Many years ago before money really existed, when an individual wanted to “purchase” something, the exchange would occur through bartering. Every item “purchased” would be traded for a different item. For example, if I needed eggs, I would find a producer of eggs (an individual who raised chickens) and would try to trade something I had, such as milk or cheese from my cow, for those eggs. This bartering system worked well for a while, but eventually society wanted an easier way to “trade” for those items that individuals needed. Certain items were selected by society to use in exchange transactions, such as shells or grains or precious metals, but eventually money was created as a way to simplify these exchanges.
Money has value and works as a medium of exchange because we believe it has value. And because it has value, we want to keep it safe. So rather than collecting money in our homes under a mattress or burying it in a coffee can in the back yard, our financial institutions and businesses have worked to create ways for us to “store” our money safely while still allowing us access to those funds.
Functions of Money
Money has three main functions – it works as a medium of exchange, a unit of account, and a store of value.
Medium of Exchange
“Medium of Exchange” means money acts as a go-between between everyone in the economy to help trade. If you are a farmer that grows corn, you might have a hard time trading your corn directly with a carpenter to help build your house, a manufacturer who builds tractors, a tailor who makes clothes, and producers of everything else you need. But if the markets allow you (and everyone else) to sell your products for money, it means everyone has a common “medium of exchange”.
Unit of Account
“Unit of Account” is the next major function of money. Everything that can be bought or sold is only as valuable as what someone else is willing to pay. Money exists to show what the “Exchange Rate” is between two different goods. Our same farmer from before might be trying to decide if they want to grow corn or soybeans this year – which one will be more valuable?
Because both corn and soybeans are traded with money, he would just be able to check the current prices for each one – and focus on growing more of whatever is most valuable.
Store of Value
Our farmer just finished his harvest of the year, and has a silo full of corn that he can trade. However, he has expenses all year round – buying food, and clothes, paying his mortgage, and all his other living expenses. If he were to trade just a little bit of corn for every purchase, the corn would rot away before the year was finished, losing all of its value.
Instead, selling his corn for money acts as a store of value – money does not expire, and he can save it up over long periods of time.
Types of Stored Value
Checks might be the oldest form of stored value. Checks are a special document that banks use to transfer money from your account to the person or business whose name you write on the check.
Every check includes:
- Your bank routing number (an ID number for your bank, so whoever receives the check can find them)
- Your bank account number
- The number of this specific check
When you write a check, you also fill in the name of the person or company you are paying, the amount (both in numbers and written out with words), and the date. You can also include a “memo” with a reminder of what the payment is for.
In the simplest terms, when you give someone a check, they take it to their bank, who then uses the bank routing number to contact your bank, and your account number to specify your exact account. Your bank then confirms your signature, and withdraws the amount of the check from your account (if you have enough money, that is) and transfers it to the other person’s account at the other bank. The check is then “cancelled”, so it cannot be used again, and the cancelled check is returned to you showing that it has been processed. Some banks will allow you to “overdraw” your account to pay a check, but they will charge you an extra fee to do so.
This allows you to send any amount of money from your account to anyone else who has a bank account. Some check-cashing services also offer to convert checks directly into cash (for a fee) for people who do not have a bank account.
Advantages of using Checks
Checks are less popular in recent years, but they have some distinct advantages.
First, they are the safest way to send a payment by mail, it is much harder to steal and modify a check than it is to just take cash out of an envelope.
Second, checks are traceable. When a check is cashed, you get a picture of the final cancelled check to show it was processed, so you can see if it was modified in any way (and serves as a perfect financial record to show the payment was received).
Disadvantages of checks
Writing checks requires a checkbook, which very few people want to carry around most of the time. Since checks are only validated using a signature, check fraud (people passing fake checks as genuine, or editing the amounts on a genuine check to be a greater amount) has historically been a major cause for concern.
Checks also take time to “clear”, or have the money transferred from your bank to another. This means that if you have any outstanding checks, you need to constantly reconcile your bank account to subtract any outstanding checks to know your “true” balance.
For businesses, taking checks can be risky, and very few still do. This is because it is impossible when receiving the check to know that the person giving it actually has the funds in their bank to make the payment. Another problem of check fraud was people writing checks that they knew were unable to be cashed, often in other towns, leaving the businesses very few ways to recover their losses. Local businesses would often refuse to take any checks from non-local banks for this reason.
Debit cards are very similar to checks, and are usually tied to your “checking account”. The biggest difference is that all payments are controlled electronically, so transactions are usually processed instantly.
