The Functions and nature of money

Theoritically, people could trade without money if they adopted a barter system. A subsistence economy is based on this system. Under this trading system, a buyer swaps or exchanges one good for another. This work

Functions

By looking at the functions of money we can learn more about its nature. Money has many functions. The primary two are:

1. Money as a medium of exchange. a. This alleviates the endless difficulties that would exist if trading under a barter

system. Because of this function, person A (the seller) and person B (the Buyer) can still trade even If they have different needs and wants from each other. In accepting payment, person A (the seller) knows well that someone else is out there ready to supply the market, for a price , with the goods and services that she desires.

b. First and foremost, money is a medium of exchange that is usable for buying and selling foods and services. A bakery worker does not want to be paid 200 bagels per week. Nor does the bakery owner want to receive , say, halibut in exchange for bagels. Money, however, is readily acceptable as payment. As we saw in Chapter 4, money is a social invention with which resource suppliers and producers can be paid and that can be used to buy any of the full range of items available in the marketplace. As a medium of exchange, money allows society to escape the complications of barter. And because it provides a convenient way of exchanging goods, money enables society to gain the advantages of geographic and human specialization.

2. Money as a store of value for wealth.a. This means that we can safely store some of our savings for future use , without fear

that they will perish, melt, evaporate or lose their value somehow (inflation aside, of course). To illustrate: would you sell some goods to someone who offered you in the payments of ice blocks, in the absence of refrigerators? Most unlikely! Storing your wealth in the form of money is often the preferred choice, probably because money is the most liquid of all assets. That means it can be used for transactions immediately, without the need for conversion. Of course not all people store their

wealth as money. There are many ways to store wealth. We may invest it in real estate, bonds, shares, and art collections, just to name a few options.

Other less essential functions of money are:

Money as a unit of account. This permits the measurement and comparison of the individual worth of various goods/services. For example, it allows you to determine how the worth of your shoes compares with the worth of your shirt. Using dollars and cents also allows for a consistency in the account books of all economic participants. Just imagine the chaos that would exist if different forms of money were used concurrently within the same trading community!

o Money is also a unit of account. Society uses monetary units—dollars, in the United States—as a yardstick for measuring the relative worth of a wide variety of goods, service, and resources. Just as we measure distance in miles or kilometres, we gauge the value of goods in dollars.

o With money as an acceptable unit of account, the price of each item need be stated only in terms of the monetary unit. We need not state the price of cows in terms of corn, crayons, and cranberries. Money aids rational decision making by enabling buyers and sellers to easily compare the prices of various goods and services, and resources

Money as a standard of deferred payment. Because money does not change, it may be used for long-term transactions, such as mortgages, loans etc. future payments can be identified in dollar terms, which allows for growth and stability.

Attributes and characteristics

To be useful, any form of money must possess several special attributes. Money must be:

Portable (a huge rock would pose some difficulty!) Divisible (hard with a cow!) Durable (can’t use perishable goods, e.g. fruit) Scarce (otherwise its value would be limited)

Without these attributes, money would not be used freely for trading purposes. People must feel confident about the form of money in use. The entire economy is based on a couple of crucial principles: these are:

Money must be accepted by all people in the economy. As we have seen, anything generally accepted can be money. Workers are happy to accept one or a few pieces of paper, for their hard work. They do so on the understanding that these pieces of paper will, in turn, be exchanged for desired goods and services. If people suddenly lost confidence in paper money, the entire economy would collapse and chaos would prevail, until a new form of accepted money emerged.

Money must be stable as unit of value. This may mean a few things: first, the value of money must be standardised. For example, if we used apples as money, a problem arises – there are endless varieties of apples, and apples of different sizes. The purchasing power of money should also be relatively stable. To illustrate: in Germany in the 1920s, the cost of a cup of coffee could double during the time it took to drink it! Such instability is catastrophic. The widespread financial desperation in Germany was the catalyst that enabled the Nazi Party to catapult to power shortly thereafter. You may now begin to appreciate the ways in which money has affected our modern way of life.

