money performs four specific functions

8/7/2019 Money performs four specific functions

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Money performs four specific functions, each of which overcomes the difficulties of barter . Thefunctions of money are to serve as:

1.

Unit of value, 2.

M edium of exchange,

3. S

tandard of deferred payments and 4.

S tore of value.

Mon ey as a U ni t of Value

The first function of money is to be a unit of value or a unit of account. The monetary unit is theunit in terms of which the value of all goods and services is measured and expressed. The valueof each good or service is expressed as a price, which is the number of monetary units for whichthe good or service can be exchanged.

If the price of a pen is Rs. 10 then a pen can be had in exchange for ten monetary units (wherethe monetary unit in this case is the rupee). Measuring values in monetary units helps inmeasuring the exchange values of commodities. If a pen is worth Rs. 10 and a notebook is worthRs.20 then a notebook is worth two pens. Further, accounting is simplified, as all items will berecorded in terms of monetary units that can be added and subtracted. Money is a usefulmeasuring rod of value only if the value of money itself remains constant. This is similar tosaying that a scale is a useful measure of length only if the length of the scale itself is constant.The value of money is linked to its purchasing power. Purchasing power is the inverse of theaverage or general level of prices as measured by the consumer price index etc. As the generalprice level increases, a unit of money can purchase a lesser amount of goods and services - so thevalue or purchasing power of money declines. So, money will be a useful unit of value only aslong as its own value or purchasing power remains constant.

Mon ey as a M ed ium of Excha ng e

Money also acts as a medium of exchange or as a medium of payments. This function of moneyis served by anything that is generally accepted by people in exchange for goods and services.'Anything' has been quite a variety of things across places and times. Some of the things thathave served as money are - clay, cowry shells, tortoise shells, cattle, pigs, horses, sheep, tea,tobacco, wool, salt, wine, boats, iron, copper, brass, silver, gold, bronze, nickel, paper, leather,

playing cards, debts of individuals, debts of banks, debts of governments, etc. Money will thenreduce the time and energy spent in barter. The person who owned a cow can now simply sell itto the person who offers the most money for it and then buy the bullock cart from another personwho offers him the best bargain. Ultimately, all trade may be considered barter - one good or service is traded for another good or service -either directly, or indirectly with money acting asthe intermediary. However, by acting as an intermediary, money increases the ease of trade.Money is also called a bearer of options or generalised purchasing power. This indicates thefreedom of choice that the use of money offers. The owner of the cow need not procure goods


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and services from those to whom he sold his cow. He can use the money to buy the things hewants most, from those who offer him the best bargain (not necessarily those who bought hiscow), at the time he considers most advantageous (not necessarily immediately). Again, thisfunction can only be performed properly if the value of money remains constant.

Mon ey as a Sta ndard of De f erred Payme nts

If money performs the previous two functions then it may also perform the function of being theunit in terms of which deferred or future payments are stated. Examples of situations wherefuture payments are to be made are pensions, principal and interest on debt, salaries etc. As longas money maintains a constant value through time, it will overcome the problems associated withmaking future payments with specific commodities.

Mon ey as a St ore of ValueIf money becomes a unit of value and a means of payment then it may also perform the functionof serving as a store of value. The holders of money are holders of generalised purchasing power that can be spent through time. They know that it will be accepted at any time for any good or service and is thus a store of value. This function will be performed well as long as moneyretains a constant purchasing power.

It may be noted that any asset other than money may also perform the function of store of value,for example, bonds, land, houses, etc. These assets have the advantage that, unlike money, theyyield income and may appreciate in value over time. However, they are subject to the following:

(1) they may involve storage costs,

(2) they may not be liquid in the sense that they could not be quickly converted into moneywithout loss of value, and

(3) they may depreciate in value. A person may choose to store value in any form depending onconsiderations of income, safety and liquidity.

Fu nct ion s of Mon ey

Money is often defined in terms of the three f un ct ion s or serv ices that it provides. Money servesas a med ium of excha ng e, as a st ore of value , and as a u ni t of acc ou n t.


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M ed ium of excha ng e. Money's most important function is as a medium of exchange to facilitatetransactions. Without money, all transactions would have to be conducted by barter , whichinvolves direct exchange of one good or service for another. The difficulty with a barter system is that in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires. In other words, in a barter system,

exchange can take place only if there is a double c oin cide nce of wa n ts between two transactingparties. The likelihood of a double coincidence of wants, however, is small and makes theexchange of goods and services rather difficult. Money effectively eliminates the doublecoincidence of wants problem by serving as a medium of exchange that is accepted in alltransactions, by all parties, regardless of whether they desire each others' goods and services.

