What is Money and its Funktions?
Whoever wants to understand what money is should first look at the functions of money. Much of macroeconomic literature explains the money functions using three phrases:
- Medium of Exchange
- Unit of Account/Measurement
- Storage of Value
Learn how to describe these three terms in the same order since they explain the motive of money demand and supply.
Money as a Medium of Exchange
First, money is a medium of exchange that enables us to exchange goods and services in an economy with a monetary system. For clarification, an economy with a system of money has money in different forms of currencies. So, how does money function as a medium of exchange? When suppliers take their goods and services to the market, they demand money in exchange for goods and services. The demanders in a market will, in return, offer/supply their money for the goods and services they receive from suppliers of goods and services. Therefore, we expect two flows to occur in an economy with money. One is the flow of money between the subjects of the economy. The second is the flow of goods and services.
Money as Unit of Account
Secondly, money is a unit of account or measurement that enables us to value goods and services in an economy with a monetary system. While exchanging goods and services, we are all interested in getting the correct amounts of goods in a basket filled with many different goods and services. So, how do we achieve that? In your microeconomics class, you learned the concept of relative prices. In this case, money places the essential role of ensuring that all prices in all markets reflect exchangeable amounts of money. This way, any individual can demand quantities of goods and services and carry out the transaction using the required amount of money that reflects their opportunity costs of exchange (or their willingness to pay).
Money as Storage of Value
Thirdly, money serves the function of storage of value that enables us to store the value of goods and services over time and between periods in an economy with a monetary system. To understand the storage function of money, you should reflect on how money helps you keep the value of goods and services over time and between periods. We want to keep the value of goods and services over time because some goods are perishable. On the other hand, we do not want to surpass the opportunity of how money today or in the future. In this case, we want to keep the value of money between periods. In much literature in economics, you will hear about something called consumption smoothing.
Motives of Money Demand and Supply
All the three functions of money flow into the explanation of the motives of money demand and supply. The behavior of those who demand money and that of those who supply money differ. All participants in the money market, who bring the money to the market, are willing to give up money in exchange for a service or a good. Those who bring money to the market withhold money for specific purposes or motives in an earlier phase.
Transactional Motive of Money
First, money enables all transactions of the economy for the exchange of goods and services. Individuals have needs that can only be covered by consuming goods and services, while firms need to access resources to produce goods and services they offer to consumers. All these activities are transactions that need money to transact with other subjects in an economy. People, firms, and governments hold money so that they can transact with each other. The exchange and measurement functions support the transactional motives.
Precautionary Motive of Money
Second, money withheld serves the function of precaution to finance access to goods and services, where the consumption is spontaneous. For example, when people get sick, they need to pay their hospital bills, but who knows when they will get sick? The exchange and measurement functions support the precautionary motives.
Speculative Motive of Money
Third, money withheld serves the function of speculation with the value of assets held or not held at any particular time. Stock markets are the places where individuals, firms, and governments participate in speculative games of money. We can keep the money to transact over time and between periods. By doing this, we speculate about the value of assets over time and between periods. Financial markets are the playgrounds for such transactions. We would associate the speculative motive more with the storage function of money than with the transactional function and measurement function of money.
What is the Cost of withholding Money? Interest Rates
Do we incur costs when we withhold money? The answer is yes. Keeping cash equivalent reflects the demand for liquidity for purposes explained hereabove relative to the forgone opportunity to hold other assets, e.g., real estate, shares, bonds, etc. Interest rates offered by Central Banks (e.g., European Central Bank, US Federal Reserve, Bank of England, and others) aim to influence the dynamics of money demand and supply. Raising interest rates aims at reducing the demand for money and the willingness to withhold money by increasing savings (equivalent to acquiring alternative assets).