Functions of Money
Money is often defined in terms of the three functions or servicesthat it
provides. Money serves as a medium of exchange, as a store of value, and as
a unit of account.
Medium of exchange.Money's most important function 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. 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 coincidence
of wants between two transacting parties. The likelihood of a double
coincidence of wants, however, is small and makes the exchange of goods
and services rather difficult. Money effectively eliminates the double
coincidence of wants problem by serving as a medium of exchange that is
accepted in all transactions, by all parties, regardless of whether they desire
each others' goods and services.
The only alternative to using money is to go back to the barter system.
However, as a system of exchange the barter system would be highly
impracticable today.
For example, if the baker who supplied the green-grocer with bread had to
take payment in onions and carrots, he may either not like these foodstuff or
he may have sufficient stocks of them.
The baker would, therefore, have to re-sell the product which would take
time and be very inconvenient. By replacing these complicated sales by the
use of money it is possible to save a lot of trouble. If the baker accepts
payment in money this can be spent in whatever way the baker wishes. The
use of money as a medium of exchange overcomes the drawbacks of barter.
Store of value. In order to be a medium of exchange, money must hold its
value over time; that is, it must be a store of value. If money could not be
stored for some period of time and still remain valuable in exchange, it
would not solve the double coincidence of wants problem and therefore
would not be adopted as a medium of exchange. 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.
A major disadvantage of using commodities — such as wheat or salt or even
animals like horses or cows — as money is that after a time they deteriorate
and lose economic value. They are, thus, not at all satisfactory as a means of
storing wealth. To realise the problems of saving in a barter economy let us
consider a farmer. He wanted to save some wheat each week for future
consumption. But this would be of no use to him in his old age because the
‘savings’ would have gone off.
Again, if a coal miner wanted to set aside a certain amount of coal each week
for the same purpose, he would have problems of finding enough storage
space for all his coal. By using money, such problems can be overcome and
people are able to save for the future. Modern form of money (such as coins,
notes and bank deposits) permit people to save their surplus income.
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.
An attribute of money is that it is used as a unit of account. The implication is
that money is used to measure and record financial transactions as also the
value of goods or services produced in a country over time. The money value
of goods and services produced in an economy in an accounting year is called
gross national product. According to J. R. Hicks, gross national product is a
collection of goods and services reduced to a common basis by being
measured in terms of money.
A Standard of Postponed Payment:
This is an extension of the first function. Here again money is used as a
medium of exchange, but this time the payment is spread over a period of
time. Thus, when goods are bought on hire-purchase, they are given to the
buyer upon payment of a deposit, and he then pays the remaining amount in
a number of installments.
Under the barter system this type of transaction could involve problems.
Imagine a farmer buying a video-recorder and agreeing to pay for it in terms
of a fixed amount of wheat each week for a certain number of weeks. After a
few weeks the seller of the video recorder might have more than enough
wheat.
Yet he will have to receive more wheat in the coming weeks. If money had
been used, the seller could then use it to buy whatever he wanted, whether
it is wheat or something else—now or in future. In other words, the use of
money permits postponement of spending from the present to some future
occasion.
In a modern economy, most transactions (buying and selling) are made on
the basis of credit. For example, it is possible to purchase consumer durables
such as T.V. sets or washing machines on hire-purchase; houses may be
purchased by means of L.I.C. or H.D.F.C. loan; most business dealings permit
payment in the future for goods delivered now; and employees wait for a
month or a week to receive their wages and salaries. Thus, the use of money
permits the members of society to defer their spending from the present to
some future date.
