Any item that is widely accepted as exchange for goods and services. It is an intermediary instrument that facilitates the sale, trade, and purchase of goods between parties.
To be effective, the medium of exchange has to have a standard of value. In our present modern day system, this is filled by fiat currency.
This is traditionally viewed as one of the characteristics of money, along with unit of account and store of value.
Replacement For Barter
Medium of exchange overcomes the limitations of barter. Since there is an agreed upon value, transactions between strangers can occur. At the same time, we also see the level of commerce increase since the intermediary eliminates the need for people to match items willing to swap.
Under a barter system, both parties require having what the other wants. That means each has an asset the other wants.
For example, if one has a pig and another eggs, the swap can occur if that is what the other wants. What happens if the one with the pig wants apples instead of eggs. This would require someone who is willing to trade those for eggs, thus bringing a third party to the table.
We can imagine how complicated this could get.
A medium of exchange eliminates this. Since the item is accepted for trade, one can swap the eggs for the currency, and then buy the pig or apples.
Here it is seen how the limitation of barter is overcome. This adds increased efficiency to the economy. Over time, this can allow for greater expansion.
The result is greater trading activity, in whatever forms that takes.
Forms
What can be used as a medium of exchange?
Throughout history, this took on many forms. The key variable is that it is agreed upon by both parties. When spreading across an economy, most participants much be willing to accept it.
Some example of medium of exchange are:
- cattle
- coins made out of precious metals
- slaves
- paper currency
- leather currency
- cigarettes
Today, in some nations in Africa, mobile phone minutes are used as a medium of exchange. As long as the parties agree, whatever is used can fill this role.
Price Stability
Just because almost anything can be used as a medium of exchange, it does not mean that it is effective.
One of the main areas of focus is price stability. This is crucial for the medium of exchange because short-term volatility is not conducive for business.
When a currency moves a great deal in a short period of time, prices fluctuate. This causes havoc for merchants when selling their wares. If the movement frequent enough, maintaining prices is impossible.
There is also the impact on profits. If the value of the medium drops so much, a profitable transaction could turn negative after only a couple hours. This is dangerous in the Internet era where purchases are made 24/7.
It is why central banks such as the Federal Reserve spend so much time trying to attain this. A large part of their monetary policy is taken with the intent of maintaining price stability.
Like any market, freely traded assets perform better with greater liquidity. This means that price stability is enhanced the more economic activity that is tied to a medium of exchange. The US dollar is the most stable of all fiat currencies for this reason. It has the largest network effect since it is an international currency. The majority of global trade is denominated in USD.
This bring predictability to the marketplace.
When money loses it value as a medium of exchange, businesses can no longer plan. It makes engaging in commerce impossible.
Prices go up as a result of worries about scarcity and fears of the unknown. Supply diminishes because of hoarding behavior, coupled with an inability of producers to quickly replenish inventory. Supply chains start to break down, having an even greater impact.
Characteristics
Being accepted and fairly stable are the biggest components of an efficient medium of exchange.
That are a couple other characteristics which are required.
Distribution is essential. People need access to the currency. If it is not available due to scarcity, trade is restricted.
This is a problem the global economy faced since the Great Financial Crisis as a result of the breakdown in the Eurodollar System. Since this is the funding mechanism for the world's trade, the constraint experienced as a result of the collateral shortage hindered the economy.
Most of the asset utilized are denominated in US dollars, the reserve currency. This resulted in a shortage, causing many countries to be de-dollared.
Another attribute is the medium of exchange requires smaller units. Commerce does not always take place in round numbers. Currency typically has smaller units, facilitating fractional unit transactions.
Cryptocurrency
Many feel that cryptocurrency is the "money of the future". There are valid reasons for this belief.
When it comes to medium of exchange, there are principles that apply yet areas where the forecasts were wrong.
Digital assets can operate as a medium of exchange, just like any other item. Again, the key parameter is the agreement.
Many feel that Bitcoin will eclipse the US dollar as the reserve currency. This is refuted by the notion of price stability. As an asset, Bitcoin is known for its volatility. This makes it a great instrument to trade.
We also see a large amount of speculation due to the instability. The fact that many project it being worth a great deal more in the future means it will not be used in this capacity. Instead, hoarding (called HODLing) is the norm. Why would anyone spend $5 on a cup of coffee using BTC when it will be worth $10 or $20 down the road?
This is not isolated to Bitcoin. Most cryptocurrency operates in a similar manner. Ultimately, they are value capture tokens as opposed to a medium of exchange.
In recent years, the evolution led to the creation of stablecoins. This is a solution to the volatility issue by offering a coin or token that is pegged to another currency, usually the US dollar. Through this, the price stability enjoyed by that is transferred to the stablecoin.
Monetary System
Monetary systems are the basis for medium of exchange.
These are the combination of accounting and communications networks. This means we are dealing with ledgers along with digital systems.
For transactions to occur, there needs to be some means to know how much is available to the individual. In the traditional financial system, this means the balance in an account. With cryptocurrency, it is what is in the the wallet.
One of the key difference is who is responsible for the ledgers. Within the existing system, it is the banks that process the transactions while adjusting the balances. Cryptocurrency decentralizes this by having different, unrelated nodes updating the ledger and mirroring the ledgers on different servers. This is often called distributed ledger technology (DLT).
Another important component is settlement. This is where the medium of exchange is utilized.
When dealing with banknotes, the settlement is cash. One making a purchase simply hands over the required amount of money.
Ledger based money is the proverbial numbers on a screen. The medium of exchange is determined by the units in the account or wallet. This is transferred by the system as more transactions are processed.
Counterparty risk is present with banks. Cryptocurrency promotes risk reduction since the blockchain is the counterparty. This means the trust is removed, placing it upon the base layer code.
The medium of exchange is the coin tied to that ecosystem.