St ore of value. In order to be a medium of exchange, money must hold its value over time; thatis, it must be a store of value. If money could not be stored for some period of time and stillremain valuable in exchange, it would not solve the double coincidence of wants problem andtherefore would not be adopted as a medium of exchange. As a store of value, money is notunique; many other stores of value exist, such as land, works of art, and even baseball cards and

stamps. Money may not even be the best store of value because it depreciates with inflation.However, money is more liq u id than most other stores of value because as a medium of exchange, it is readily accepted everywhere. Furthermore, money is an easily transported store of value that is available in a number of convenient denominations.

Uni t of acc oun t. Money also functions as a unit of account, providing a c ommon measure of thevalue of goods and services being exchanged. Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about howmuch of the good to supply and how much of the good to purchase.

1. Money as a Medium of Exchange: The function of money as a medium of exchange solves all the difficulties of barter system. There is nonecessity for a double coincidence of wants in the money economy. The man with cow who wants topurchase cloth need not seek a cloth seller who wants a cow. He can sell his cow in the market formoney and then purchase cloth with the money obtained.

2. Money as Measure of Value:In money economy values of all commodities are expressed in terms of money. Money is like the yardstick of cloth merchant, as yard-stick measures all varieties of cloth, money measures the value of allvarieties goods. This function of money makes transactions easy and also fair

3. Standard of Deferred Payment:

In a money economy the contracts are made for future payments terms of money instead of goods andpromise to repay the loan in money. In this way money is the standard of deferred payments. Thisfunction stimulates all kinds of economic activities wjtich depend on borrowed money.

4. Money as a Store of Value:Goods cannot be stored because they are perishable. People receive their incomes in money form andkeep their savings in money form in banks.In this way, money is used to store value of commodities.


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5 . The essential or primary functions of money are:a) To serve as medium of exchange.b) To serve as a measure of value.

The later two functions are of secondary importance because they; derived functions. In moderneconomy, money plays a very important role. Its disappearance would cause disappearance of theeconomy itself.

We say traditionally that money has four major functions. It is a

medium of exchangeWhatever people usually give in exchange for the things that they buy is the medium of exchange. As we have seen, this is the function that defines money.

unit of accountThe unit of account is the unit in which values are stated, recorded and settled. The

differences between this and the medium of exchange may seem subtle, but there are afew cases in which the unit of account is different from the unit in which the medium of exchange is expressed. In Britain a few decades ago, Guineas were often used as the unitof account, while the medium of exchange was expressed in Pounds. Both Guineas andPounds in turn could be expressed in shillings -- the Pound was 20 shillings and theGuinea was 21 shillings. (British currency has since been redefined).

standard of deferred paymentThis is the unit in which debt contracts are stated. Deferred payment means a paymentmade in the future, not now. Here, again, it is usually the same as the medium of exchange, but not always. During periods of inflation, people may accept paper moneyfor immediate payment, but insist on some other medium, such as real goods and servicesor gold, for deferred payment -- because the medium of exchange would lose much of itsvalue in the meanwhile.

store of valueAgain, this is something that people keep in order to maintain the value of their wealth.Again, while it would usually be the same as the medium of exchange, in inflationarytimes other media might be substituted, such as jewelry, land or collectable goods. In thissense, money is "set aside" for the future.

Three Functions of Money

Summary: Money has to serve three basic functions -- as a medium of exchange, a unit of accounting, and a store of value -- in order to be considered as money.

When people think of money, they think of bronze and silver coins, green, crisp, dollar bills, andchecks. They are used to get what people want. However, money is much more than that. Itincludes cowrie shells that were used in Africa and gold coins that were used in Europe. In fact,


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money is anything that serves three functions. It must be used as a medium of exchange, a unit of accounting, and a store of value.

