Compilation of answers on: Functions of Money!
Answer 1. Functions of Money:
Prof. Kinley has classified the functions of money into three groups:
1. Primary functions,
2. Secondary functions, and
3. Contingent functions.
1. Primary Functions:
Primary functions include those functions of money which it performs in an economic system under all circumstances.
These functions include the following:
i. Medium of Exchange:
Money is used as a medium of exchange or means of payment. Any and every type of economic transactions related to the exchange of goods and services are conducted with the help of money. Money acts as a ‘medium of exchange’ for ensuring smooth operation of trade of goods and services between buyers and sellers. This function of money solves the problem of Tack of double coincidence’ created under the barter system, or commodity- commodity exchanges. That is why it is called the primary function as it solves the most basic issue of the barter system.
Transactions of various goods could be conducted independently, i.e., with money in the scene the purchase of one good does not require the simultaneous sale of another. Money has, thus, relieved us from all difficulties that were being faced under the barter system.
ii. Measure of Value or Unit of Account:
Money as a standard of value or the unit of account plays a vital role in setting up of a common ‘measuring rod/yardstick’ for measuring any economic transactions. It helps us to set ‘price’ of goods and services vis-a-vis the other commodity. Under the barter system, this ‘measurement’ was extremely difficult and therefore at times people used to forgo the transaction without completing it.
As a unit of account it measures the value of all kinds of goods and services. If we pay Rs.50 for a fountain pen, we have a measure of value in terms of the basic unit of account, which is rupee.
By reducing the value of all goods and services to a single unit of account, money has facilitated and simplified the system of exchange. Also, this function facilitates in preparation of books of accounts of a business, the budget for the economy, estimating inflation in an economy using index numbers, etc.
2. Secondary Functions:
The secondary functions of money include money as:
(i) Standard of deferred payments,
(ii) Store of value, and
(iii) Transfer of value.
(i) Standard of Deferred Payments:
Money serves as a standard of delayed payments or future payments or debt payment or deferred payments, which is practically very important in the complex modern-day economies. Money is preferred as a standard of deferred payments because its value generally remains stable over time and the fluctuations are foreseeable. Other goods are perishable and their value gets depleted over time.
Inability to handle the debt-related transaction was one of the major reasons for the collapse of the barter system as the complexities increased in the economic systems over time.
Barter system could not handle the situations where the payments/considerations were to be made on some future date and not executed immediately. This is most common in transactions related to loans and debt where the lender expected additional amount in the form of interest along with the principal amount on some stipulated future date. This function helps in establishing the financial institutions/lending organisations and further resulted in setting up of well-defined financial markets which are operating in the present time.
(ii) Store of Value:
Money serves as a ‘store of value’. Wealth, accumulated form of income, can be stored in the form of various other assets as well, but money is considered to be the best form of holding wealth/assets. It is so because money is the most liquid form of all the available assets. Liquidity here means the ability of an asset to be exchanged for something else of value without loss of value and time.
We must have seen people around them talking about their investments in real estate, gold/bullion, and bank fixed deposits, etc. These all are one or the other form of stored wealth which people enter into with a motive to have capital appreciation or interest income or both. Money, as a matter of fact, depreciates if kept unused/idle; it is ideal when it pays you back. This was another hurdle of barter system very well handled by money.
(iii) Transfer of Value:
In this global listed world, various people or firms are carrying their assets to various other destinations in the form of foreign direct or indirect investment. This couldn’t have been possible under the commodity-commodity exchange system. Students must have noticed the transfer of millions of dollars by one transnational company from one country to another.
Money also performs certain contingent functions, which are as follows:
(i) Equalisation of Marginal Utilities of Spending;
(ii) Distribution of National Income;
(iii) Basis of Credit;
(iv) Liquidity or Uniformity of Wealth; and
(v) Bearer of Option.
3. Contingent Functions of Money:
(i) Equalisation of Marginal Utilities of Spending:
A consumer can maximise his satisfaction by spending his money income according to the law of equi-marginal utility. This enables a consumer to maximise his satisfaction. Producers can also maximise their position by equalising the marginal productivity of different factors of production.
(ii) Distribution of National Income:
Barter system did not offer proper solution to the problem of distribution of national income. It is easier to measure the contribution of various factors of production to the national income in terms of money now. Thus, money helps in the determination of the share of the various factors of production in the national income.
