 3. It follows from 1 and 2 that fiat money isn't really money. It's a has-been money, an echo of gold, a tool to conduct policy. It also follows that if we were on a hard money standard, there would be no need for multiple stores of value. People who wanted to save, would just hold money ("maintain a cash balance"). People who wanted to invest would invest, trade the certainty of money for uncertainty of something else.
This is the economic meaning of the topic you're investigating.
John,
ReplyDeletewhile it is entirely true that "store of value" function is least useful in defyining money, it is still necessary for the medium of exchange to be a store of value. This is less of an issue for day to day transactions where even rapidly depreciating currencies will do (buying a lolipop for instance), but becomes crucial in a capitalist economy where exchanges over long periods of time are common.
After all, a good medium of exchange (unit of account) is one which specifiey obligations in long term contracts - inconcievable with a bad store of value.
Yep, a medium of exchange does have to store value. No doubt about it. More broadly, every valuable thing (i.e. anything that has a positive price) has to be able to "store value" over time because if it can't then by definition it can't be valued.
DeleteHumans have a quirky impulse to ascribe value to rarity. Honus Wagner's baseball card is to me the classic example. Gold, the barbaric relic, is the oldest. Bitcoin is rare insofar as its supply is defined. It operates like a game because of that definition. Seekers of the value it confers by its defined rarity have no choice but to bid up the price. But the distinction between the way game is played and the way gold and other collectibles are used as investment vehicles is just technical.
ReplyDeleteDear JP, I'm quite confident that you will find my thoughts on money interesting.
ReplyDeletehttps://amasso.substack.com/p/money
I am definitely excited to read your comments on them.
Best,
G.