Entrepreneur A can obviously exchange his apples with entrepreneur B, who produces pears, only if he himself needs pears for himself or his workers. If A should prefer butter, he cannot exchange his apples with B because B has produced no butter. Butter may have been produced by C. But if B owns something which is gladly taken by others in exchange for their products, then A can sell his apples to B against this medium and use it in an exchange with C for butter. Nowadays money, mainly paper money, serves as such a medium that is gladly taken by all members of the community in exchange for their products. Money is, therefore, the general medium of exchange.
The chief function of money is to enlarge the number of people between whom exchanges can take place. It is an enlarger of exchange possibilities. It enables any one member of the community to dispose of his goods to any other member, regardless of whether the latter produces anything the first wants; the money received enables him to get the equivalent in goods he wants from a third person.
We have seen above (p. 14) how division of labor increases the productivity of the work done. Division of labor in its turn depends upon the possibility to exchange. Even if B can produce pears at lower cost, this is of no benefit to A so long as B is not prepared to take A's apples in exchange for his pears. It follows that the introduction of money as an enlarger of exchange possibilities must result in increased division of labor and thus in higher output. Since higher output as a rule increases the amount of hours worked, the introduction of money raises living standards in two ways.
Money works not only as an enlarger of exchange possibilities, but also as an exchange act saver. Before the introduction of money apples wandered from entrepreneur A to entrepreneur B, who delivered them to his workers, while pears wandered from B to A, who delivered them to his workers—four exchange acts. Now the workers no longer receive the finished goods from their own entrepreneur, who is eliminated as a middleman between them and other entrepreneurs. With the money received from his entrepreneur each worker buys directly from other entrepreneurs—two exchange acts are eliminated.
Figure 8 shows, in very simplified form, the circulation of money in the case of apple production by worker A and pear production by worker B.
Besides being an enlarger of exchange possibilities and an exchange act saver, money has many other important functions. We shall here mention only one of them—that of an indicator of profits, as we can call it.
As we have already seen, there are no profits of the national economy as a whole. In a money economy this is even more obvious than in a barter economy. The same amount of money the entrepreneurs spend on the factors of production—the workers—comes back to them in exchange for their products. Taken as a whole, money received can neither exceed nor be short of money spent—at least so long as the flow of money is not interrupted. This latter assumption applies, by definition, to a stationary economy.
On the other hand, money is clearly the medium in which the private profits of individuals materialize. If an entrepreneur—as described earlier—can manage by his special knowledge and skill to produce 80 pears in one work-hour, instead of 50 as other entrepreneurs do, he spends 371/2 per cent less for the production of the same number of pears. The difference will show up as a stock of money not needed for the payment of wages and available for other expenditure. This is the kind of profit we have discussed above; the entrepreneur pays his workers less than the full yield of their work because this yield would be smaller if they worked in another enterprise.
Money is, however, also the indicator of another kind of private profit. It can happen that an entrepreneur makes a profit not, so to speak, at the expense of his workers but at the expense of other entrepreneurs. Entrepreneur A may receive more for his products than corresponds to his input, whereas entrepreneur B receives less. This can obviously not happen in the long run because no entrepreneur will continue spending money on production that he knows he will not get back. But in the short run it might turn out, owing perhaps to a change in tastes, that the consumer-workers spend more money on apples and less on pears than anticipated. The result will be that at the end of the production period the distribution of money among the entrepreneurs will be different from what it was at the beginning. A's stock of money will have grown by the amount that B's has become smaller.
We may, in this connection, add a remark on balance sheets and income statements. These show only the relative prosperity of individual economic subjects, i.e. the extent to which the income and wealth of some entrepreneurs have changed in relation to those of others. They give no information on the absolute wealth of the community because they do not indicate what can be bought with the money amounts shown. A scarcity of goods may lead to fancy prices and hence to higher incomes and capital appreciation for some entrepreneurs. This does not mean that the community's real income or wealth has increased. A community will, on the other hand, have become richer if two-horse carriages have been replaced by 100-horse-power automobiles produced with the same labor effort. But such things cannot be gathered from balance sheets. Simple addition of the balance sheets or income statements of all the members of a community does not, therefore, tell us anything about its real product or income. This should be remembered in appraising some of the usual national income calculations.