(iii) Basis of Credit:
Credit is the life-blood of modern business. Legal tender money provides the basis for credit. Banks create credit on the basis of their primary deposits. It is the change in the quantity of money that brings about change in the supply of credit in the economy.
(iv) Liquidity or Uniformity of Wealth:
Money is the most liquid of all assets. It can be easily converted into any type of asset without loss of value and time.
Heterogeneous assets could be expressed in identical assets with the help of money.
(v) Bearer of Option:
Money serves as a bearer of option. Man can command any commodity or service in the world if he has sufficient money to purchase it. Thus, money helps people to satisfy their multiple and divergent wants.
Answer 2. The Functions of Money:
Money performs three main functions. It is a medium of exchange, a unit of account and a store of value.
(i) Medium of Exchange:
Anything which is universally accepted as a medium of exchange is called money. In other words, money is what we use to buy goods and services. A currency note is legal tender for all debts, private and public. Money is the most liquid of all assets. Money can always be converted into goods and services.
Money was introduced to remove the main difficulties associated with the barter system under which commodities are directly exchanged for commodities, without the use of money as a medium of exchange. Under the barter system trade requires the double coincidence of wants — two people each having a good that the other wants at the right time and place.
Only simple transactions are possible in a barter economy. In a modern complex economy trade is indirect and requires the use of money.
(ii) A Unit of Account:
Numerous prices are quoted and debts recorded in terms of money. Economic transactions (purchases and sales, borrowing and lending) are recorded by using money as the yardstick (measuring rod). National income is calculated by using money as measure of value. In fact, a country’s GDP is a collection of goods and services reduced to a common basis by being measured in terms of money.
(iii) A Store of Value:
Money is the store of saving — a way to transfer purchasing power from the present to the future. However, money is an imperfect and unreliable store of value in a situation of inflation — when people are robbed of their purchasing power. Yet people save money to be able to buy goods and services in the future.
Answer 3. Functions of Money:
Since the earliest times almost all societies- from the most primitive to the most modern and with many types of political and economic systems- have used money.
Several functions of money can be divided into four broad groups:
1. Primary functions
2. Secondary Functions
3. Contingent Functions, and
4. Other Functions
1. Primary Functions:
The primary functions of money are also called main or original functions of money.
Primary functions of money are:
1. Medium of Exchange
2. A Measure of Value
3. Unit of Account
1. Medium of Exchange:
In an economy with no money, trading takes the form of barter, or the direct exchange of certain goods for other goods. Generally, though, barter is an inefficient way to trade because finding someone who has the item you want and is willing to exchange that item for something you have is both difficult and time consuming.
Money makes searching for the perfect trading partner unnecessary. Money performs the function of a medium of exchange. In functioning as a medium of exchange or a device for making transactions, money allows people to trade at less cost in time and effort.
This is considered as the most primary function of money. Since money possesses the virtue of general acceptability, all exchanges take place in terms of money. In the money exchange system of modern times, the prices of goods and services are expressed in terms of money. On account of the use of money, sale and purchase of goods and services came into prevalence. Thus money acts as the medium in sales and purchases and has done away with the difficulty of the lack of double coincidence of wants. Since money is commonly acceptable, everybody accepts it in exchange for goods and services and use it for purchase and sale of goods and services of his choice.
2. A Measure of Value:
Another important function of money is that it gauges the value of goods and services. As the prices of all goods and services are expressed in terms of money, it is considered as a collective measure of values. Since all values are indicated in terms of money, it is convenient to determine the rate of exchange between various types of goods and services in the community. Further, in view of money’s function as a measure of value, money also serves as a unit of account. All records are kept and maintained in terms of the unit of money.
3. Unit of Account:
As a unit of account, money is the basic unit for measuring economic value. In India, for example, virtually all prices, wages, asset values, and debts are expressed in rupees. Having a single, uniform measure of values is convenient. For example, pricing all goods in India in rupee -instead of some goods being price in gold, some in Reliance shares and some others in dollars- simplifies comparison among different goods.
