There are four main functions of money. The functions of money can also be referred to as the uses of money. These functions have a role to play in the economy. They include:
Money as a standard deferred payment
Deferred payments means that goods can be acquired now and paid for at a later date. Therefore, money acts as the best medium for deferring payments since it has a value that can be calculated with interest. This payment system has made money popular in the lending businesses as the money given out can be easily assigned a value and interest made in the process.
Example: Mary wants to buy a car but cannot raise the full amount for purchase. She takes a loan from a lender and is then able to buy the car. The payments of the loan are deferred into the future while she keeps using her purchase (the car).
Money is used as a store of value
Money has the ability to retain its purchasing power into the future. This means that money has the ability to keep wealth in a form so that it can be readily available to spend in the future. However, this can be affected by inflation which means the general increase in the prices of goods over time. Inflation can affect the ability of money to be a stable store of value by reducing its purchasing power over time.
Example: Betty bought gold bars and stored them in her safety deposit box five years ago. She now wants to buy a house and needs more money to acquire the house debt free. She then sells her gold bars and makes enough money to make the purchase.
Money acts as a medium of exchange
Money acts as a medium of exchange for products and services. It is the best exchange form since it is easy to assign a monetary value to products and services. Money makes it possible for products and services to be given a monetary value that they can be exchanged with. In the past, the value of items was often unclear and this led some buyers to be taken advantage of by the sellers. For example, if Person A has a goat and they are looking to exchange it for a dress, it is not always clear what defines the value of the animal to be enough to match the value that is needed for the dress. The value of either item can be higher or lower, meaning that the buyer or seller can both lose from this transaction.
Example: Molly is hungry and wants to eat a hamburger. She walks into the fast food restaurant next to her office building and makes her order. The hamburger is ten dollars. She reaches into her purse and removes a ten-dollar note and hands it to the cashier. She is given a receipt and allowed to move to the counter where she gets to pick up her food. She receives her purchased hamburger and goes back to the office.
Money as a unit of account
A unit of account is a measure of the value of commodities, which gives a common base for making comparisons between commodities. The aspect of money being countable makes it useful to account for losses, profits, and debt. This measure is imperative for understanding the importance of commodities; hence, money works as the perfect unit of account. In addition, money is a unit of account because all things within the economy can be quoted in terms of it. Simply put, everything in the economy has a value that is expressed in monetary terms.
Example: Andy walks into a shop and wants to buy a shirt. The average price range of the shirts is between thirty to forty dollars, which represents the unit of account. This can be seen on the price tags found on each shirts collar. This direct price listing is much easier to comprehend for Andy than having to figure out an exchange. Imagine if Andy walked in and the prices were given according to the number of onions and tomatoes. In that case Andy would then need to check how many tomatoes and onions translate to the value each shirt and which one would cost more per unit (an onion or a tomato).
It is important to note that the most well-known function of money is as a medium of exchange since it helps individuals buy goods or services to meet their needs.
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There are various properties of money. These properties include:
Acceptability
Money is an acknowledged form of payment for various businesses in the world. It is easy to determine the value of commodities using money; thus, it is suitable for conducting business. Though the value of currencies may vary, the use of money to perform different transactions makes it suitable for most any business deal.
Durability
The materials used in making money are long lasting. This aspect is important to ensure that money is not easily destroyed. It is observable that coins and notes are not easy to destroy. This is because the materials used to make them have been carefully chosen to ensure that money can withstand multiple conditions that could cause wear and tear. However, in the US, the Bureau of Engraving and Printing and the US Mint destroy money when it becomes mutilated. The US Federal Reserve Bank destroys money that has been taken out of circulation and replaces it with fresh money.
Divisibility
Money is easily divisible into smaller units. A five-dollar note can be split into five one-dollar notes. This factor makes it easier for a transaction to be made with it. To make one hundred dollars, one can combine ten-dollar notes with five-dollar notes to add up to one hundred dollars. The aspect of divisibility makes it possible for buyers to get the balance from purchases that they make using a higher value of a currency. For example, say that Maya has a fifty-dollar note in her pocket and she wants to buy a thirty-dollar handbag. She can use the fifty dollars to pay for the handbag and, in return, she will receive the handbag plus a twenty-dollar note.
Portability
Money is easily carried from one place to another (it is portable). This factor makes it easier to transact with money. For example, to buy a house, Tony has written a check for 500,000 dollars, which he is now carrying around in his wallet. He is waiting for the real estate agent to show up so that they can close the deal using the check.
