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Money and Banking » Money: Forms, Functions and Characteristics

What you'll learn this session

Study time: 30 minutes

Cambridge spec: 3.1.1

The main forms of money, from coins to digital payments
Why barter is a problem and how money solves it
The four functions of money
The seven characteristics of good money

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Why do we need money?

Imagine you grow tomatoes and you want a pair of shoes. You find a shoemaker, but the shoemaker does not want tomatoes. You are stuck. Before money existed, people had to solve this problem all the time.

Money is anything that people accept as payment for goods and services and for paying off debts. It is not just notes and coins. Anything can be money, as long as people agree to accept it.

Key terms:

Money: anything that is generally accepted as payment for goods and services and for settling debts.
Barter: swapping goods and services directly for other goods and services, with no money used.

Problems of barter

Barter only works if you find someone who has what you want and also wants what you have. That causes several problems:

No double coincidence of wants: the shoemaker has to want tomatoes at the very moment you want shoes.
No common measure of value: how many tomatoes is a pair of shoes worth? Every swap has to be negotiated again.
Goods may not be divisible: you cannot hand over half a cow for a loaf of bread.
Difficult to store wealth: tomatoes rot, so you cannot save them for next year.
Difficult to pay later: it is hard to agree what a future debt in goods should be.

Money solves all of these problems. That is why almost every economy uses it.

Forms of money

Money has taken many forms over time. Today the main forms are:

💵 Coins and banknotes

Physical cash. It is made by or for the government and can be handed over by anyone, with no bank needed.

🏦 Bank deposits

Money held in a bank account. Most of the money in a modern economy is in bank accounts rather than in notes and coins. A debit card is not money itself, it is a way of paying from your bank deposit.

📱 Digital and electronic payments

Phone apps, online transfers and contactless payments. No cash changes hands at all.

Notice that all of these are accepted because people trust them. A banknote is only a piece of paper. It has value because everyone agrees to accept it.

The four functions of money

Economists say money does four jobs.

🔄 Medium of exchange

Money is used to buy and sell goods and services. It removes the need for a double coincidence of wants. You sell your tomatoes for money, then use the money to buy shoes.

📏 Measure of value (unit of account)

Money gives every good a price, so values can be compared. A pair of shoes costs $40 and a shirt costs $20, so the shoes are worth twice as much as the shirt.

💸 Store of value

Money keeps its purchasing power over time, so you can save it now and spend it later. Unlike tomatoes, notes do not rot.

📅 Standard of deferred payment

Money lets people agree to pay later. A loan or a monthly rent can be set as a fixed sum of money to be paid in the future.

Characteristics of good money

Not everything makes good money. Salt or cattle have been used as money in the past, but they are not very good at it. Good money needs these seven characteristics:

Characteristic	What it means	Example
Acceptability	Everyone is willing to take it as payment	Shops all take the local currency
Durability	It lasts and does not wear out quickly	Metal coins last for years
Portability	Easy to carry and move around	A banknote fits in a pocket, a cow does not
Divisibility	Can be split into small amounts to pay for cheap goods and give change	A note can be exchanged for smaller coins to give change
Homogeneity	Every unit is the same as every other unit	Any $1 coin is worth exactly $1
Scarcity (limited supply)	Supply is limited, so it keeps its value	If anyone could print money freely, it would be worth little
Difficult to forge	Hard to copy, so people trust it is real	Banknotes have special security features

Worked example

A made-up island, Kelmar, uses large shells as money. The shells break easily, vary in size and anyone can collect more from the beach. Which characteristics are missing? The shells are not durable because they break. They are not homogeneous because they vary in size. They are not scarce because anyone can collect more, so they would lose value. They are also easy to forge with similar shells. Kelmar's shells would make poor money.

Common mistakes

Students often say money is only notes and coins. Bank deposits and digital payments are money too. Another mistake is to mix up the functions: measure of value is about giving goods a price, while store of value is about saving for later. Finally, do not forget that barter does not fail because goods have no value. It fails because there is no common unit to compare them and no easy way to find a swap.

Exam-style question

In the made-up country of Torvia, people used to swap goats and sacks of grain. Today most people in Torvia use coins, banknotes and a phone payment app.

(a) Identify two forms of money used in Torvia today. [2 marks]

(b) Explain one problem of barter. [2 marks]

Model answer

(a) Coins (1) and banknotes (1). The phone payment app is also correct.

(b) One problem is that there is no double coincidence of wants (1). A goat owner who wants grain might find that the grain owner does not want a goat, so no trade can happen (1).

(c) Medium of exchange (1): people can sell goats for money and then use the money to buy grain from someone else, so they do not need to find a person who wants exactly what they have (1). Store of value (1): money keeps its purchasing power, so a farmer can save it and spend it months later, unlike a goat that might die (1).

Exam tip

For an Explain question, name the function or problem, then add a developed point that links it to the information in the question. A definition on its own does not earn the second mark.

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