The medium-of-exchange and unit-of-account functions of money are closely related. Because goods and services are most often exchanged for money (the medium of exchange function), expressing economic values in money terms (the unit of account function), is natural. However, the medium’ of exchange and the unit of account are not always the same.
In countries with high and erratic inflation, for example, fluctuating currency value makes money a poor unit of account because prices must be changed frequently. In such cases economic values are commonly expressed in terms of a more stable unit of account, such as dollars or ounces of gold, even though transactions may continue to be carried out in the local currency.
2. Secondary Functions:
Money performs the following secondary functions:
1. As a Standard of Deferred Payments:
Money has proved to be a suitable standard of deferred payment for the reasons:
(i) The value of money is more stable as compared to the values of other commodities.
(ii) Money is more durable than other commodities.
(iii) Money has the quality of general acceptability.
But in its role as a standard of deferred payments, money also suffers from certain drawbacks.
Money’s value is not wholly stable. It keeps on fluctuating from time to time. As a result, debtors and creditors are affected differently at different times. For instance, if the value of money depreciates on account of a price-rise, the creditors suffer loss while debtors gain.
2. As a Store of Purchasing Power:
In the absence of money, saving could be made only in terms of commodities, some of which happen to be perishable.
Hence, savings could not remain permanent. The introduction of money has done away with this shortcoming! Now savings are done in terms of money. Therefore, savings are more permanent than they used to be under the barter system. Further, money has also made possible capital-accumulation an essential requirement for economic growth. Money also performs the function of an excellent store of wealth, as it can be conveniently converted in to other marketable assets such as land, building, machinery, plant and equipment etc.
3. As a Means of Transferring Purchasing Power:
The activity of exchange further extended with advancements in economic development. The exchange of goods and services now extended to distant lands. It was, therefore, felt necessary to transfer purchasing power from one place to another and one country to another country. Money performed this function easily and quickly. Since money has the characteristic of general acceptability, a person can dispose of his property at one place and buy new property at another place. Furthermore, borrowing and lending also take place in terms of money. It is on account of the general acceptability of money that purchasing power can be transferred from one person to another.
3. Contingent Functions:
Prof. Kinley described four contingent functions of money:
1. As the basis of Credit:
In recent years, the significance of the credit has increased in all parts of the world. Credit instruments such as cheques, bills of exchange etc. are extensively used. Money is the basis of credit. Without money, credit instruments cannot circulate. For example, depositors can make use of cheques only when they have sufficient funds in their accounts.
2. Money Facilitates Distribution of Social Income:
Money has also facilitated the distribution of income into different sections of the society. Modern production is possible by the collective efforts of the different factors of production. The share of each factor is determined in terms of money and each factor is paid the reward for its contribution in terms of money.
3. Helps to Equalize Marginal Utilities and Marginal Productivities:
Every rational consumer tries to secure maximum utility out of his expenditure. But the consumer can derive maximum satisfaction only if he makes expenditure on a bundle of commodities in such a way as to equate marginal utilities accruing from them. Money plays an important role in equalizing these marginal utilities because the prices of all commodities are expressed in terms of money.
4. Increases productivity of capital:
Capital may take several forms, but money is the most liquid form of capital. Capital in the form of money can be put to any use. It is because of this liquidity of money that capital can be shifted from the less production to the more productive uses. The mobility of capital has also increased on account of the liquidity of money.
4. Other Functions:
In addition to the primary, secondary and contingent functions, money also performs certain other functions:
1. Helps to maintain Repayment Capacity:
Money characterizes the virtue of general acceptability. Therefore, to maintain its capacity to pay, every individual and firm has to keep some amount of liquid money in its assets. By so doing, the firm protects its repayment capacity. Similarly, banks, insurance companies and even governments keep some money in the liquid form so that they are able to maintain their repayment capacity.
2. Money represents Generalized Purchasing Power:
Money represents the purchase power. This purchasing power stored in terms of money can be put to any use. It is not necessary that money should be utilized for the same purpose for which it has been saved. For example, if a person has saved now to construct a house sometime in future, it is not necessary that he should utilize that saving only for constructing the house. The saver may prefer to spend it on some other more important uses such as education of his children. Objectives for which saving has been made may change overtime. If the objective of the saver changes, he faces no difficulty because money represents generalized power that can be put to any use saver likes.