Real money – nominal money

This issue of purchasing power stability forces us to consider money values from two angles- real and nominal. In doing so we must consider briefly the ravaging effects of inflation, the sustained growth of prices in general. A dollar in 1985 could buy a great deal more than a dollar now. These days we receive higher nominal (in actual dollar terms) wages than in 1985. We earn more actual dollars, but has our purchasing power really increased? If we were to consider what we can purchase now and compare it to the purchases of the 1985 dollar, we would see that the current real dollar value is greatly diminished. According to the Australian Bureau of Statistics (ABS), nominal money has inflated by about 60 per cent on its original 1985 nominal value. This means that if in 1985 you had in your pocket $100 to do your shopping, in 1995 (an estimate) you would need $160 to buy the exact goods. For purposes of accuracy, from now on we shall talk about money using the terms ‘real and ‘nominal’ where appropriate.

By now you should be convinced of the great importance of the attributes and characteristic of money. Let us now look at the origin of the various kinds of financial institutions.

The demand for money

Our new-found knowledge of the various functions of money enables us to look at the reasons why people demand and hold money. It is commonly believed that there are three reasons. These are:

1. Transactions demand2. Wealth or speculative demand3. Precautionary demand

Transactions demand

Since money is a means of payment, people demand money for their routine day-to-day transactions. Money is required because payments do not coincide with money received. As a result, people must hold some money to meet their obligations when they fall due. The smaller this timing mismatch, the lower the amount required to be held. The amount of money required is dependent on the number of transactions that occur and the average amount for each transaction. For example, suppose a person had seven $100 payments in a week, one a day, and received $700 in wages. How much would he need

to hold in cash? He would need to hold $300. Why? All he need to do is to add his cash holding and divide the answer by the number of transactions, as follows:

($600 + $500 + $400 + $300 + $200 +100 + $0)/7 = $300

(You have probably noticed that we started the averaging equation with $600 and not $700 and that we finished with $0 instead of $100. This is because we assumed that the first payment was required as soon as the cash was received.)

Wealth or speculative demand

By now we are aware that money is a store of wealth. John Maynard Keynes, a prominent economist, explained that some people, in order to have a balanced portfolio (range) of assets, require some money holdings for wealth and speculative purposes. He argued that people hold either money or bonds (another store of wealth) and that they switch between these two stores of wealth to suit their needs; for example, to realise a capital gain. It is vital to note that their demand for money depends on two variables: changes in their wealth and portfolio changes (whether they wish to hold a smaller or a larger proportion of their wealth in the form of money). This wealth demand theory is based on the assumptions that neither of the two variables substantially changes. The theory basically asserts that real demand for money is constant. This assertion has far-reaching budgetary implications that will be addressed later on.

Precautionary demand

This demand remains reasonably constant. It refers to people’s expectations of unforeseen catastrophes that are going to take place. It is triggered by uncertainty. It is the money people hold in their pockets for the rainy day(s). This type of money demand is minor and is often grouped with transactions demand.

CHAPTER 13 MONEY AND BANKING

Money is a fascinating aspect of the economy:

Money bewitches people. They fret for it, and they sweat for it. They devise most ingenious ways to get it, and most ingenuous ways to get rid of it. Money is the only commodity that is good for nothing but to be gotten rid of. It will not feed you, clothe you, shelter you, or amuse you unless you spend it or invest it. It imparts value in parting. People will do almost anything for money, and money will do almost anything for people. Money is a captivating, circulating, masquerading puzzle.

In this chapter and the two chapters that follow we want to unmask the critical role of money and the monetary system in the economy. When the monetary system is working properly, it provides the lifeblood of the circular flows of income and expenditure. A well-operating monetary system helps the economy achieve both full employment and the efficient use of resources. A malfunctioning system

creates severe fluctuations in the economy’s levels of output, employment, and prices and distorts the allocation of resources.

MONEY CHARACTERISTICS:

The four primary characteristics of money are: (1) durability, (2) divisibility, (3) transportability, and (4) noncounterfeitability. Although a number of items or assets have served as money, those that best match these four characteristics are the ones that best function as money, the ones that best operate as a medium of exchange.

Almost any item, any asset, any "thing" can function as money so long as it is generally accepted as payment. In fact, a lot of different "things" have been used as money over the centuries--gold, silver, copper, nickel, animal skins, chocolate bars, cigarettes, precious gems, semi-precious gems, really precious gems, and assorted food products.

While a number of "things" have been used as money, some have worked better than others. Those "things" that did not work so well were replaced by other "things" that worked better. Those "things" that worked best tended to have four basic characteristics: (1) durability, (2) divisibility, (3) transportability, and (4) noncounterfeitability.