In place of the signature of a check, you instead need to input a PIN number to verify your identity and authenticate the purchase. Debit cards may or may not be used for online transactions, depending on your card issuer.
Debit cards evolved from ATM cards. ATM cards were originally used only at ATM machines to withdraw cash and to check account balances. The cards operate by using a magnetic stripe that contains your bank account information. When you “swipe” your card, the card reader reads your account information and electronically notifies your bank of money being subtracted or added to your account. In most of the world, and increasingly in the United States, debit cards also come with a chip, which includes more security features thus increasing the difficulty of “stealing” your account information when you use your debit card.
Advantages of Debit Cards
Debit cards were developed to make financial transactions easier than using checks. The money comes directly from your linked account, usually a checking account, and you don’t need to carry around a checkbook and a pen. Because the electronic transaction occurs almost instantly, the seller knows immediately that the funds were transferred or that the transaction was rejected due to lack of funds. This reduces the possibility that “check fraud” will occur, a positive outcome for retailers. Since debit cards do not require a verification signature, a unique PIN number is used to verify that the individual using the card is the rightful owner of that card. Without the correct pin number, the transaction will not go through.
Disadvantages of Debit Cards
Debit cards can be counterfeited. Remember that the magnetic stripe stores your bank account information, so when you swipe your card, the data that describes your account can now be captured. On the other hand, the chip on your chip debit card scrambles your data, making it extremely hard to “capture” your account information.
Using a debit card frequently also makes it easy to over-spend, since it you do not see the money actually changing hands. This can make it possible to overdraw your account, which typically comes with heavy fees from your bank.
Prepaid cards are usually issued by a credit card company or bank, and are often given as gifts. To use a prepaid card, you need to “Charge” it by adding value (either using cash at a kiosk for the card issuer, or sometimes online by transferring value from your bank account). Once it is stored, you can use a prepaid card any place you would use a credit card. The card issuer may charge a fee to use these services.
Advantages of prepaid cards
Prepaid cards can be a great way for people without a credit card to make online transactions, since you can make payments in the same way as you would with a credit card. They are also often used as gifts as a “use it anywhere” gift card. Generally speaking, prepaid cards work as a more flexible form as cash.
Disadvantages of prepaid cards
Like cash, prepaid cards can be easily lost or stolen. Since they are not tied to you in any way (and are normally given as gifts), whoever is currently holding the prepaid card controls all the value it has. This makes them very risky to use for large amounts of money.
The card issuer also usually charges a fee to use the card, and if you maintain a balance, they may charge “storage fees” as well.
Gift Cards are another form of stored value. Many stores and online retailers will let you convert cash into a gift card which you can use in their store. Gift cards usually have no fees, so they retain their value longer than other prepaid cards.
As their name implies, a “Gift Card” is typically given a as a gift. Due to their limiting nature, it is very rare to purchase and use a gift card for yourself.
Advantages of Gift Cards
Gift cards are great to give as gifts. Because they can only be used in one location, they are less prone to theft and loss as other stored value cards.
Disadvantages of Gift Cards
Although you can purchase gift cards at many different retail locations, the card itself can only be used at the place of business identified on the card. For some businesses, like Amazon.com ( AMZN) this is not really a limit, but for restaurants and individual retailers it might be.
Note about Credit Cards
Unlike these other items, credit cards are NOT a form of stored value, and do not act as money. This is because credit cards are a loan (or a form of “credit”). When you make a purchase using a credit card, no value is being transferred from you to the place where you are spending money. Instead, you are creating a debt that you must pay back later with interest.
In contrast, when you use any of the items of stored value, money is being directly transferred from you to the person you are paying. There is no loan or credit card company acting as a “middle man”. There is a direct transfer from one person or company to another.
Bitcoins and Other Virtual Currencies
Bitcoins and virtual currencies have become very popular in the last few years, but it is not always easy to tell if they are a form of money in and of themselves, or if they are just a stored value of money. Their actual definition shifts based on how you, the consumer, uses them.
For example, if you convert your dollars into bitcoins and then visit a shop that lists their prices in bitcoins and accepts bitcoins as payment, your bitcoins are acting as money. However, if that shop lists all their prices in dollars, but they also accept bitcoins as payment, then your bitcoins are just acting as a ‘stored value’ for dollars.
To make things more complicated, you can also buy bitcoin because you think its value will go up over time. This means that you are treating it not as stored value or as money but as an investment, and you are using “speculation” to try to gain a profit.