3. Money provides Liquidity to Capital:
Money is the most liquid form of capital and can be put to any use. It is essential to keep capital in a liquid form for a variety of motives.
According to J.M. Keynes, money is kept in liquid form for four motives:
(a) Income motive
(b) Transactions Motive
(c) Precautionary Motive
(d) Speculative Motive
Answer 4. Functions of Money:
The main functions performed by money are as follows:
(i) Medium of Exchange:
The most important function of money is to remove the difficulties of barter exchange. In a barter system, there was a need for double coincidence of wants. A person who wants to sell a cow and buy a goat has to look out for a person who wants to sell a goat and buy a cow.
There also arises the problem of indivisibility in such goods. But with the invention of money, goods can be exchanged at any time and any place. The problem of indivisibility is also eliminated since money is available in all denominations.
(ii) Money as a Measure of Value:
Money has now become a common measure of value or a unit of account. Any commodity can be valued in terms of money. Under barter system, each and every good had to be valued against each and every other good. Money can address this difficulty and can be used as a yardstick to value all the goods and services in a common unit.
(i) Standard of Deferred Payment:
Money payments can be made after a lapse of time. In the barter economy, lending and borrowing took place in terms of goods. But most of the goods deteriorate in value over time. Money, however, has stable value over time and therefore, it facilitates lending and borrowing, making such activities less risky.
(ii) Store of Value:
Money can be stored as a liquid asset. Currency notes can be kept at home or in the bank account for withdrawal at any time when the need arises. Thus, income and expenditure do not occur at the same time. For example- an employer may have to pay daily wages to the laborers but he may not receive his income daily. Here, money acts as a store of value and is used whenever required.
(iii) Transfer of Value:
Money also acts as a means of transferring value. The value of money can be easily transferred from one place to another. Money earned from sale of an asset in one place can be used at another place for purchase of other assets.
(i) Distribution of National Income:
Money helps in the optimal distribution of national income among the various factors of production. The remuneration in the form of rent, wages, interest and profits to the factors of production namely, land, labor, capital and entrepreneur can be easily distributed in monetary terms.
Money provides the purchasing power to its bearer. It is the most liquid asset that can be used when required.
(iii) Basis of Credit:
Banks cannot create credit without money. As a store of value, people store money in the banks in the form of deposits. These deposits can be used to offer loans and create credit.
(iv) Maximum Satisfaction to the Consumers:
Money helps in maximisation of satisfaction of the producers and the consumers. The producers try to maximise their satisfaction by equating the marginal product of the factor of production to its price while the consumers try to maximize their satisfaction by equating the price of the product to the marginal utility.
Answer 5. Functions of Money:
Money performs several important functions.
PROF. KINLEY has classified the functions of money into three categories:
The essential and fundamental functions that money should perform is every economy are regarded as primary functions of money.
1. Medium of Exchange:
Money serves as a medium of exchange. This is the main and most important function of money. Money carries the capacity to purchase goods and services which people want. Money is normally accepted as a medium through which all the sales and purchases takes place.
As the money is accepted as a common medium of exchange, it has eliminated the difficulties of barter system. It has avoided the wastage of time and resources and has eliminated the need for double coincidence of wants involved in the barter.
2. Measure of Value:
Money is accepted as a common measure of value. Under the barter system, the value of a commodity used to be expressed in terms of other commodity. The value of rice used to be expressed in terms of a piece of cloth but after the evolution of money, value of any commodity can be expressed in terms of money.
When we express the value of a commodity in terms of money, it is known as price. Thus, money provides a language of economic communication. Money will be a useful unit of value only as long as its own value or purchasing power remains constant.
Money also acts as a unit of account, for example- Rupee is the unit of account in India, Dollar in U.S.A. and so on.
These categories of functions are those, which are derived from the primary functions.
Secondary functions of money are as follows:
1. Standard of Deferred Payment:
Money acts as a standard of deferred payment. In other words, money can be used in the settlement of debts. It means payment to be made in future can be assessed and expressed in terms of money. This function of money has been derived from medium of exchange function of money.
Under barter system, credit transactions were not possible because the seller was not sure of getting the same kinds of good after a certain time period. This problem has been removed completely with the introduction of money. In modern economy, many transactions involve the deferred payment.
