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Functions of Money

The six functions of money are set out in Table 15.1, but it will be useful, to clarify our thoughts on the nature of money, and to examine the functions in greater detail.

  1. Medium of exchange Controversy has taken place over which is the most significant function of money, and a good case can be made out for the importance of all of them. The most logical attitude is to regard each function as dovetailing with the others to make money acceptable. When an exchange takes place, money is acting as a circulating medium or a means of payment, but it is only possible for money to do this because it is a recognized unit of account and a store of value. There can be no doubt that the oldest function of money is to act as a medium of exchange and it can be argued that the other functions of money follow from this function. Many money substances have been used as a medium of payment, the only essential requirement being that the objects utilized as money must possess general acceptability. In the widest sense, all transactions are a form of barter, but with money acting as a medium, an exchange of goods and services is brought about by two transactions, and money features in each transaction; money is a broker or a go-between. In modern economic society, people sell their labor for a monetary wage to enable them to purchase the things that they consider will provide the most utility. By using money as an intermediary, trade and commerce are conducted more smoothly and speedily.
  2. Unit of account With the increased adoption of sophisticated methods of transferring money, e.g., by telegraphic transfer, some economists have contended that the unit of account is the most important monetary function because so many large payments are made without the necessity of using a material money substance. The monetary unit must act as the legal yardstick in terms of which the exchange value of goods and services is expressed and measured. Each community develops its monetary unit, e.g., a pound sterling, a dollar, a peseta, or a peso, by which the value of goods and services may be expressed as a price. As goods are scarce, prices are at the root of economic choice. The price is the number of monetary units for which the economic good or service can be exchanged. The price of any good is the ratio at which it will exchange for the monetary unit or for divisions or multiples of that unit. Thus if the price of a kilogram of grapes is 50p, the ratio of exchange is 50p = 1 kilogram, or 25p = a kilogram. As money is only an intermediary, the most important consideration is the ratio at which grapes can be exchanged for other commodities. The seller of grapes has an idea of what 50p is worth in terms of other economic goods and services. If he had no idea of relative prices, 50p would tell him nothing about the value of his grapes. As we saw in Topic 2.5, price is not the same thing as value.
  3. If money did not exist, the seller of grapes would have to display an enormous notice enumerating the relative values of all other goods in terms of grapes. Even if he attempted to show relative values of 100 commodities, 4950 rates of commodity exchange would have to be listed:

                           n(n - 1) = 100 × 99 = 9900 = 4950.

                                2                   2                     2

    But if money is adopted as a unit of account, then 100 articles necessitates remembering or looking up, only 100 prices. The relations of commodities to one another remain unaltered by money; the only new relation introduced is their relation to money itself (John Stuart Mill, Principles of Political Economy. Book III, Routledge).

  4. Store of value In the short run, if money does not act as a store of value, it will not be able to fulfill its other functions. This is a truism that was well illustrated in the German hyper-inflationary period of 1923 when people lost all conception of the value of the mark so that it could no longer act as a common denominator of value, i.c., a unit of account. Money was no longer accepted as a medium of exchange-it was found safer to accept scrap iron which at least retained some value. Some of the early commodities used as money did not prove satisfactory as a store of value because they were liable to deteriorate, e.g... Adam Smith's examples of cod, salt, sugar, and tobacco. In the twentieth century, people often save by storing such valuable things as silverware and works of art. because they think that money will decline in value. But in the short run, money has sufficient stability of value in most countries for it to serve as an adequate store of value. Some decline in the value of money, over a long period, is not of great significance and will not seriously retard economic progress. For many years, we have lived in conditions of inflation with prices rising while the value of money falls, but for day-to-day purposes, money serves satisfactorily as a store of value.
  5. In the short run, money is a good store of value with which to make transactions and meet emergencies. Although money has not always been a completely adequate store of value, its purchasing power doesn't need to remain constant for money to fulfill its functions. Other economic goods and assets that may be used as a store of value may have advantages over money (because they yield a return in profit, rent, or interest) but have the following disadvantages:

    1. They may depreciate in monetary terms, e.g., motor cars.
    2. They suffer from differing degrees of liquidity, e.g., stocks and shares.
    3. They may involve storage charges, e.g., valuable paintings.
    4. They may be difficult to utilize in exchange for goods, e.g., houses.
    5. The ownership or entitlement may be difficult to transfer, e.g., insurance policies.

