AQA Specification focus:
‘The characteristics and functions of money.’
Introduction
Money is central to modern economies, acting as the medium through which goods and services are exchanged, valued, and stored. Understanding its characteristics and functions is essential.
The Characteristics of Money
Economists identify several key characteristics of money that ensure it can perform its role effectively in the economy. These characteristics explain why some items can serve as money while others cannot.
Durability
Money must be able to withstand physical wear and tear over time. Items that deteriorate quickly cannot function as reliable money.
Portability
Money must be easily transportable, allowing individuals to carry it and use it in everyday transactions.
Divisibility
Effective money must be capable of being divided into smaller units without losing value. This ensures that both small and large transactions can be carried out.
Uniformity
Money must be standardised, so that each unit is identical in value to another. A £10 note is always worth the same as another £10 note.
Limited supply
Money must be relatively scarce to maintain its value. If supply is excessive, inflation occurs, reducing its purchasing power.
Acceptability
Money must be widely recognised and accepted as a medium of exchange. This depends on trust and confidence in the issuing authority, such as the central bank.
The Functions of Money
Economists outline four main functions of money in the economy.
Medium of Exchange
Medium of Exchange: Anything that eliminates the need for barter by providing a universally accepted way to trade goods and services.
This function removes the inefficiencies of the barter system, such as the double coincidence of wants (both parties wanting what the other has).
Unit of Account
Unit of Account: A standard measure of value that allows goods and services to be compared and priced consistently.
With this function, individuals and businesses can express prices, record debts, and make cost-benefit decisions in a common numerical format.
Store of Value
Store of Value: A means of holding wealth that maintains value over time and allows future spending.
Money must retain its purchasing power over time, although inflation can erode this function.
Standard of Deferred Payment
Standard of Deferred Payment: A function of money allowing borrowing, lending, and contracts to be settled at a future date.
This enables credit markets to operate, supporting economic growth and long-term financial planning.
Why These Characteristics and Functions Matter
For money to perform these four essential functions effectively, it must have the key characteristics outlined earlier. For example:
If money were not durable, it could not serve as a store of value.
If it were not divisible, it could not serve as a medium of exchange for smaller purchases.
Without acceptability, none of the functions could operate effectively, since people must agree on what constitutes money.
Modern Money
Fiat Money
Most modern economies use fiat money, which has no intrinsic value but is accepted because it is issued and guaranteed by the government or central bank.
Fiat Money: Currency that has value because the government maintains it and people have confidence in its acceptance, not because of its intrinsic worth.
Unlike commodity money (e.g., gold or silver), fiat money derives its usefulness entirely from trust and regulation.
Digital Money
In contemporary economies, money increasingly takes digital forms such as electronic bank deposits, mobile payments, and even cryptocurrencies. These continue to perform the essential functions of money, but their characteristics (such as acceptability or stability) can vary.
Key Links Between Characteristics and Functions
To understand money fully, it is helpful to connect its characteristics to the functions it performs:
Durability → Ensures money acts as a store of value.
Divisibility → Supports money’s role as a medium of exchange.
Uniformity → Strengthens its function as a unit of account.
Limited supply → Protects money’s ability to be a store of value.
Acceptability → Underpins every function of money, as trust is central.
FAQ
Early societies used commodity money because it had intrinsic value. Goods like gold, silver, or salt were widely accepted due to their usefulness outside trade.
Unlike modern fiat money, commodity money did not rely on government trust. Its value came directly from the material, meaning people accepted it even without formal authority.
Inflation reduces the purchasing power of money, making it less effective as a store of value.
Mild inflation may not disrupt savings significantly.
High or unpredictable inflation leads people to switch to alternative stores of value, such as property, commodities, or foreign currencies.
Divisibility ensures that money can be broken into smaller units for precise transactions.
Without divisibility, large-value items could not be exchanged for smaller-value goods. For example, a single £10 note must be divisible into coins for smaller purchases.
Acceptability relies heavily on public confidence in the issuing authority, such as the central bank.
If trust is lost due to hyperinflation, corruption, or political instability, people may stop using the currency. In such cases, foreign currencies or bartering may replace domestic money.
Digital currencies can act as a medium of exchange and unit of account in limited contexts.
However, their volatility makes them weak as a store of value and unreliable as a standard of deferred payment. Their acceptability also varies, preventing them from fully replacing traditional money.
Practice Questions
State two characteristics that money must have in order to function effectively in an economy. (2 marks)
1 mark for each correct characteristic, up to a maximum of 2 marks.
Acceptable answers include: durability, portability, divisibility, uniformity, limited supply, acceptability.
(e.g. “Durability” = 1 mark, “Divisibility” = 1 mark).
Explain how money functions as both a store of value and a standard of deferred payment. (6 marks)
Up to 3 marks for accurate explanation of “store of value”:
Money retains value over time (1 mark).
Allows individuals to save and use it for future purchases (1 mark).
Inflation may reduce effectiveness but it generally enables future spending (1 mark).
Up to 3 marks for accurate explanation of “standard of deferred payment”:
Money can be used to settle debts or contracts at a future date (1 mark).
Facilitates borrowing and lending in the economy (1 mark).
Relies on trust in money maintaining value and stability (1 mark).
Award full marks where both functions are clearly explained with reference to their economic role.
