Money and its Functions

 

Although the crucial feature of money is its acceptance as the means of payment or medium of exchange, money has three other functions. It serves as a unit of account, as a store of value, and as a standard of deferred payment. We discuss each of the four functions of money in turn.

 

The Medium of Exchange

 

Money, the medium of exchange, is used in one-half of almost all exchange. Workers exchange labour services for money. People buy or sell goods in exchange for money. We accept money not to consume it directly but because it can subsequently be used to buy things we do wish to consume. Money is the medium through which people exchange goods and services.

To see that society benefits from a medium of exchange, imagine a barter economy.

A barter economy has no medium of exchange. Goods are traded directly or swapped for other goods.

In a barter economy, the seller and the buyer each must want something the other has to offer. Each person is simultaneously a seller and a buyer. In order to see a film, you must hand over in exchange a good or service that the cinema manager wants. There has to be a double coincidence of wants. You have to find a cinema where the manager wants what you have to offer in exchange.

Trading is very expensive in a barter economy. People must spend a lot of time and effort finding others with whom they can make mutually satisfactory swaps. Since time and effort are scarce resources, a barter economy is wasteful. The use of money - any commodity generally accepted in payment for goods, services, and debts - makes the trading process simpler and more efficient. Instead of having to find a restaurant that will give you a meal in exchange for your doing the washing up, you can get a job anywhere and subsequently use the money to pay for a meal; and the restaurant can sell meals in exchange for money without having to worry about what goods or services you could supply in return. By economizing on time and effort spent in trading, society can use these resources to produce extra goods or leisure, making everyone better off.

 

Other Functions of Money

 

The unit of account is the unit in which prices are quoted and accounts are kept.

In Britain prices are quoted in pounds sterling; in France, in French francs. It is usually convenient to use the units in which the medium of exchange is measured as the unit of account as well. However there are exceptions. During the rapid German inflation of 1922-23 when prices in marks were changing very quickly, German shopkeepers found it more convenient to use dollars as the unit of account. Prices were quoted in dollars even though payment was made in marks, the German medium of exchange.

Money is a store of value because it can be used to make purchases in the future.

To be accepted in exchange, money has to be a store of value. Nobody would accept money as payment for goods supplied today if the money was going to be worthless when they tried to buy goods with it tomorrow, But money is neither the only nor necessarily the best store of value. Houses, stamp collections, and interest-bearing bank accounts all serve as stores of value. Since money pays no interest and its real purchasing power is eroded by inflation, there are almost certainly better ways to store value.

Finally, money serves as a standard of deferred payment or a unit of account over time. When you borrow, the amount to be repaid next year is measured in pounds sterling. Although convenient, this is not an essential function of money. UK citizens can get bank loans specifying in dollars the amount that must be repaid next year. Thus the key feature of money is its use as a medium of exchange. For this, it must act as a store of value as well. And it is usually, though not invariably, convenient to make money the unit of account and standard of deferred payment as well.

 

Different Kinds of Money

 

In prisoner-of-war camps, cigarettes served as money. In the nineteenth century money was mainly gold and silver coins. These are examples of commodity money, ordinary goods with industrial uses (gold) and consumption uses (cigarettes) which also serve as a medium of exchange. To use a commodity money, society must either cut back on other uses of that commodity or devote scarce resources to producing additional quantities of the commodity. But there are less expensive ways for society to produce money.

A token money is a means of payment whose value or purchasing power as money greatly exceeds its cost of production or value in uses other than as money.

A £10 note is worth far more as money than as a 3x6 inch piece of high-quality paper. Similarly, the monetary value of most coins exceeds the amount you would get by melting them down and selling off the metals they contain. By collectively agreeing to use token money, society economizes on the scarce resources required to produce money as a medium of exchange. Since the manufacturing cost are tiny, why doesn't everyone make £10 notes?

 

Text 28

Inflation

 

In the 1980s President Reagan, Mrs. Thatcher, Chancellor Kohl, and many other national leaders named inflation as public enemy number one. Getting inflation down became their top priority.

Inflation is a rise in the average price of goods over time. Pure inflation is the special case in which all prices of goods and factors of production are rising at the same percentage rate.

Persistent inflation over many years is in fact quite a recent phenomenon. Before 1950, prices tended to rise in some years but fall in other years. In the UK the price level - the average price of goods as a whole - was no higher in 1950 than it had been in 1920. Figure shows that the UK price level fell quite sharply during some of the interwar years when inflation was negative. Yet since 1945 there has not been a single year in which the price level fell. Since 1950 the price level has increased by a factor of ten, more than its increase over the previous three centuries. This broad picture applies not only in the UK but also in most of the advanced economies.

In this chapter we shall try to explain why inflation is thought to be so bad as to justify its title of public enemy number one. Inflation does have bad effects, but we shall see that some of the popular criticisms of inflation are based on spurious reasoning. It requires some care to distinguish between the good and bad arguments about why inflation is costly for the economy as a whole.

To understand the costs of inflation we need to understand the effects of inflation. But these effects may depend on what is causing the inflation in the first place. Hence the chapter is divided into three parts. First we examine the causes of inflation. Monetarists such as Milton Friedman say that inflation is caused by too much money chasing too few good. And they attribute this excess demand for good to an increase in the nominal money supply Friedman has asserted that 'inflation is always and everywhere a monetary phenomenon'. Thus we begin by examining the link between the money supply and the price level. And we take this argument a stage further by asking whether it is large budget deficits that lead the government to print large quantities of money in order to finance these deficits.

We then turn to the consequences or inflation. How does it affect the markets for goods and labour? Is high inflation bad for output and employment? And does it matter whether the inflation was previously expected or whether it takes people by surprise?

Finally, we return to the theme of this chapter. To what extent is inflation a bad thing? We distinguish the costs that inflation might impose on individuals and the costs it might impose on society as a whole. We conclude by considering what the government can do about inflation.