Durability

This first characteristic means that an item retains the same shape, form, and substance over an extended period of time; that it does not easily decompose, deteriorate, degrade, or otherwise change form. However, durability also extends beyond the physical realm to include social and institutional durability.

Durability is critical for money to perform the related functions of medium of exchange and store of value. People are willing to accept an item in payment for one good because they are confident that the item can be traded at a later time for some other good. An item works as a medium of exchange precisely because it stores value from one transaction to the next. And this requires durability.

Refined metals, such as gold, silver, copper, or nickel, have historically taken center stage as money because they are extremely durable materials. An ounce of gold today will be an ounce of gold tomorrow, next week, and a thousand years hence. Organic products, such as lettuce, ice cream, or raw

meat, are seldom if ever used as money because they are extremely perishable. A crisp leaf of lettuce might not be recognizable as lettuce next week let alone a thousand years hence.

While physical durability has been historically important for money, social and institutional durability is also important for modern economies. The durability of modern money, especially paper currency and bank account balances, depends on the durability of social institutions--especially banks and governments. While government-issued paper currency might remain physically intact for centuries, its ability to function as money depends on the institutional durability of the government.

Divisibility

This second characteristic means money can be divided into small increments that can be used in exchange for goods of varying values. For an item to function as THE medium of exchange, which can be used to purchase a wide range of different goods with a wide range of different values, then it must be divisible. The smaller the divisions, the better. For an item to function as THE medium of exchange it must have increments that allow it to be traded for both battleships and bubble gum, and everything in between.

Divisibility is one reason why metals, such as gold, silver, copper, and nickel, have been widely used as money throughout history. As pure elements, each can be divided into really, really small units, in principle, down to the molecular level. In contrast, livestock, which has seen limited use as money in less sophisticated agrarian societies, never become widely used as money in modern economies. Dividing live water buffalo into increments small enough to buy bubble gum is highly impractical.

For example, U.S. money, both paper currency and bank account balances, comes in increments of one penny, sufficiently divisible to accurately match the value of virtually every good and service available in the economy. If U.S. money consisted exclusively of $100 gold coins, and nothing smaller, people would have problems buying goods such as soft drinks, gasoline, or bubble gum. These goods, and millions more, have values that cannot be rounded to the nearest $100.

Transportability

This third characteristic means that money can be easily moved from one location to another when such movement is needed to complete exchanges. When people head off to the market to make a purchase

or two, then they need to bring along their money. But to "bring along their money" they obviously need to "BRING along their money." That is, the money must be transportable. Money that is NOT transportable is not transported, so it is not used.

Once again, transportability has played a key role in the use of metals like gold, silver, copper, and nickel as money. Carrying around a satchel of metal coins was never much of a burden. However, these metals were largely replaced by paper currencies in the 20th century because paper was lighter and easier to carry. In fact, a $100 bill is just as easy to carry as a $1 bill. This notion has been taken a step farther with paper checks used to access checking account balances. A check for $1 million is just as easy to transport as a check for $1.

Items such as granite blocks, radioactive plutonium, and maple syrup come up short on the transportability scale. Items that are physically heavy relative to their value in exchange, or need special handling, are not easily transportable. Heading off to the market with a vat of syrup or a lead canister of plutonium just does not work. And who wants to lug blocks of granite around the shopping mall?

Noncounterfeitability

This fourth characteristic means that money cannot be easily duplicated. A given item cannot function as a medium of exchange if everyone is able to "print up," "whip up," or "make up" a batch of money any time that they want. Why would anyone accept money in exchange for a good, if they can make their own? Money that is easily duplicated ceases to be THE medium of exchange.

Preventing the unrestricted duplication of money is a task that has long been relegated to government. In fact, this task is one of the prime reasons why governments exist. An economy needs government, ABSOLUTELY NEEDS government, to regulate the total quantity of money in circulation. By controlling money duplication, governments are also able to control the total quantity in circulation, and this control is what gives money value in exchange.

While governments try to keep pace with counterfeiters, they are usually a step or two behind. Through the years governments have tried to thwart counterfeiters by stamping images on coins, using special ink and paper for currency, and generally maintaining high levels of security surrounding money "production." To counter advances in computer technology in the 1990s, the United States redesigned paper currency, adding water marks, microscopic printing, and magnetic strips, in an ongoing effort to make the task of counterfeiting currency just a little more difficult.