What’s it: Money is everything we use or accept widely as a means of payment for goods and services, including coins and banknotes. It also functions as a unit of account and a store of value. It replaces barter payments in the modern economy.
In ancient times, we used gold or silver as money. We all accept it as a medium of exchange because we think it is valuable.
However, in today’s modern economy, fiat money, such as banknotes and coins, replaced gold coins even though they had no intrinsic value. And now, electronic money and cryptocurrency are starting to gain popularity and replace physical money for some transactions.
Importance of money in economics
Money solves problems in barter transactions. You rely on double coincidence desire. I mean, to exchange goods, you have to find another party, who has the things you need and who needs your belongings.
You also have to transport goods from one location to another just to exchange them.
Bartering is more problematic when it involves indivisible goods. You might have to break them down into smaller pieces just to trade them out. And, it’s hard.
In bartering, there is no common measure of value. You do not have a reference price for each item. If you want to exchange oranges for apples, how many apples must be exchanged for one orange? The answer will be subjective between individuals. It is even more difficult to service.
Money solves such problems. With money, you have freedom and choices about where and how you spend it.
You only need to carry it (physical or digital) to buy things. All sellers are willing to accept it.
We also use the money to determine the unit value of goods. That way, you don’t have to measure the value of the goods yourself. You just have to look at the price and can exchange some money to get it.
Characteristics of money
Money facilitates transactions. To function effectively, it must have the following qualities:
- Money must be readily accepted by all parties. Conversely, some people may not accept goods as money in bartering because they do not need them.
- It must have some known value. Money comes in all sizes, shapes, and values.
- It must be easy to share. You can exchange 100 dollars for other smaller amounts such as 50 and 10 dollars. The sum will be the same. It differs from goods like money, in which the quality of each item may be different.
- It must be hard to fake. The supply must be limited for it to be worth and retain its value over time.
- It must be easy for us to move from one location to another. It’s easy to carry paper money around with you instead of carrying things to exchange.
Types of money in economics
In the economy, what counts as “money” tends to vary. In its narrow definition, it consists of banknotes and coins in circulation. In addition, there are deposits in banks and other financial institutions, which are liquid and quick to use as a means of payment.
Each monetary authority in different countries has a different size. The most common measures are narrow money and broad money.
- Narrow money consists of banknotes and coins in circulation plus other highly liquid deposits.
- Broad money consists of narrow money plus various liquid assets that can be used to make purchases.
Functions of money in economics
The three main functions of money are:
- Medium of exchange
- Store of value
- Unit of account
Medium of exchange
Money facilitates our transactions every day. With it, we can buy shoes, tickets or pay tuition fees.
As a medium of exchange, money is more accessible because it is available in several convenient denominations and easily transported.
Store of value
Money retains its value over time. By saving it, we can transfer our wealth today to the future.
However, the ability to maintain value varies with each type of money. Fiat money, like paper money, is vulnerable to inflation because it has no intrinsic value. When inflation is high, its purchasing power for various goods and services decreases.
It differs from gold, which is relatively resistant to inflation. From traditional economies to modern economies, people regard gold as a valuable item. Hence, like money, gold retains its value, even though the price of goods and services rises. For this reason, we consider gold a safe asset.
Units of account
Money provides a general measure of the value of the goods and services exchanged. With this function, we can compare the values of various products.
For example, if a bag costs $9 per unit and a pair of shoes costs $18, we can calculate the opportunity cost of buying a pair of shoes, two units of the bag. Comparisons are made easier when the value of the goods is expressed in money (price).
For this reason, money makes it easy to calculate the opportunity cost of consumption, facilitating efficient decision-making.
The demand for money and the supply for money determine the equilibrium interest rate in the economy. The money demand curve slopes downward, showing a negative relationship between the interest rate and the amount of money demanded. Meanwhile, the money supply curve is a vertical line, telling you the central bank determines the amount of money supplied to the economy.
The central bank determines the money supply. It can be done in several ways and instruments.
The policy to change the money supply is what we call monetary policy. The instrument can be via:
- Policy rate: the interest rate set for central bank loans to commercial banks.
- Open market operations: sale or purchase of government securities by a central bank
- Reserve requirements: the portion of deposits held by commercial banks as reserves and can not be lent.
Changes in the money supply affect interest rates in the economy. It affects consumption and investment behavior, where the real sector relies on loans. Ultimately, it affects aggregate demand.
An increasing money supply causes interest rates to fall. Conversely, a decrease in the money supply causes interest rates to rise.
Money demand reflects the amount of financial assets that households choose to hold in money, not bonds or stocks. Why is money being asked for? Economists share three motives for asking for money:
- Transaction motives. Economic actors need money to finance transactions. The larger the transactions involved, the greater the demand for money. In general, it depends on the average transaction size and the overall GDP. GDP represents the monetary value for goods and services transacted in the economy.
- Precautionary motives. Economic actors save money for use in unforeseen circumstances. It may be to take advantage of opportunities or prevent unexpected or immediate expenses.
- Speculative motives. It relates to the perceived returns and risks from holding other financial instruments. When the returns on other financial instruments increase, the speculative demand for money decreases. People prefer to hold financial instruments than money. Conversely, if the risk of other financial instruments increases, speculative demand falls.