It is possible to accept money as a standard of deferred payment because money has a general acceptability and it can be expressed in definite and standardized units. For example, A lends Rs. 1000 to B for a year. He knows well what he will receive after a year. On the other hand, A lends 1 kg rice to B for a year, it is not definite that he will receive back the rice of same quality as he lend out.
Money is a more successful functional unit of the standard of deferred payments, because:
(i) It’s value is relatively more stable.
(ii) The element of durability is higher.
(iii) There is a quality of general acceptability.
2. Transfer of Value:
Money also acts as a means to transfer of value. This function of money has derived from the general acceptability of money as a medium of exchange. Value can be transferred from one person to another with the help of money. When we pay the price of any commodity to its owner, we transfer the value to the owner.
Similarly, money is a quick and efficient means of transferring value from one place to another. The price of any commodity can be paid in terms of money from one city to another or from one state to another or even from one country to another country.
3. Store of Value:
Money acts as a store of value. It means people can store their wealth in the form of money. Before the evolution of money, it was not always possible to store the wealth. As the perishable commodities, i.e., wheat, rice, vegetables which were not needed at a time, could not be stored for a long time.
Money has facilitated the store of value. Though there are some other things which can be stored as store of money like gold, bond, shares, debentures, etc. But money is considered a better storage of value particularly in one respect. Money is a perfectly liquid asset, i.e., it is a readily and generally acceptable means of payment. It gives the immediate purchasing power which other goods do not give.
Thus, in the form of money, purchasing power can be stored and can be used at any time as and when needed.
The contingent functions of money were not the contemplated functions. Rather they emerged or evolved with the expanded scope of facilitating functions of money.
Money can be used in assisting various economic entities such as consumers, producers, etc., in arriving at economic decisions relating to consumption, production, etc.
These are the contingent functions of money. The main contingent functions are as below:
1. Maximization of Utility:
As we know a rational consumer wants to maximize his utility (or satisfaction) while purchasing various goods and services. A consumer will be able to maximize his satisfaction, if the ratios of marginal utilities of different commodities is equal to the ratio of price between different goods. For equalizing the marginal utilities, money plays an important role because prices of all commodities are expressed in terms of money.
2. Employment of Factor Inputs:
Money helps the producer in deciding how many units of different factors of production should be employed. Every producer wants profit maximization while employing various factors of production. A producer with maximum profit objective will equate marginal productivity (expressed in value terms) of a factor with its price or rate of remuneration and remuneration is expressed in terms of money.
Thus, money is helpful in taking decisions regarding employment of units of factors of production.
3. Credit System:
Money has facilitated the application of credit system in the economy. In modern economy, various commercial and business transactions take place on credit. It is the money which provides the basis of entire credit system. Without the existence of money, important credit instruments like cheques, bills of exchange cannot be used.
4. Distribution of National Income:
Distribution of national income among the various factors of production can be easily made with the use of money because various factors contribute in the process of production. Thus, production is the outcome of the contribution of the numerous units of these various factors.
Without the use of money, the distribution of national income among these factors of production would have become impossible.
Answer 6. Functions of Money:
Various functions of money can be classified into three broad groups:
(a) Primary functions which include the medium of exchange and the measure of value;
(b) Secondary functions which include standard of deferred payments, store of value and transfer of value; and
(c) Contingent functions which include distribution of national income, maximisation of satisfaction, basis of credit system, etc.
These functions have been explained below:
1. Medium of Exchange:
The most important function of money is to serve as a medium of exchange or as a means of payment. To be a successful medium of exchange, money must be commonly accepted by people in exchange for goods and services.
While functioning as a medium of exchange, money benefits the society in a number of ways:
(a) It overcomes the inconvenience of barter system (i.e., the need for double coincidence of wants) by splitting the act of barter into two acts of exchange, i.e., sales and purchases through money,
(b) It promotes transactional efficiency in exchange by facilitating the multiple exchange of goods and services with minimum effort and time,
(c) It promotes allocation efficiency by facilitating specialisation in production and trade,
(d) It allows freedom of choice in the sense that a person can use his money to buy the things he wants most, from the people who offer the best bargain and at a time he considers the most advantageous.
