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Functions of Money in the Modern Economic System

How does money work?

How does money work?

Money is one of the fundamental inventions of mankind. It has become so important that the modern economy is described as the money economy. The modern economy cannot work without money. Even in the early stages of economic development, the need for exchange arose. At first, the family or village was a self-sufficient unit. But later on, with the development of agriculture and application of the division of labor—that is, the division of the society into agriculturists, carpenters, merchants, and so on—the need for exchange arose.

Exchange took place first in the form of barter. Barter is the direct exchange of goods for goods. Barter is a system of trading without the use of money. At first, when the wants of men were few and simple, the barter system worked well. But as days passed by, it was found to be unsuitable. It has many difficulties.

Role of Money in Modern Economies

All the difficulties of barter were overcome with the introduction of money. Crowther had defined money as “anything that is generally accepted as a means of exchange (i.e., as a means of settling debts) and that at the same time acts as a measure and as a store of value.” An important point about this definition is that it regards anything that is generally acceptable as money. Thus, money includes coins, currency notes, cheques, Bills of Exchange, and so on. It is not always easy to define money. That is why Prof. Walker has said that money is that which money does. By this, he refers to the functions of money. Money performs many functions in a modern economy. The most important functions are given in the form of a couplet quoted below.

“Money is a matter of functions four - a medium, a measure, a standard, a store.”

Thus, money is a medium of exchange, a measure of value, a store of value, and a standard of deferred payments.

  1. Medium of exchange: The most important function of money is that it acts as a medium of exchange. Money is accepted freely in exchange for all other goods. The barter system is very inconvenient. So the introduction of money has got over the difficulty of barter.
  2. Measure of value: Money acts as a common measure of value. It is a unit of account and a standard of measurement. Whenever we buy a good in the market, we pay a price for it in money. And price is nothing but value expressed in terms of money. So we can measure the value of a good by the money we pay for it. Just as we use yards and meters for measuring length, and pounds for measuring weights, we use money for measuring the value of goods. It makes economic calculations easy.
  3. Store of value: A man who wants to store his wealth in some convenient form will find money admirably suitable for the purpose. It acts as a store of value. Suppose the wealth of a man consists of a thousand cattle. He cannot preserve his wealth in the form of cattle. But if there is money, he can sell his cattle, get money for that and can store his wealth in the form of money.
  4. Standard of deferred payments: Money is used as a standard for future (deferred) payments. It forms the basis for credit transactions. Business in modern times is based on credit to a large extent. This is facilitated by the existence of money. In credit, since payment is made at a future date, there must be some medium which will have as far as possible the same exchange power in the future as at present. If credit transactions were to be carried on the basis of commodities, there would be a lot of difficulties, and it will affect trade.

The History of and Use of Money

Money to be used as a medium of exchange must be universally acceptable. All people must accept a thing as money. Or the government should give it legal sanction. And for performing the other two functions—that is, to be used as a store of value and standard of deferred payment—money should have stability of value. In other words, the value of money should not change often.

Money is one of the most fundamental inventions of mankind. Every branch of knowledge has its fundamental discovery. In mechanics, it is the wheel; in science fire; in politics, the vote. Similarly, in economics, in the whole commercial side of man’s social existence, money is the essential invention on which all the rest is based. Money is indispensable in an economy, whether it is capitalistic or socialistic. Price mechanism plays a vital role in capitalism. Production, distribution, and consumption are influenced to a great extent by prices, and prices are measured in money. Even a socialist economy, where the price system does not play so important a role as under capitalism, cannot do without money. For a while, the socialists talked of ending money, i.e., abolishing money itself, because they considered money as an invention of the capitalists to suppress the working class. But later on, they found that even under a system of planning, economic accounting would be impossible without the help of money.

In the early stages of civilization, different people used different things as money. Cattle, tobacco, shells, wheat, tea, salt, knives, leather, animals such as sheep, horses, and oxen, and metals like iron, lead, tin, and copper have been used as money. Gradually, precious metals such as gold and silver replaced other metals such as iron, copper, and bronze as money. Now, paper is used as money. Almost all countries in the world today have paper money. We may describe one more form of money; that is, bank deposits that go from person to person by means of cheques.

How does money work?

How does money work?

