The 3 Functions of Money: Medium of Exchange, Unit of Account and Store of Value

Economists define money by what it does. In the Bank of England's words, money “should fulfil three important roles”: it is a store of value, a unit of account and a medium of exchange. Anything that does all three well is good money. Anything that fails one of them, eventually, stops being used as money at all.

1. Medium of exchange

A medium of exchange is something people accept, not because they want it, but because they can swap it for something else later. The Bank of England's example: in some prisoner-of-war camps in the Second World War, cigarettes became the medium of exchange, and even non-smokers took them in trade (Bank of England).

Without one, trade is barter, and barter only works when each side happens to want what the other has. A medium of exchange removes that problem: you sell your work for money, and spend the money on whatever you need, whenever you need it.

Examples of a medium of exchange

• Paying for groceries with a debit card: your bank deposit is the medium of exchange.
• Receiving a salary in pounds or dollars.
• Paying a merchant in bitcoin over the Lightning Network.

2. Unit of account

A unit of account is the measure that prices are written in: on menus, contracts and price labels, as the Bank of England puts it. In modern economies it is usually the national currency. In the past, prices were often set in staple goods such as bushels of wheat, or in farm animals.

A shared unit lets people compare prices, keep accounts and judge whether a business is making a profit. It only works if the unit itself stays steady. A ruler that shrank a little every year would make every measurement harder to trust, and that is what inflation does to prices.

Examples of a unit of account

• A loaf of bread with its price marked in pounds.
• A rent contract written in dollars per month.
• Company accounts showing profit in euros.

3. Store of value

A store of value is something that keeps its value in a reasonably predictable way over time. The Bank of England's example: gold or silver mined hundreds of years ago is still valuable today, while perishable food quickly becomes worthless. Saving only makes sense in money that is a good store of value.

Examples of a store of value

• Gold, which has held its value over centuries.
• Land and buildings, though they are hard to sell quickly and cost money to keep.
• Bitcoin, for those who hold it for years, accepting large swings in price along the way.

A fourth function: standard of deferred payment

Many textbooks add a fourth function: money is the standard in which debts are written and later repaid. A mortgage or a pension promise is a sum of money due in the future. It depends on the other three: a debt is only a fair deal for both sides if the money keeps its value between the day it is lent and the day it is repaid.

How the functions depend on each other

The three functions hold together or fail together. As the Bank of England notes, an asset is less useful as a medium of exchange if it will not be worth as much tomorrow. When money stops storing value, people stop wanting to hold it, and then stop pricing in it.

Germany after the First World War shows the order in which it happens. In the five years after the war, prices in German marks doubled 38 times: something that cost one mark in 1918 would have cost over 300 billion marks in 1923, and people began using other currencies to buy and sell (Bank of England). In October 1923 alone, German wholesale prices rose 29,500% (Hanke and Krus). The mark failed first as a store of value; prices and trade then moved to other currencies.

Why fiat money fails the third function by design

Today's government money does the first two functions well. It is accepted everywhere in its country, and prices are written in it. But it is designed to fail the third. The Federal Reserve and the Bank of England both aim for inflation of 2% a year, which means money that loses half its value every 35 years if they hit the target.

They have often missed on the high side. A dollar from August 1971 buys about 12 cents' worth today, a loss of 87.8% (BLS). A pound from 1971 buys less than a tenth of what it did, even on the CPI measure (92.3% lost, ONS). So savers are pushed out of cash and into houses, shares and bonds, and take on the risks that come with them.

What is fiat money? How it works, and why it loses value →

What is inflation, and what causes it? →

How bitcoin does on each function

• Store of value: bitcoin's supply is capped at 21 million and issued on a fixed schedule that no one can change, which is the property a store of value needs. Its price in dollars swings widely, so it suits saving over years rather than months.
• Medium of exchange: it works for payments of any size, worldwide, and the Lightning Network makes small payments fast and cheap. Few shops accept it yet.
• Unit of account: very few people price goods or wages in bitcoin today.

Many bitcoin advocates argue that money gains its functions in this order: first people hold it as a store of value, then they spend it, and only once it is widely held and stable do they price things in it. Whether bitcoin completes that path is still open. What is not in doubt is that it was designed to do the third function well, the one fiat money is designed to fail.

Why is bitcoin so volatile? →

The Lightning Network explained →

Questions people ask

What are the three functions of money?

A medium of exchange (people accept it in trade), a unit of account (prices and debts are measured in it) and a store of value (it keeps its purchasing power over time). Many textbooks add a fourth: a standard of deferred payment, the unit in which debts are repaid.

Which function of money is most important?

They depend on each other, but the store of value comes first in practice: money that loses value quickly stops being used to set prices and then stops being accepted in trade, as Germany's hyperinflation showed.

What is an example of a store of value?

Gold is the classic example: metal mined centuries ago still holds its value. Bitcoin is held as a store of value by many people because its supply is fixed. Fiat money is a weak store of value because central banks aim for it to lose about 2% a year.

What are the characteristics of money?

To perform its three functions well, money needs to be scarce, durable, portable, divisible and easy to verify. The guide below covers each one.

The characteristics of money: the properties of sound money →

Types of money: commodity, representative, fiat and bitcoin →

Money 101: the reading list →

Sources

• Bank of England, Money in the modern economy: an introduction (2014); Federal Reserve, longer-run goals; Bank of England, inflation target; BLS, CPI-U; ONS, CPI; Hanke and Krus, World Hyperinflations (Cato, 2012).