Functions of Money

Introduction

Pictorial representation of definitions in paragraph preceding it. Money is generally accepted in payment for goods and services and serves as an asset to its holder. Money is anything that serves three important functions: a medium of exchange, a unit of account, and a store of value.

To be a good medium of exchange, money must be accepted by people when they buy and sell goods and services. It should be portable or easily carried from place to place. It must also be divisible so that large and small transactions can be made. It must also be uniform so that a particular unit such as a quarter represents the same value as every other quarter.
To be a good unit of account, money must be useful for denominating values (prices). To accomplish this, money must be familiar, divisible, and accepted.
To be a good store of value, money must be durable so that it can be kept for future use. It also should have a stable value so people do not lose purchasing power if they use the money at a later time.

Functions of Money

Let’s first focus on the 3 functions of money.

Medium of Exchange

The exchange of goods and services in markets is among the most universal activities of human life. To facilitate these exchanges, people settle on something that will serve as a medium of exchange—they select something to be money.

We can understand the significance of a medium of exchange by considering its absence. Barter occurs when goods are exchanged directly for other goods. Because no one item serves as a medium of exchange in a barter economy, potential buyers must find things that individual sellers will accept. A buyer might find a seller who will trade a pair of shoes for two chickens. Another seller might be willing to provide a haircut in exchange for a garden hose. Suppose you were visiting a grocery store in a barter economy. You would need to load up a truckful of items the grocer might accept in exchange for groceries. That would be an uncertain affair; you could not know when you headed for the store which items the grocer might agree to trade. Indeed, the complexity—and cost—of a visit to a grocery store in a barter economy would be so great that there probably would not be any grocery stores! A moment’s contemplation of the difficulty of life in a barter economy will demonstrate why human societies invariably select something—sometimes more than one thing—to serve as a medium of exchange, just as prisoners in federal penitentiaries accepted mackerel.

Unit of Account

Ask someone in the United States what he or she paid for something, and that person will respond by quoting a price stated in dollars: “I paid $75 for this radio,” or “I paid $15 for this pizza.” People do not say, “I paid five pizzas for this radio.” That statement might, of course, be literally true in the sense of the opportunity cost of the transaction, but we do not report prices that way for two reasons. One is that people do not arrive at places like Radio Shack with five pizzas and expect to purchase a radio. The other is that the information would not be very useful. Other people may not think of values in pizza terms, so they might not know what we meant. Instead, we report the value of things in terms of money.

Money serves as a unit of account, which is a consistent means of measuring the value of things. We use money in this fashion because it is also a medium of exchange. When we report the value of a good or service in units of money, we are reporting what another person is likely to have to pay to obtain that good or service.

Store of Value

The third function of money is to serve as a store of value, that is, an item that holds value over time. Consider a $20 bill that you accidentally left in a coat pocket a year ago. When you find it, you will be pleased. That is because you know the bill still has value. Value has, in effect, been “stored” in that little piece of paper.

Money, of course, is not the only thing that stores value. Houses, office buildings, land, works of art, and many other commodities serve as a means of storing wealth and value. Money differs from these other stores of value by being readily exchangeable for other commodities. Its role as a medium of exchange makes it a convenient store of value.

Because money acts as a store of value, it can be used as a standard for future payments. When you borrow money, for example, you typically sign a contract pledging to make a series of future payments to settle the debt. These payments will be made using money, because money acts as a store of value.

Money is not a risk-free store of value, however. We saw in the chapter that introduced the concept of inflation that inflation reduces the value of money. In periods of rapid inflation, people may not want to rely on money as a store of value, and they may turn to commodities such as land or gold instead.

Money & the Financial Sector

The presentation below will cover the functions of money.

Monetary Aggregates

Pictorial representation of definitions in paragraph preceding it. The Federal Reserve uses monetary aggregates (called M1 and M2) as a way to measure the money supply. In defining these measures of the money supply, the Fed draws lines between groups of assets that serve both the medium-of-exchange and store-of-value functions of money to varying degrees. M2 is broader than M1. M2 includes M1 plus additional liquid assets. Liquidity refers to the ease with which an asset can be turned into cash. Cash is therefore the most liquid asset (because it is cash already!). The other assets that are included in M2 are less liquid since it takes time (or a loss of value) to turn them into cash.

