Definition: A medium of exchange is an element of standardized value used to settle the exchange of a given item. In other words, it is an instrument that facilitates the trade of goods and services.
What Does Medium of Exchange Mean?
The best example of a medium of exchange is currency and the whole purpose of it is to facilitate trading activities. By providing an element that has a known and collectively-agreed value of exchange the medium of exchange becomes a generally accepted way to settle economic transactions. Modern economy dynamics are possible because of the existence of currency as a medium of exchange. It will be impossible to settle many trade operations quickly if the mediums of exchange were not as standard as currency is. The main requirement for an instrument to become an accepted medium of exchange is an intrinsic collective agreement of its value and reliability.
A medium of exchange must have a reliable valuation and in modern day society, it must be easily interchangeable. Additional to currency, barter is also a medium of exchange. In such transactions, each item is a medium of exchange itself and there’s an individual and subjective valuation process in the mind of each party involved. This will increase the difficulty of settling the deal. That is the reason why barter is not widely practiced in our modern society.
Here’s an example of medium of exchanges.
Mr. Lowell loaned $2,500 to Mrs. Gladwich. The conditions of this loan was that Mrs. Gladwich paid the loan back to Mr. Lowell exactly 2 months after the money was given to her and that she paid Mr. Lowell an additional $100 for the trouble. When the 2 months elapsed Mr. Gladwich told Mr. Lowell she didn’t have the money but she had a new motorcycle she could give him to cancel the debt commitment. Mr. Lowell refused the offer because he didn’t think the motorcycle was enough. Why Mr. Lowell refused the proposal?
As we previously stated, a medium of exchange is an element of standardized value that facilitates trading. The medium of exchange used for the initial transaction was currency and by the time the loan had to be re-paid Mr. Gladwich offered a different medium, the motorcycle. As we discussed beforehand, the medium of exchange should be standardized to meet the requirements of modern day society. The motorcycle didn’t have enough value for Mr. Lowell and that is why the transaction couldn’t be settled.