The useful functions money performs in an economy make it indispensable for the functioning of the economy. Just as it has its advantages, money has also brought about the problem of inflation into the modern society. Inflation is seen by many people today as the number one public enemy.
In this article, we will examine the useful functions money performs in an economy make it indispensable. Money is the medium through which economic exchanges take place, it serve as a useful medium through which those who need money are brought into contact with those who have money.
Money is anything generally acceptable as a means of payment for goods and services and for the settlement of debts. Money performs various functions, and different kinds of money vary in the degree of efficiency with which they can fulfil these functions.
Useful Functions Money Performs in an Economy
The useful functions money performs in an economy include the following:
1. Medium of Exchange
One of the most important useful functions money performs in an economy is as a medium of exchange to facilitate transactions. Without money, all transactions would have to be conducted by barter, which involves direct exchange of one good or service for another.
Money allows the complexity of modern economy based on specialization to be possible. This removes barter, which is the system of exchanging goods for goods directly.
This is a cumbersome system in which every transaction requires a double coincidence of wants.
2. Unit of Account
Money also functions as a unit of account, providing a common measure of the value 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 how much of the good to supply and how much of the good to purchase.
Money provides a common denominator by which all other commodities are expressed. Therefore, this makes it very easy to record economic transactions, involving different commodities.
As a unit of account, money allows for the formation of prices which can then be used for recording transaction entries in books of accounts.
3. A Store of Value
Possession of money confers purchasing power on the holder who can then decide either to spend it now or save for future transactions.
More importantly, money as a store of value introduces flexibility into the money economy.
It is now possible to sell goods today, store the money until one needs it later.
However, for money to be able to function effectively as a store of value, then it must have a stable value.
Rapid fluctuation in the general price level reduces the usefulness of money as a store of value.
As a store of value, money is not unique; 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 liquid 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.
4. A Standard of Deferred Payment
Money also allows for the practice of credit system in an economy. In other words, it is possible to buy now and pay later or alternatively speaking, to sell now and collect money later on.
However, this is impossible in a barter economy. This decoupling of purchase/sales and payments provide much of the development, which characterizes our economy today.
It is a fact that many companies borrow from banks or make use of credit facilities to be able to function effectively.
What Are the Purposes for Holding Money
Money could either be held as liquid cash or be used to purchase income earning assets which would generate some rates of return.
The holding of money therefore have an opportunity cost which is the rate of Interest that could have been earned if the money were used to purchase income earning assets such as treasury bills.
The total amount of money balances that everyone wishes to hold for all purposes is called the Demand for Money.
There are generally three purposes for holding money.
These are transactive motive, precautionary motive and speculative motive.
The three motives are discussed fully below.
1. Transactive Demand for Money
This is the total amount of money that people want to hold in order to carry out their day-to-day activities such as settling their bills.
The transactive demand for money arises because of the time difference between the receipts and expenditures of households and firms.
For instance, while workers are paid wages and salaries at the end of the month they often need money to meet some financial commitments between one period of salary payment and another period.
Money held for this purpose depends on two factors.
- the size of national income measured at current prices; and
- the time span between one payment period and another
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2. Precautionary Demand for Money
This refers to the money held for the purposes of meeting unexpected contingencies. Life is often full of uncertainty.
Unexpected business opportunities may arise, for which a firm may need money to take advantage.
If the firm has not made adequate provisions for such an occurrence, then it may not be able to benefit from such unexpected opportunities.
The demand for money for this purpose however depends on the rate of interest. The higher the rate of interest, the higher the opportunity cost of holding money and invariably the less the amount of money held for precautionary motive.
However, the total amount of money held for this purpose varies directly with the size of the national income.
3. Speculative Demand for Money
This is the money set aside for the purposes of speculative trading. For instance, if one thinks prices are now very low and may rise in the future, the tendency is to buy now and to postpone selling until prices rise and vice-versa.
Hence, when prices are low, people will rush to purchase and this will therefore reduce money held for speculation.
On the other hand, in a situation when prices have come down, large quantities of money may be held in anticipation of a more favorable change in price before they make their purchases in the future.
The speculative demand for money also varies inversely with the rate of interest.
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