The Monetary System

A monetary system establishes two different types of standardization in the economy. First, it establishes a unit of value—a common unit for measuring how much something is worth. A standard unit of value permits us to compare the costs of different goods and services and to communicate these costs when we trade. The dollar is the unit of value in the United States. If a college textbook costs $75, while a one-way airline ticket from Phoenix to Minneapolis costs $300, we know immediately that the ticket has the same value in the marketplace as four college textbooks.

The second type of standardization concerns the means of payment—the things we can use as payment when we buy goods and services. In the United States, the means of payment include dollar bills, personal checks, money orders, credit cards like Visa and American Express, and, in some experimental locations, prepaid cash cards with magnetic strips.

These two functions of a monetary system—establishing a unit of value and a standard means of payment—are closely related, but they are not the same thing.

The unit-of-value function refers to the way we think about and record transactions; the means-of-payment function refers to how payment is actually made.

The unit of value works in the same way as units of weight, volume, distance, and time. In fact, the same sentence in Article I of the U.S. Constitution gives Congress the power to create a unit of value along with units of weights and measures. All of these units help us determine clearly and precisely what is being traded for what. Think about buying gas in the United States—you exchange dollars for gallons. The transaction will go smoothly and quickly only if there is clarity about both the unit of fluid volume (gallons) and the unit of purchasing power (dollars).

The means of payment can be different from the unit of value. For example, in some countries where local currency prices change very rapidly, it is common to use the U.S. dollar as the unit of value—to specify prices in dollars—while the local currency remains the means of payment. Even in the United States, when you use a check to buy something, the unit of value is the dollar, but the means of payment is a piece of paper with your signature on it.

In the United States, the dollar is the centerpiece of our monetary system. It is the unit of value in virtually every economic transaction, and dollar bills are very often the means of payment as well. How did the dollar come to play such an important role in the economy?

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