Money and Banking Explanation

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What are the functions of money? Why is money better than the barter system? Why do people hold money? What affects our demand for money?

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Jun 12th, 2014

Money is often defined in terms of the three functions or services that it provides. Money serves as a medium of exchange, as a store of value, and as a unit of account.

Medium of exchange: Money's most important function is as a medium of exchange to facilitate transactions. Without money, all transactions would have to be conducted by barter, which involves direct exchange of one good or service for another. The difficulty with a barter system is that in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires. In other words, in a barter system, exchange can take place only if there is adouble coincidence of wants between two transacting parties. The likelihood of a double coincidence of wants, however, is small and makes the exchange of goods and services rather difficult. Money effectively eliminates the double coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each others' goods and services.

Store of value: In order to be a medium of exchange, money must hold its value over time; that is, it must be a store of value. If money could not be stored for some period of time and still remain valuable in exchange, it would not solve the double coincidence of wants problem and therefore would not be adopted as a medium of exchange. As a store of value, money is not unique; many other stores of value exist, such as land, works of art, and even baseball cards and stamps. Money may not even be the best store of value because it depreciates with inflation. However, money is more liquid than most other stores of value because as a medium of exchange, it is readily accepted everywhere. Furthermore, money is an easily transported store of value that is available in a number of convenient denominations.

Unit of account: Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged. Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to purchase.

Suppose I'm a fisherman, and I need a suit. Under the barter system, I have to find a tailor who needs fish. Or, I could find a tailor who needs some bread, then go find a baker who needs some fish. As you can see, the barter system can be quite inefficient and time-consuming. When you replace barter with currency, you have a system that is truly efficient. Now, I can sell my fish to anyone who wants fish, and they can pay me in currency. I can take my currency and get whatever I need. Not only is it more fluid, I also have more time to fish.

Why People Hold Money

Economists have identified three broad motives:

a. The transactions motive: People need to make day-to-day transactions (buy food, Clothes etc.) and therefore need to hold cash in their hands. Of course, the increasing Spread of plastic money (credit cards) has considerably reduced the transactions incentive for holding money. Assuming no plastic money, an individual’s transactions demand for money is likely to increase with his/her income, as s/he is more likely to make more transactions if he feels richer.

b. Precautionary motive: In addition to money held for making transactions, people sometimes hold money for precautionary purposes as well: i.e. to meet any urgent or unexpected expenditure needs, or to “snatch a bargain” that might be taken by someone else. Again, precautionary demand for money is likely to increase with income

c. Assets motive (also called speculative or investments motive): In addition to a and b, people might wish to keep some cash to switch between various investments. So consider a person who owns some land, holds some bonds, and has some stock market investments. Let’s say he spots a good investment opportunity on the stock market but doesn’t have instant buyers for the land or bonds he holds. In this situation some spare cash in hand would have helped him acquire the equity asset. The assets demand for money is likely to increase with income (for reasons similar to those for a and b) and decrease with interest rates (because the interest rate is the opportunity cost of holding cash in your hands).

Three macroeconomic factors that affect the demand for money are: 

A. the nominal interest rate; real income, and the price level. 
B. the nominal interest rate; capital, and labor. 
C. globalization, skill-biased technological change, and labor mobility. 
D. capital, labor, and technology. 
E. average labor productivity, real income, and the nominal interest rate.

Jun 12th, 2014

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