The Functions of Money
What are the functions of money in an economy, and why do households and firms hold money? The answer is that money performs three important functions.
First, money is a unit of account.
In a monetary economy, all prices are determined and quoted in terms of the monetary unit. Otherwise, economic agents would have to calculate all the relative prices of goods and services to conduct their transactions. For example, in an economy with N goods plus money, households and firms have to calculate N money prices. Without money, economic agents would need to calculate N(N − 1)/2 relative prices to make their transactions. As the number of goods and services increases, the number of relative prices to be calculated grows exponentially. For example, if there are 5 goods and services, there are 5 money prices, and 10 relative prices of goods between them. With 10 goods and services, there are 10 money prices, and and 45 relative prices of all goods and services. With 100 goods and services, there are 100 money prices, and 4,950 relative prices between goods and prices. With 1,000 goods and services, there are 1,000 money prices, and 499,500 relative prices between goods and prices. Money therefore helps simplify the calculation of prices and values and thus facilitates economic transactions through its function as a unit of account.Second, money is a generally accepted means of payment. Being accepted by all, money greatly facilitates economic transactions and drastically reduces their costs. Without money, to complete a transaction, the seller of a product or service would have to find a buyer who would be prepared to offer in return another good or service that the seller wishes to acquire. This requires a double coincidence of wants in all economic transactions. Transactions or this kind are called barter, which implies large transactions costs on the part of economic agents to find suitable counterparties to their transactions.
A modern economy would immediately cease functioning if there were no generally accepted medium of exchange and payments, because transaction costs would become prohibitive. This is probably the most important role of money.Third, money is a store of value (i.e., a means of holding wealth) and is indeed the asset that is characterized by greater liquidity than any other asset, as it can be used directly for payments for the acquisition of goods and services. This is a key feature of money, because if money were not a store of value and lost its value quickly, it would not be generally accepted as a means of payments. And because money is the only store of value that is also a means of payments, by definition, it is the most liquid store of value. However, as a means of holding wealth, money does not pay interest, unlike other, less-liquid assets.
All three functions of money—as a unit of account, a means of payments, and a store of value—determine its social role in an economy and help explain why households and firms attach such great importance to money.
We now turn to the determinants of the supply and the demand for money.
12.2