Money must be used as a medium of exchange. It must be universally accepted in order for it tobe used. It is a commodity or a token that everyone must accept in exchange for the things that

they need to or want to sell. Today, we use paper money and coins as our "money." Laborersoffer their hard work in exchange for money, which they can use whenever they want to getwhatever they want. But before our time, the people didn't have "money, so they bartered. Theyexchanged from farm animals to elaborately designed and hand-made rugs to get the things theywanted. However, bartering wasn't very efficient because it was hard to get both the seller andthe buyer to agree to the exchange. Whatever the buyer offered as "payment" may not have beenwhat the seller wanted or agreed to. Therefore, today, paper money and coins can be used asmoney because it can be universally accepted and exchanged for a good or service.

The next function of money is the unit of accounting. Money must be something that can be usedto measure the worth or value of goods and services. Every country uses a different unit to

measure this worth or value. In the United States, we use the "dollar" and "cent." In Japan, theyuse the "yen." In France, they call it the "franc." So within the country the single unit makes iteasier to make transactions and compare goods and determine their values. It can also help withkeeping accurate financial records like recording transactions, debts, profits, and losses.

Last of all is that money has to be a store of value. For example, if and employer paid his/her employee with food for their services, then the employee would have to eat it then or then it willspoil. So what if the employee wasn't hungry? Therefore, employers pay their employees withmoney (bills, checks) and that money can be stored in a bank, as cash, etc., to be used later. Thenthe employee could go out and buy food when he actually was hungry. So even though peopleget paid at their jobs bimonthly or monthly, but they can spend their money at different times.

However, one problem with storing money is that it is not very efficient in times of rapidinflation, when the value of money decreases. Otherwise, money is something that can be easilystored and still have the same value.

In conclusion, money has to serve all three functions in order to be considered as money. It hasto be a medium of exchange, a unit of accounting, and a store of value. Medium of exchangemeans that it is accepted in exchange for a good or service. As a unit of accounting, it makes itmore convenient to compare, value, and make transactions. As a store of value, people can getmoney, store it, and then spend it whenever they want because the value is still there. All of theseare functions are important and can also be the reason why bartering failed and people decided toturn to the idea of "money."

MONEY FUNCTIONS:

A ny item used as money in an economy automatically takes on four basic functions: (1) medium of exchange, (2) unit of account, (3) store of value, and (4) standard of deferred payment. While "buyingand selling" means that money is THE medium of exchange, and by far THE most important function of money, money also performs unit of account, store of value, and standard of deferred paymentfunctions.


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Money provides four key functions for an economy : (1) medium of exchange, (2) unit of account, (3)store of value, and (4) standard of deferred payment. Medium of exchange means that money is used toconduct transactions. Unit of account, also termed measure of value, means that prices are stated interms of money. Store of value means that value, the satisfaction of wants and needs, can be storedover time using money. Standard of deferred payment means that future payments, such as paying off a

car loan, are also in terms of the monetary unit.

Medium of Exchange THE primary function of money is to act as THE medium of exchange. People use money to buy and sellgoods. Buyers give up money and receive goods. Sellers give up goods and receive money. Moneymakes transactions easier because everyone is willing to trade money for goods and goods for money.

To see why money makes transactions easier, consider a barter economy that has no money,where one good is traded directly for another. The key to successful barter trades is doublecoincidence of wants , each trader has want the other wants and wants what the other has.Without double coincidence of wants, a barter economy can become exceedingly inefficiency.Traders spend more time seeking trades and less time producing goods.

Suppose, for example, that Duncan Thurly heads into town with a basket full of hand-craftedhamster hats (not hats made FROM hamsters, but hats made FOR hamsters) which he hopes totrade for a pair of knickers--what others might call pants. If the local knicker-maker (Kevin)needs hamster hats, the there is a double coincidence of wants and they are ripe for a trade.However, if Kevin the tailor has no desire to acquire hamster hats, then there is NOT a doublecoincidence of wants and Duncan does NOT get his knickers.

At least he will not get his knickers without spending some time, perhaps a great deal of time,seeking to trade his hamster hats to someone else for a good that the tailor does desire. Duncanmight need to seek out dozens of other people, conducting dozens of intermediate trades, beforehe finally has a good that can be traded for knickers. The time he spends on barter trades is timethat he CANNOT spend fabricating additional hamster hats, to the loss of hamster ownersworldwide.

Money eliminates the need for double coincidence of wants because EVERYONE is willing toaccept money in payment for goods. Duncan can trade his hamster hats for money (that is, sell),trade this money for the knickers (that is, buy), then returned home for further hamster-hatfabrication. With a generally accepted medium of exchange, trades are easier, more efficient, andresources can spend more time doing production.

