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Medium of exchange versus unit of account

Posted By Kurt Schuler On November 8, 2012 @ 11:23 pm In Economic Thought,Fiat Money,Financial Markets,Inflation & Deflation | 10 Comments

Scott Sumner and Nick Rowe have been having a friendly debate about which is the more essential function of money: medium of exchange (Rowe) or unit of account (Sumner). I think they are missing an important point: the combination of the three textbook functions of money — medium of exchange, unit of account, and store of value — in one good makes it far more powerful and significant than if the functions are separated.

When the functions are separated, attempts to influence the economy through monetary policy can lose much of their effect. Here’s an example. When I visited Peru in 1999, I noticed an advertising circular in a local newspaper for Ace Hardware. The prices were in U.S. dollars, not Peruvian soles. I asked my hosts about it and they said that at the cash register, customers paid in soles at the exchange rate of the day against the dollar. And this was after Peru had enjoyed five years of inflation at 15 percent or lower. People were still cautious because in the 1980s inflation been very high, peaking at above 7,000 percent in 1990. Even goods priced in soles might in practice be closely indexed to the dollar.

Where the local currency is not the dominant unit of account, changes in the local central bank’s policy will have much weaker effects on the economy than if people are using the local currency both as a medium of exchange and unit of account (which they are only likely to do if it is also a reasonably good store of value). It’s also true that in such a case, changes in the Federal Reserve’s monetary policy that are significant in the United States, such as a 0.25 percentage point change in the target interest rate, are not so significant in the partly dollarized country. The partly dollarized country has looser transmission of monetary policy–both for its own central bank and the Fed–to prices and incomes because of the separation of the textbook functions of money.

If I recall correctly, Larry White stressed the power of the combination of the textbook functions of money in an article quite a few years ago.

As some of you will know, inflation has remained low in Peru for many years now and, from what I understand, local-currency pricing predominates.

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