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Medium of exchange is one of the three fundamental functions of money in mainstream economics. It is a widely accepted token which can be exchanged for goods and services. Because it can be exchanged for any good or service it acts as an intermediary instrument and avoids the limitations of barter; where what one wants has to be exactly matched with what the other has to offer.
Most forms of money can act as mediums of exchange including commodity money, representative money and most commonly fiat money. Representative and fiat money often exist in digital form as well as physical tokens such as coins and notes.
A barter transaction is the exchange of one valuable good for another of equivalent value. William Stanley Jevons described how a widely accepted medium allows each barter exchange to be split into a sale and a purchase. This process overcomes three difficulties of barter. A medium of exchange eliminates the need for a coincidence of wants.
A barter exchange requires finding a party who both has what you want and who wants what you have. A medium of exchange removes that requirement, allowing you to sell what you have and buy what you want from different parties via an intermediary instrument.
A barter market would theoretically require an exchange rate for every possible pair of commodities, which is impractical to arrange, and impractical to maintain as the relative value of things changes all time. If all exchanges go 'through' a common medium, then all goods can be priced in terms of that one medium instead of with against other good. The medium of exchange thus makes it much easier to set and adjust the relative values of things in a marketplace.
A barter transaction requires that the held object and the wanted object be of equivalent value. A medium of exchange can typically and be subdivided to small enough units to approximate the value of any good or service.
A barter transaction typically happens over a short period of time, or on the spot. A medium of exchange can held for a period of time until what is wanted becomes available. This relates to another function of money, the store of value.
The ideal medium of exchange should be spread throughout the marketplace so that anyone with stuff to exchange can buy and sell. When money also serves the function of a store of value, as fiat money does, there are conflicting drivers of monetary policy, because a store of value can become more valuable if it is scarce in the marketplace. When the medium of exchange is scarce, traders will pay to rent it (interest), which acts as an impedance to trade and a net transfer of wealth from poor to rich.
Fiat currencies' most important and essential function is to provide a 'measure of value'[dubious ]... Hifzur Rab has shown that the market measures or sets the real value of various goods and services using the medium of exchange as unit of measure i.e., standard or the yard stick of measurement of wealth. There is no other alternative to the mechanism used by the market to set, determine, or measure the value of various goods and services. Determination of price is an essential condition for justice in exchange, efficient allocation of resources, economic growth, welfare and justice. The most important and essential function of a medium of exchange is to be widely acceptable and have relatively stable purchasing power (real value). Therefore, it should possess the following characteristics:
To serve as a measure of value, a medium of exchange, be it a good or signal, needs to have constant inherent value of its own or it must be firmly linked to a definite basket of goods and services. It should have constant intrinsic value[dubious ] and stable purchasing power. Gold was long popular as a medium of exchange[dubious ] and store of value because it was inert, was convenient to move due to even small amounts of gold having considerable value, and had a constant value[dubious ].
Some critics of the prevailing system of fiat money argue that fiat money is the root cause of the continuum of economic crises, since it leads to the dominance of fraud, corruption, and manipulation precisely because it does not satisfy the criteria for a medium of exchange cited above. Specifically, prevailing fiat money is free floating and depending upon its supply market finds or sets a value to it that continues to change as the supply of money is changed with respect to the economy's demand. Increasing free floating money supply with respect to needs of the economy reduces the quantity of the basket of the goods and services to which it is linked by the market and that provides it purchasing power. Thus it is not a unit or standard measure of wealth and its manipulation impedes the market mechanism by that it sets/determine just prices. That leads us to a situation where no value-related economic data is just or reliable. On the other hand, Chartalists claim that the ability to manipulate the value of fiat money is an advantage, in that fiscal stimulus is more easily available in times of economic crisis.
Although the unit of account must be in some way related to the medium of exchange in use, e.g. coinage should be in denominations of that unit making accounting much easier to perform, it has often been the case that media of exchange have no natural relationship to that unit, and must be 'minted' or in some way marked as having that value. Also there may be variances in quality of the underlying good which may not have fully agreed commodity grading. The difference between the two functions becomes obvious when one considers the fact that coins were very often 'shaved', precious metal removed from them, leaving them still useful as an identifiable coin in the marketplace, for a certain number of units in trade, but which no longer had the quantity of metal supplied by the coin's minter. It was observed as early as Oresme, Copernicus and then in 1558 by Sir Thomas Gresham, that bad money drives out good in any marketplace (Gresham's Law states "Where legal tender laws exist, bad money drives out good money"). A more precise definition is this: "A currency that is artificially overvalued by law will drive out of circulation a currency that is artificially undervalued by that law." Gresham's law is therefore a specific application of the general law of price controls. A common explanation is that people will always keep the less adultered, less clipped, sweated, less filed, less trimmed coin, and offer the other in the marketplace for the full units for which it is marked. It is inevitably the bad coins proffered, good ones retained.
The fact that a bank or mint has always been able to generate a medium of exchange marked for more units than it is worth as a store of value, is the basis of banking.[dubious ] Central banking is based on the principle that no medium needs more than the guarantee of the state that it can be redeemed for payment of debt as "legal tender" – thus, all money equally backed by the state is good money, within that state.[dubious ] As long as that state produces anything of value to others, its medium of exchange has some value, and its currency may also be useful as a standard of deferred payment among others, even those who never deal with that state directly in foreign exchange.
Of all functions of money, the medium of exchange function has historically been the most problematic because of counterfeiting, the systematic and deliberate creation of bad money with no authorization to do so, leading to the driving out of the good money entirely.
Other functions rely not on recognition of some token or weight of metal in a marketplace, where time to detect any counterfeit is limited and benefits for successful passing-off are high, but on more stable long term social contracts: one cannot easily force a whole society to accept a different standard of deferred payment, require even small groups of people to uphold a floor price for a store of value, still less to re-price everything and rewrite all accounts to a unit of account (the most stable function). Thus it tends to be the medium of exchange function that constrains what can be used as a form of financial capital.
It was once common in the United States to widely accept a check (cheque) as a medium of exchange, several parties endorsing it perhaps multiple times before it would eventually be deposited for its value in units of account, and thus redeemed. This practice became less common as it was exploited by forgers and led to a domino effect of bounced checks – a forerunner of the kind of fragility that electronic systems would eventually bring.
In the age of electronic money it was, and remains, common to use very long strings of difficult-to-reproduce numbers, generated by encryption methods, to authenticate transactions and commitments as having come from trusted parties. Thus the medium of exchange function has become wholly a part of the marketplace and its signals, and is utterly integrated with the unit of account function, so that, given the integrity of the public key system on which these are based, they become to that degree inseparable. This has clear advantages – counterfeiting is difficult or impossible unless the whole system is compromised, say by a new factoring algorithm. But at that point, the entire system is broken and the whole infrastructure is obsolete – new keys must be re-generated and the new system will also depend on some assumptions about difficulty of factoring.
Due to this inherent fragility, which is even more profound with electronic voting, some economists argue that units of account should not ever be abstracted or confused with the nominal units or tokens used in exchange. A medium is just that, a medium, and should not be confused for the message.[dubious ]
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