M1 includes paper currency and coins, demand deposits, and traveler’s checks.
M2 includes M1, savings and small time deposits, and money market shares.
M1 includes items that are primarily used as a medium of exchange while M2 adds items that are primarily used as a store of value.

How does Money have Time Value?

Money has a time value because interest rates are positive. For example, if you earn 5% per year on your savings account, one dollar will grow to one dollar plus five cents after one year. Since the present value of $1.05 to be received one year from now (if interest rates are 5%) is $1.00, then the present value of $1.00 to be received one year from now (again if interest rates are 5%) must be some value less than $1.00. In fact the present value can be calculated using the formula:

Pictorial representation of equation in paragraph preceding it. PV = FV / (1 + r) ^n

Where

PV is present value
FV is future value
R is the rate of interest per period
N is the number of compounding periods (per year).

Using the formula for our example:

PV = $1.00 / (1.05)^1

PV = $0.95

Today’s value of $1.00 to be received one year from now if the interest rate is 5% is $0.95.

Watch the video below to learn more about calculating the present value.

The business should invest in the machine since the present value of its future profits from the machine is greater than the cost of the machine - $2,095.78 - $2000 = $95.78 Business executives must consider the time value of money when making business investment spending decisions. They know that future profit projections must be converted to the present value in order to make a correct decision about whether a certain business project is profitable. Notice the interest rate is in the denominator of the formula indicating the present value is inversely related to the interest rate. Thus, less business investment spending is worthwhile at higher interest rates.

For example, assume a business was considering the purchase of a new machine that costs $2,000 now. The machine is expected to generate profits of $1,000 at the end of year one and $1,400 at the end of year two. For simplicity, assume the machine completely wears out and is worthless after the two years. Also assume the business must borrow the $2,000 at 9% interest. Should the business borrow and purchase the machine?

Let's look at another example:

Now, what if the rate the business had to pay to borrow increased to 15%?

The business should not invest in the machine since the present value of its future profits from the machine is now less than the cost of the machine - $1928.17 - $2000 = ($71.83)

Understanding the time value of money also helps for understanding the relationship between bond prices and interest rates. A bond is a loan with a fixed interest rate called the coupon rate. Bonds are long-term fixed-rate loans of usually 20 or 30 years. The seller (borrower) of a bond agrees to pay the buyer (lender) the amount of interest specified each year plus the face value of the bond at the end of the specified period, again typically 20 or 30 years. Often, the buyer of the bond (lender) incurs a liquidity problem and needs to sell the bond before it reaches its maturity. So, at what price can the owner of the bond sell the bond?

To answer that question, let’s assume the original bond was a 20-year bond with a face value of $1,000 and the coupon rate was 5%. That means the owner was receiving $50 in interest payments each year and was planning on receiving the $1,000 back at the end of year 20. But, let’s further assume the owner needs some cash and wants to sell the bond after owning it for 18 years and that current interest rates for bonds with the same level of risk are now 7%. That means there are two more interest payments due (one next year and one two years from now) and the face value will be due at the date of maturity or 20^th year (two years from now). What price can the owner sell the bond for now that the current interest rates are higher?

Using the present value formula:

PV = $50/ (1.07)^1 + $1,050/(1.07)62 = $46.73 + $917.11 = $963.84.

Note: current interest rate is higher and the price of the bond is lower.

Now assume that current interest rates for bonds with the same level of risk are now 3%, which is lower than the 5% coupon rate. So, now what price can the owner sell the bond?

Using the present value formula:

PV = $50/ (1.03)^1 + $1,505/ (1.03)^2 = $48.54 + $1,019.42 = $1,067.96

Note: current interest rate is lower and the price of the bond is higher. We can conclude that bond prices are inversely related to interest rates.

Learn more in the activity below.

Review

Review what you have learned by completing the activity below.

In Summary . . .

What's Your takeaway? Icon Financial Weapons of Mass Destruction

This is precisely what we would expect to see if a new economic downturn was beginning. Our economy is very highly dependent on the flow of credit, and when that flow begins to diminish that is a very bad sign.

For the moment, financial markets continue to remain completely disconnected from the hard economic data, but as we saw in 2008 the markets can plunge very rapidly once they start catching up with the real economy.

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