1. Functions of Money
Try to imagine an economy without money. Without money, it would be almost impossible to carry out the usual day to day business of life. For instance, if you wanted to buy a burger without cash, you would have to give the restaurant something else in return. Perhaps you could wash the dishes, or sweep the floor. Either way, the ability to pay for goods and services with money greatly simplifies consumer life and eliminates the necessity of bartering goods and services for other goods and services.
What exactly does money do? Sure, you can buy things with it and save it, but how does it function within the economy? There are four basic functions of money:
- The first is as a medium of exchange.
- The second is as a unit of account.
- The third is as a store of value.
- The fourth is as liquidity.
By understanding each of these functions, it is possible to see how important money is to the economy.
The most obvious function of money is as a medium of exchange. When you hand the waiter a five-dollar bill in exchange for your burger, you are using money as a medium of exchange. You might have a hard time paying for your burger with five dollars worth of apples, but if you did, the apples would serve as a medium of exchange as well. To simplify, a medium of exchange is something that buyers give to sellers in exchange for goods and services. Perhaps money’s most compelling advantage is that it is a commonly recognized and universally accepted medium of exchange. This allows anyone with money to walk into any restaurant with the confidence that the waiter or clerk will take your cash in exchange for goods or services. This would likely not be the case with a basket full of apples.
The second function of money, as a unit of account, is rather obvious, but you may never have considered it before. When you walk into a restaurant, the menu tells you that a burger costs $5 and a steak costs $15. You know what this means and are able to compare these prices. If, on the other hand, apples and oranges were used as units of account, comparison between the costs of goods and services would be much more difficult. Imagine trying to determine what costs more, a burger costing 25 apples or a steak costing 30 oranges. As a unit of account, money serves as the common base of comparison that people use to present prices and record debts. Without a common unit of account, these tasks would be much more difficult.
The third function of money, as a store of value, is one that we all know well. When you work, you are paid a wage. The portion of that wage that you do not spend gets saved. By saving money, you are able to spend some now and some later. In this way, money serves as a store of value, allowing you to trade current consumption for future consumption. Imagine if you were paid in bananas. Any bananas that you did not eat or trade immediately would rot, rendering you unable to enjoy the fruits of your labor at a later time.
The fourth and final function of money, as a means of liquidity, is important for an economy to move beyond a simple system of bartering. Imagine that you have 30 apples, and you really want a steak. You walk to the local restaurant and ask the waiter if you can trade 30 apples for a steak. He informs you that they have plenty of apples, but could use some oranges. Frustrated and hungry, you walk out of the restaurant. In this example, apples lacked liquidity since they could not easily be traded for what you wanted. Liquidity describes the ease with which an item can be traded for something that you want, or into the common currency within an economy. Money is the most liquid asset because it is universally recognized and accepted as the common currency. In this way, money gives consumers the freedom to trade goods and services easily without having to barter.
2.Types of Money
Money comes in a number of different forms. In the preceding section, we saw apples and oranges used as money. When something with intrinsic value, like precious metals, is used as money, it is called commodity money. It is interesting to think about the enormous variety of goods that can serve as commodity money. Basically, anything that can fulfill the four functions of money, to so some degree, can be used as commodity money.
Barter economies depend on commodity money. When something lacking intrinsic value is used as money, it is called fiat money. This system only works if a government backs the fiat money and regulates its production. In most countries, the cash or currency is a form of fiat money. The advent of fiat money is a great convenience in many ways– imagine trying to carry a week’s pay in apples and oranges!
- Value Of Money
What gives money value? We know that intrinsically, a dollar bill is just worthless paper and ink. However, the purchasing power of a dollar bill is much greater than that of another piece of paper of similar size. From where does this power originate?
Like most things in economics, there is a market for money. The supply of money in the money market comes from the Fed. The Fed has the power to adjust the money supply by increasing or decreasing the number of bills in circulation. Nobody else can make this policy decision. The demand for money in the money market comes from consumers.
The determinants of money demand are infinite. In general, consumers need money to purchase goods and services. If there is an ATM nearby or if credit cards are plentiful, consumers may demand less money at a given time than they would if cash were difficult to obtain. The most important variable in determining money demand is the average price level within the economy. If the average price level is high and goods and services tend to cost a significant amount of money, consumers will demand more money. If, on the other hand, the average price level is low and goods and services tend to cost little money, consumers will demand less money.
QUESTION / ANSWER SESSION:
Q.1- Describe the basic functions of money.
ANS. There are four basic functions of money. First, money is a medium of exchange. Buyers use a medium of exchange to compensate sellers in exchange for goods and services. Second, money is a unit of account. A unit of account is simplifies the exchange of goods and services between buyers and sellers by ensuring that they work in the same pricing units. The third function of money is as a store of value. A store of value allows the exchange of current consumption for future consumption. The fourth function of money is as a means to liquidity. Liquidity describes the ease with which an item can be traded for something that you want, or into the common currency within an economy.
Q2 – Could milk be used as a form of money? Why or why not?
ANS. Milk would be a very poor form of money because it does not fulfill the four functions of money. It is not a common medium of exchange or unity of account. It does not store value well because it sours. Also, it is not liquid since it is difficult to exchange for goods and services desired.
Q3. Could diamonds be used as a form of money? Why or why not?
ANS. Diamonds would be a decent form of currency. They fulfill some of the four functions of money. They have a set value and can be used as a medium of exchange and a store of value. They do not work well as a unit of account though since their size and quality vary. They are also only slightly liquid because they are not easy to exchange for desired goods and services