    It is customary for a person to frequently rearrange his assets, of which one is money. among various stores of value. The proportion of money that is held compared with non-monetary assets depends upon safety, liquidity, and how successfully money is performing (or is expected to perform in the future), as a relatively stable store of value. Unless used, money will not secure any income for the holder: its use as a store of value is the one good reason for holding it.

  6. A means of deferred payment If money is fulfilling satisfactorily the first three functions, it can be used for postponed or future payments. Professor Wicksteed has stressed the 'roundaboutness of production and Nassau Senior drew attention to the "waiting' that is involved in a modern society so that wages, rents, interest, and profits may be gained. A man may have to wait until the end of the week for his wage or until the end of the month for his salary. A shareholder will have to wait until the public joint stock company, in which he has vested, declares a dividend. The landlord waits for his rent; the local authority waits for rates to be paid, while the central Government waits for its taxes. Payment is inevitably deferred, but the business of life would not go on unless it was certain that payments will be made eventually. These payments will usually be in the form of currency or bank money. A modern economic system requires the existence of a huge volume of contracts involving deferred payments. It is not considered a disgrace these days for credit transactions to take place. although Professor Tawney points out, in Religion and the Rise of Capitalism (Murray), that the Christian Church once regarded the lending and borrowing of money for interest as a major sin. Today, production is so indirect that it could not take place unless it was financed in advance. A Canadian farmer may be virtually certain of selling his wheat to English buyers, but he has to embark on a great deal of expenditure before he receives any payment. He has to buy or rent his land, finance the plowing, purchase seed and fertilizers, and pay wages to those who look after the crops until the time of reaping; the grain has to be transported via the St Lawrence Seaway and the Atlantic Ocean before it is sold on the Corn Exchange, at Mark Lane in London. None of these economic activities could be carried on unless money acted as a standard by which payments may be deferred.
  7. The Consumer Credit Act of 1974 repealed all existing laws governing consumer credit and resulted in a new unified law covering all money loans. Before granting organizations a license to engage in credit transactions, the Office of Fair Trading (OFT) makes a careful examination of the applicant's past trading record. The OFT also ensures that the public is not hoodwinked in matters of credit by such practices as misleading advertisements which obscure true rates of interest. About 70 000 businesses engaged in consumer credit are licensed. These businesses include clearing banks, finance houses, money lenders, pawnbrokers, stores, debt collectors, mortgage brokers, etc. Applicants have to satisfy the OFT that they are 'fit and proper people to engage in business involving deferred payments. Licenses are not issued to lenders who have been found to mislead the public by consistently breaking the law, overcharging, or leaning too heavily on debtors. Licenses can be revoked if lenders are found to engage in deceitful, oppressive, or unfair business practices or discriminate on grounds of race, color, or sex. The object of the Act is to ensure that people receive justice on credit matters; lenders who practice unfairly are not allowed to continue business or allowed to enter the credit industry in the future. In the six months between September 1979 and February 1980, 31 traders were either refused credit licenses or had their licenses taken away by the OFT. During the same period, 45 applicants for credit licenses and 32 existing license holders were warned that the Director General might refuse or revoke a license. Just over half the warning notices issued by the OFT were sent to motor dealers.

    When payments of debts are postponed over a long period, justice between creditors and debtors can only be sustained if money fulfills its function as a store of value. If money decreases in value, creditors will suffer financially, while the burden of debtors will be lessened. On the other hand, if money increases in value during a period of deflation, then those who have made contracts promising payment at a later date will lose, while creditors will enjoy a windfall.