Uniformity
In general, in a given country, every coin and note of the same value looks the same or similar. For example, in the US, a current ten-dollar note looks exactly the same as other ten-dollar notes.
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Limited Supply
Money must have a limited supply for it to be valuable. This is the reason for central banks actively regulating the flow of money in most countries. According to studies, if there is a lot of money in a country, its value decreases. But when money supply is limited, its value rises, or is at least maintained for a long time.
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Money is a tool used to facilitate the exchange goods and services. Money is mostly in the form of coins and notes, and individuals use it to buy what they need for their daily lives. There are different types of money, such as;
- Fiat money
- Commodity money
- Fiduciary money
Each type of money has its unique features. It is imperative to note that fiat money is the most used type of money in the world. Also, money has various functions or uses in the economy such as a standard of deferred payments, a store of value, a medium of exchange, and a unit of account. Money has properties such as divisibility, portability, and acceptability that help in carrying out its role in the economic system.
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Video Transcript
The Four Basic Functions of Money
Now, let's take a look at how economists view the basic functions of money. Money serves four basic functions: it is a unit of account, it's a store of value, it is a medium of exchange and finally, it is a standard of deferred payment. Let's take a look at each one of these functions with the help of Margie the cake baker and Bob the lawn guy.
Money Is a Unit of Account
Money is a unit of account because everything in the economy is quoted in terms of it. For example, when Margie sells cakes in her bakery, she offers the cakes for sale at a certain price. That price is quoted in terms of money. Let's say she has a chocolate cake selling for ten dollars - that's a really good one, by the way. When Bob sells his lawn service, the price of his service is quoted in dollars, also. Let's say he charges $20 per yard. If you think about it, Bob's lawn service is really worth two of Margie's chocolate cakes, and Margie's $10 cake is worth a half of Bob's lawn service. Since Bob is not the only customer Margie has, and Margie isn't Bob's only customer, they need a unit of account that works for everyone in the economy. In this way, money functions as a unit of account, which is the foundation of every transaction taking place around us.
Money Is a Medium of Exchange
Money is a medium of exchange because it can be used to satisfy unlimited needs and wants. For Bob, he wants chocolate cake (who doesn't?) and lots of it. Bob is a business owner in the town of Ceelo. Every time he buys a cake from Margie's bakery, he exchanges the money he earned from his job for a cake. Money serves as an important medium of exchange in the economy, empowering people to purchase goods and services in an attempt to satisfy their unlimited needs and wants.
Money Is a Store of Value
Money is a store of value because Bob can exchange his lawn services for money one day and then use it to purchase goods and services at a later date. When he earns his paycheck, he cashes it at the bank, for example. Bob can hold on to that cash in his wallet for a few minutes, a few days or even a few months or years before he decides to exchange the money for one of Margie's outrageously, decadently delicious, chocolate cakes. Unfortunately, inflation prevents most of the money in existence today from serving as a pure store of value, because the money loses a significant portion of its purchasing power over time. However, if there were no inflation, then money would serve as a near-perfect store of value.
Money Is a Standard of Deferred Payment
Finally, money is a standard of deferred payment because it's sometimes used to buy something today and pay for it over time. For example, when Bob needs a new commercial lawn mower with a built-in TV and a roach taser (everybody needs one of those), he borrows the money from the bank. They require him to make a small down payment of cash today; however, he pays for most of the cost of the mower through monthly loan payments over time. When Bob buys now and pays later over time, money is functioning as a standard of deferred payment.
For something to be considered money, it must be a unit of account, a medium of exchange and a store of value. For example, gold is not considered money, because it is not used as a medium of exchange (at least in most places in the world). In addition, it does not serve as a unit of account. It may, however, serve as a store of value. The Mona Lisa painting with a fake mustache painted over it is not money. It does serve as a store of value, however, and I would argue that, with the mustache that's been added, it could be worth even more than it was before. However, it isn't a medium of exchange or a unit of account. Therefore the Mona Lisa is not money.
Lesson Summary
Okay, it's time to review. Money serves four basic functions:
1. It is a unit of account.
2. It is a store of value.
3. It is a medium of exchange.
4. It's a standard of deferred payment.
Learning Outcome
After completing this lesson, you should be able to describe the four basic functions of money in the economy and identify units that qualify as money.
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