2. Measure of Value:
Money serves as a common measure of value in terms of which the value of all goods and services is measured and expressed. By acting as a common denominator or numeraire, money has provided a language of economic communication. It has made transactions easy and simplified the problem of measuring and comparing the prices of goods and services in the market. Prices are but values expressed in terms of money.
Money also acts as a unit of account. As a unit of account, it helps in developing an efficient accounting system because the values of a variety of goods and services which are physically measured in different units (e.g, quintals, metres, litres, etc.) can be added up. This makes possible the comparisons of various kinds, both over time and across regions. It provides a basis for keeping accounts, estimating national income, cost of a project, sale proceeds, profit and loss of a firm, etc.
To be satisfactory measure of value, the monetary units must be invariable. In other words, it must maintain a stable value. A fluctuating monetary unit creates a number of socio-economic problems. Normally, the value of money, i.e., its purchasing power, does not remain constant; it rises during periods of falling prices and falls during periods of rising prices.
3. Standard of Deferred Payments:
When money is generally accepted as a medium of exchange and a unit of value, it naturally becomes the unit in terms of which deferred or future payments are stated. Thus, money not only helps current transactions though functions as a medium of exchange, but facilitates credit transaction (i.e., exchanging present goods on credit) through its function as a standards of deferred payments.
But, to become a satisfactory standard of deferred payments, money must maintain a constant value through time; if its value increases through time (i.e., during the period of falling price level), it will benefit the creditors at the cost of debtors; if its value falls (i.e., during the period of rising price level), it will benefit the debtors at the cost of creditors.
4. Store of Value:
Money, being a unit of value and a generally acceptable means of payment, provides a liquid store of value because it is so easy to spend and so easy to store. By acting as a store of value, money provides security to the individuals to meet unpredictable emergencies and to pay debts that are fixed in terms of money. It also provides assurance that attractive future buying opportunities can be exploited.
Money as a liquid store of value facilitates its possessor to purchase any other asset at any time. It was Keynes who first fully realised the liquid store value of money function and regarded money as a link between the present and the future. This, however, does not mean that money is the most satisfactory liquid store of value. To become a satisfactory store of value, money must have a stable value.
5. Transfer of Value:
Money also functions as a means of transferring value. Through money, value can be easily and quickly transferred from one place to another because money is acceptable everywhere and to all. For example, it is much easier to transfer one lakh rupees through bank draft from person A in Amritsar to person B in Bombay than remitting the same value in commodity terms, say wheat.
6. Distribution of National Income:
Money facilitates the division of national income between people. Total output of the country is jointly produced by a number of people as workers, land owners, capitalists, and entrepreneurs, and, in turn, will have to be distributed among them. Money helps in the distribution of national product through the system of wage, rent, interest and profit.
7. Maximisation of Satisfaction:
Money helps consumers and producers to maximise their benefits. A consumer maximises his satisfaction by equating the prices of each commodity (expressed in terms of money) with its marginal utility. Similarly, a producer maximises his profit by equating the marginal productivity of a factor unit to its price.
8. Basis of Credit System:
Credit plays an important role in the modern economic system and money constitutes the basis of credit. People deposit their money (saving) in the banks and on the basis of these deposits, the banks create credit.
9. Liquidity to Wealth:
Money imparts liquidity to various forms of wealth. When a person holds wealth in the form of money, he makes it liquid. In fact, all forms of wealth (e.g., land, machinery, stocks, stores, etc.) can be converted into money.
In short, the main functions of money can be summed up in the following form:
Money is a matter of functions four,
A medium, a measure, a standard, a store,
As this does not complete the picture,
We may add transferability more.
Static and Dynamic Functions:
Paul Einzing has classified the functions of money into two broad categories, i.e., static and dynamic functions:
1. Static Functions:
In the static functions, money acts as a passive or technical tool to ensure a smooth working of the economic system. It does not have a causative influence on the economic activities. The traditional functions of money, i.e., medium of exchange, measure of value, standard of deferred payments and store of value, all are the static or technical functions of money.
Paul Einzing adds one more technical function, i.e., money as a medium of price mechanism. Prices are the value of goods and services, expressed in money terms. Money is a medium through which the price mechanism operates in order to establish a balance between demand and supply in the market, and, thereby, to reconcile the interests of the producers and consumers.