  8. A channel of purchasing power Supporters of what is termed a free-enterprise economy is inclined to eulogize upon the maximization of choices available under a capitalist system. The consumer is supposed to be sovereign. The owner of any factor of production will use it for whatever purpose seems likely to yield him the greatest money return. But the money returns, the earnings of factors of production, come in the last resort from the money paid by consumers for the goods which these factors help to produce. Hence it is the preference of consumers, as shown by how they spend their money, which determines what shall be produced. (Professor Benham, Economics, Pitman.)
  9. But although there may be enough matches, salt, or sugar for everybody to have all that they require, there are insufficient cine cameras, video cassette recorders, and Rolls-Royce cars for everybody to have even one. During the Second World War, limitations on the supply of economic goods were dealt with as fairly as possible, by the issue of ration books. With the removal of wartime controls, we returned to a system of 'rationing by money'. The main difference is that there is less social justice brought by price rationing; this is a political rather than an economic problem. It is merely the task here to point out that money acts inequitably as a means of channeling purchasing power in a capitalist society because there is great inequality in the distribution of wealth. This is not to say that the poor may not be worse off under a communist system if there are fewer goods to share out. Money is still used in collectivist economies, but there are ways other than money that can be utilized for sharing out the world's goods. However, even Karl Marx did not advocate the abolition of money.

    The great advantage of this fifth function of money, which Professor Chandler, in The Economics of Money and Banking (Harper and Row), refers to as 'generalized purchasing power' or 'a bearer of options, is that many economic goods are too large to divide into small amounts so that each individual, who wishes to do so, could enjoy some utility from the commodity. Thus the function has less bearing upon 'inferior' goods but is vital when considering the distribution of 'superior' goods. Even allowing for taxation the man earning £100 per week has more purchasing power than the man earning £20 per week. Superior goods are channeled in the direction of the man who possesses more money.

  10. A liquid asset or means of liquidity If the term liquidity is used to mean how easily a thing can be turned into money, then the money is by definition the most liquid asset of all. If by liquidity one means how easily one asset may be exchanged for another asset. then the money is an of liquidity. It can be contended that to act as a means of liquidity, money must be a unit of account, a medium of exchange, a store of value, etc.
  11. The great advantage of holding money is that it is completely liquid because it is universally accepted in the payment of a debt. As soon as money is loaned or changed into any other assets, then this advantage of holding money is forgone. If money is lent for a short term, the lender will expect to receive, at least, a low rate of interest to compensate him for sacrificing liquidity; if money is lent over a long period, then it becomes more illiquid and a higher rate of interest will be charged and paid. If the value of money is depreciating, there will be a decreased desire to hold liquid assets, especially money, so interest will tend to fall.

    rates Without any alteration to the total amount of securities, the Bank of England can change the liquidity ratio of the clearing banks. The resultant increase or decrease in liquidity will influence bank lending policies and affect prices. If the Bank sells short and buys long, i.e., sells liquid and buys illiquid, then the liquid holdings of the commercial banks will be increased and they will be able to expand credit. This operation indicates how the control of the money supply influences prices.

    Liquidity is important both to ordinary people and to banks. If people keep their assets as money, they retain their freedom to use them when and how they like, i.e., it is a liquid assets. If banks keep their assets in money, they will be satisfying their customers' requirements for liquidity but at the cost of the bank's profitability. The strength of the demand by the public for money as a liquid asset is known as liquidity preference, and the payment of interest arises as an inducement to persuade people to forgo holding money. Thus liquidity preference influences interest rates and is important because interest rates influence the value of money.

    The six functions of money are merely facets of one vital economic principle which is that no sophisticated economic society, that relies upon specialization and the division of labor, could manage without money. The fact that money is accepted as a yardstick of comparatively stable value enables wages to be paid, interest rates to be ascertained, profits to be reaped, and prices to be charged.

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