Difficulties of Barter

The barter economy presents many difficulties:

  • Absence of double coincidence of wants: Barter requires a double coincidence of wants. That is, one must have what the other man wants, and vice versa. This is not always possible. For example, say I want a cow. You must have it. If you want a horse in return, I must have it. But if I do not have it, exchange cannot take place. So, I should go to a person who has a horse, and I must have what he wants. All of this means a lot of inconvenience. But money overcomes these difficulties. If I have an object, I can sell it for some price. I get the price in money. With that, I can buy whatever I want.
  • No standard of measurement: Barter provides no standard of measurement. In other words, it provides no measure of value. It does not provide a method for estimating the relative value of two goods.
  • Absence of subdivision: Sometimes it will be difficult to split up commodities into parts. They will lose their value if they are subdivided. For example, say a man wants to sell his house and buy some land, some cows, and some cloth. In this case, it is almost impossible for him to divide his house and barter it for all the above things. Again, suppose a man has diamonds. If he divides them, he will make a great loss.
  • Difficulty of storage: Money serves as a store of value. In the absence of money, a person has to store his wealth in the form of commodities, and they cannot be stored for a long period. Some commodities are perishable, and some will lose their value.

Qualities of a Good Money Material

  1. General acceptability: A good money material must be generally acceptable. People should not hesitate to exchange their goods for the material. Precious metals like gold and silver are always acceptable.
  2. Portability: A satisfactory money material must be of high value for its bulk. Since it has to be moved about from place to place, it must be possible for us to carry it from one place to another without difficulty, expense, or inconvenience. Precious metals such as gold and silver are satisfactory in this regard. Even paper money is ideal in this regard. Iron, for instance, would not be satisfactory in this respect.
  3. Cognizability: The material used as money should be easily recognizable. Gold and silver, for example, can be easily recognized by their colour and heavy weight for small bulk.
  4. Durability: The material used as money should not deteriorate. The early forms of money, such as corn, fish, and skin were unsuitable in this regard. Gold coins will last many hundreds of years.
  5. Divisibility: The material must be capable of division without difficulty and without loss of value on account of division. Metals have this advantage.
  6. Homogeneity: All coins of the material should be of the same quality. One coin should not be superior to another.
  7. Malleability: A material must be capable of being moulded without much difficulty. Even if a material is divided into a number of pieces, it must be capable of being reunited without loss. Gold is excellent for such purposes.
  8. Stability of value: This is another important quality of a good money material. Commodities, which are subject to violent changes in supply and demand, are unfit for money. For, the value of money, like any other thing, is determined by its supply and demand. If there are violent changes in its supply and demand, its value is not likely to be stable. Since money is used as a store of value and standard of deferred payments, it cannot perform these two functions well, if there is no stability of value for money. If money goes on losing its stability of value, it will not be accepted as money.

Questions & Answers

Question: Why is the U.S. Dollar an internationally accepted money?

Answer: Any currency could replace the U.S. Dollar as a global currency. However, for a currency to be accepted internationally, two major factors play a vital role. Firstly, the credibility of the currency is very important. A country cannot print or circulate currency as it likes. The quantity of money a country circulates purely depends upon how much gold reserve it has. The currency of a nation that does not follow the basic rule of gold reserve loses its credibility naturally. The US Dollar dominates other currencies when it comes to credibility. It does not mean that other countries do not maintain enough gold reserves to strengthen their currencies. However, the global community believes that the United States follows higher standards comparatively. And this belief of the global community is true to some extent.

Secondly, the global community looks at the stability of the political and economic system of a nation to use its currency for important international transactions. The United States has not undergone any major political crisis. Even though the country faced great depression in 1930 and subprime mortgage crisis in 2008, it was able to regain its economic stability magically. Other countries struggle a lot for restoration, if they face such traumatic events. For instance, Euro tried to replace US Dollar as an international currency. However, the currency of the European Union lost its credibility because of Eurozone crisis, and the restoration magic that worked in the US economy has not taken place in the Eurozone till now.

Question: Why don't all countries of the world use one currency?

Answer: In 2009, Timothy Geithner, former American central banker and the 75th United States Secretary of the Treasury, hinted that the idea of a gradual move toward single currency governed by the International Monetary Fund is quite impressive. Though his statement surprised everyone, the idea of ‘one currency one world’ has been lurking in the minds of economists for many years. For example, John Maynard Keynes cited the idea of a single currency many years ago. Though most of his suggestions and theories were successfully adopted by the world, his single currency idea has not been able to overwhelm the existing currency system.

If the world adopts one currency, the problem of currency risk will be eradicated completely. Countries, who use currency exchange to make their goods and services cheaper, as China often devalues its currency to gain from international trade, will no longer be able to gain from the single currency model. Also, countries may not be able to implement an independent monetary policy because of the single currency method.

However, the idea of single currency cannot be brushed aside because if it is impractical, legendary economist such as John Maynard Keynes would not have proposed it.

© 2013 Sundaram Ponnusamy

Comments

Mel on August 05, 2020:

Good

Vhel Sevilla on May 08, 2020:

Explain the role of money in a modern economic system. Does this simplify or complicate matters?

MaInAPrIyA on April 04, 2020:

Value of money in moder times. Write a note on this point

HASSAN IQBAL on March 25, 2020:

Explain the relevance of money as a medium of exchange in modern day business.

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