2. Dynamic Functions:
The dynamic functions are those by which money actively influences the economic system through its impact on price level, interest rates, volume of production, distribution of wealth and income etc. In its dynamic role, money tends to influence the economic trends.
Important dynamic functions of money are described below:
(i) Effect on Price Level:
Money has great influence on the economic activity through a rise or fall in the price level (or a fall or rise in the value of money.) According to one explanation, inflation or a general rise in price level is caused by an increase in the amount of money in circulation; and deflation or a general fall in price level is due to decrease in money supply.
(ii) Effect on Interest Rate:
Money has great influence on the economic system by changing interest rates. Change in the money supply is partially responsible for the fluctuations in the interest rates. Interest rate falls with an increase in money supply and rises with a decrease in money supply.
(iii) Effect on Utilisation of Resources:
Proper application of monetary system can bring about an efficient and full utilisation of natural and human resources of the country and of its technological process. This, in turn, increases the national product and improves the standard of living of the people.
(iv) Effect on Government Expenditure:
The monetary system has also influenced the expenditure of the modern governments. Through deficit financing, the present governments are able to spend much more than what they receive by way of taxation or other sources of revenue. This enables the government to undertake a number of economic, social and defence activities in the country.
Answer 7. Functions of Money
Money acts as a medium of exchange and can also serve as a store of value and a unit of account. The problems prevalent during Barter system were resolved with the evolution of money.
The four major functions of money are as following:
1. Medium of exchange
2. Unit of account
3. Store of value
4. Standard of deferred payment.
Goods would have to be exchanged by barter (one good being swapped directly for another) in the absence of money. The major difficulty with barter system is that each transaction requires a double coincidence of wants; i.e. a great deal of time is required to search an eligible person for a viable transaction. Thus a thirsty economics lecturer would have to find a brewer who wanted to learn economics before he could swap a lesson in economics for a pint of beer.
The severity of this problem could be reduced by using money as a medium of exchange. Output could be sold for money and could be used subsequently to purchase the commodity of requirement from others. So a monetary economy typically involves exchanges of goods and services for money and of money for goods, but not of goods for goods.
The double coincidence of wants, which is required for barter, is unnecessary, when money is used as medium of exchange.
By facilitating transactions, money makes possible the benefits of specialization and the division of labour, which in turn contributes to the efficiency of the economic system.
The primary function of money is that it acts as medium of exchange. This function helps as identifying money as money. Money must possess several characteristics to be able to serve as a medium of exchange. It must have a known value i.e. readily acceptable. Its value must be high in relation to its weight. Also, it must be divisible, as for making transactions of small value, it would be useless if money comes only in large denominations. It must be difficult, if not impossible, to counterfeit or print duplicate money.
Money serves as common unit of account and measure of value. As Crowther explains ‘Money acts as a standard measure of value to which all other things can be compared’. Money serves as common denominator to measure the value of all goods and services.
In India, for example virtually all prices, wages, asset values, and debts are expressed in rupees. Having a single uniform measure of value is convenient. For example, pricing all goods in India in rupees – instead of some goods being priced in yen, some in gold and some in Microsoft shares – simplify comparison among different goods.
To store the purchasing power, money is the most convenient way. This function of money is derived from the use of money as medium of exchange. It divides the single transaction into sale and purchase. So, it is not necessary that a person make sale and purchase at the same time; he can sell it today and make a purchase later this converts the function of ‘medium of exchange’ as ‘store of value’.
The money taken in exchange for the goods sold today may be stored until it is required. However, money must have a relatively stable value to be a satisfactory store of value. A rise in the price level leads to decrease in the purchasing power of money because more money is required to buy a typical basket of goods. When the price level is stable, the purchasing power of a given sum of money is also stable. When the prices are highly fluctuating then the usefulness of money as a store of value is undermined.
4. Standard of Deferred Payments:
Money also serves as standard of deferred (future) payments like interest, loan payments, rents, wages etc. In barter system, commodity loans were prevailing where future payment became an issue. But, in economy where money is in use, all the payments are not instantly.
Debtors promise to pay the money in future, so all deferred payments are stipulated in money terms, if there are large fluctuations in the value of money, and then it will be bad standard of deferred payments. So, monetary authorities have to take steps so to keep the value of money stable.