U nit of Account The second function means that is money is being used as the common benchmark to designate theprices of goods throughout the economy. Unit of account, or measure of value, means money isfunctioning as the measuring unit for prices. In other words, prices of goods are stated in terms of themonetary unit.


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If Duncan Thurly is heading off to the market in search of hamster hats or tailored knickers, thenhe will find each has a price in terms of the medium of exchange. If his society make use of U.S.dollars, then hamster hats carry a U.S. dollar price. If he lives in a land that uses German marks,then knicker prices are in terms of marks--German marks.

The reason is that sellers are willing to trade for, and buyers are willing to give up, THE mediumof exchange--money. That is why money is THE medium of exchange. It is used for exchanges.

Using money as the unit of account for prices, however, also provides a measure of value--howmuch value buyers and sellers place on a good. If tailored knickers carry a $10 price, whilehamster hats go for $5 each, then this indicates a measure of the relative value of eachcommodity--knickers have twice the value of hamster hats. Buyers are willing to give up twiceas much money to buy a pair of knickers as to acquire a hamster hat and sellers incur twice theopportunity cost of producing a pair of knickers as that of hamster-hat production.

S tore of Value

The third function, store of value, emerges because money is one way of postponing the satisfactionobtained from using or consuming goods until a later time. Value is obtained from a good when it isconsumed, when it is used to satisfy wants and needs. The value from consuming goods can be stored inseveral different ways, one of the best is money.

Consider a few ways that Duncan Thurly might be able to store the value of a $2 hot fudgesundae for one week.

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F irst, he could buy a freshly fabricated hot fudge sundae for $2 and store this product for sevendays. Successful storage requires a freezer, especially during the summer. Would this hot fudgesundae retain its full $2 value one week hence? Probably not. The hot fudge is likely to be cold.

The whipped topping is probably unwhipped.

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Second, Duncan could purchase a $2 gift certificate from the ice cream parlor, a coupon that istradeable for one hot fudge sundae. A fter a week, he can redeem the certificate and enjoy histreat. In this case the value of the sundae is stored in the coupon. While this is a relatively goodstore of value for the hot fudge sundae, it ONLY stores the value of a hot fudge sundae. A hotfudge sundae coupon cannot be used to store the value of other goods.

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Third, he could take his $2, use it to purchase another good, like a book, hold onto it for a week,sell it, then use the proceeds to buy a hot fudge sundae. Of course, if the book is not very liquid,meaning that it cannot be easily converted into money, then he probably will not end up withthe $2 that he needs to buy his hot fudge sundae. Storing the value of one good by purchasingthen later selling another good is seldom the best way to go.


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F ourth, Duncan could simply keep $2 stashed away in his billfold, sock drawer, or coffee canburied in his back yard. A fter one week, he can then amble down to the ice cream parlor withthis $2 in hand to make his hot fudge sundae purchase. In this case, he has stored the deliciousvalue of the hot fudge sundae in the form of money.

The problem with storing value in money is price changes. If the price of the hot fudge sundae risesduring this week, then Duncan's money becomes a less effective means of storing value. A s a generalrule, price inflation is the nemesis for the store of value function of money.

S tandard of Deferred Payment This fourth function means money is used as a standard benchmark for specifying future payments forcurrent purchases, that is, buying now and paying later. This function may seem obscure, but it is adirect result of the store of value and unit of account functions.

A common example of deferred payments is a car loan. Duncan Thurly get a loan to buy a car today, then pay off the loan with payments deferred into the future. The amount of those future

payments are stated in terms of money.

Using money as a standard of these deferred payments is a direct consequence of the unit of account and store of value functions of money. If money is the standard for current prices, thenmoney is also the standard for future payments based on those prices. But, for money to functionas a DEFERRED payment standard, it must retain value, it must store value. The key to storingvalue in money is price inflation.

This means that deferred payments need to anticipate future money values based on futureinflation. If inflation is, for example, 10 percent next year, then deferred payments need to beadjusted for the resulting decline in money value. This inflation adjustment is accomplished by

through interest rate s.

Fu nct ion s of mon ey

The basic function of money is to enable buying to be separated from selling, thus permittingtrade to take place without the so-called double coincidence of barter . In principle, credit couldperform this function, but, before extending credit, the seller would want to know about theprospects of repayment. That requires much more information about the buyer and imposes costsof information and verification that the use of money avoids.

money performs four specific functions

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