Functions of Money

Money performs four specific functions, each of which overcomes the difficulties of barter. The functions of money are to serve as: 1.Unit of value, 2. Medium of exchange, 3. Standard of deferred payments and 4. Store of value.

Money as a Unit of Value The first function of money is to be a unit of value or a unit of account. The monetary unit is the unit in terms of which the value of all goods and services is measured and expressed. The value of each good or service is expressed as a price, which is the number of monetary units for which the 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 (where the monetary unit in this case is the rupee). Measuring values in monetary units helps in measuring the exchange values of commodities. If a pen is worth Rs. 10 and a notebook is worth Rs.20 then a notebook is worth two pens. Further, accounting is simplified, as all items will be recorded in terms of monetary units that can be added and subtracted. Money is a useful measuring rod of value only if the value of money itself remains constant. This is similar to saying 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 the average or general level of prices as measured by the consumer price index etc. As the general price level increases, a unit of money can purchase a lesser amount of goods and services - so the value or purchasing power of money declines. So, money will be a useful unit of value only as long as its own value or purchasing power remains constant. Money as a Medium of Exchange Money also acts as a medium of exchange or as a medium of payments. This function of money is 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 that have 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 then reduce the time and energy spent in barter. The person who owned a cow can now simply sell it to the person who offers the most money for it and then buy the bullock cart from another person who 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 as the 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 the freedom of choice that the use of money offers. The owner of the cow need not procure goods and services from those to whom he sold his cow. He can use the money to buy the things he wants most, from those who offer him the best bargain (not necessarily those who bought his cow), at the time he considers most advantageous (not necessarily immediately). Again, this function can only be performed properly if the value of money remains constant. Money as a Standard of Deferred Payments If money performs the previous two functions then it may also perform the function of being the unit in terms of which deferred or future payments are stated. Examples of situations where future payments are to be made are pensions, principal and interest on debt, salaries etc. As long as money maintains a constant value through time, it will overcome the problems associated with making future payments with specific commodities. Money as a Store of Value If money becomes a unit of value and a means of payment then it may also perform the function of 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 money retains 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, they yield 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 money without loss of value, and (3) they may depreciate in value. A person may choose to store value in any form depending on considerations of income, safety and liquidity.