Money and banking are two subjects closely intertwined with our daily lives and with the very day functioning of our economy. On atypical day, you encounter money and banks in many firms like from the obvious contact made when you use shillings to buy lunch or go to the bank to withdraw funds to the almost invisible contact via the investment of your school’s endowment.
Money and banks, and the financial system as a whole, play a vital role in the national economy. The total quantity of money in the economy and the rate at which the quantity grows over time has important implications for interest rates, inflation rates, and the economy’s overall functioning.
Money is anything generally accepted as a medium of exchange. A medium of exchange is virtually anything used to pay for goods and services or settle debts. Thus, the distinguishing future of money is that society widely accepts it to settle transactions. Throughout the history of humankind, numerous things have served as money, including shells, stones, and beads, sacks of grain, gold, cigarettes, paper bills and checks. Money is not synonymous with wealth or income.
An individual’s wealth refers to the stock of assets the individual owns, less his or her debts. For example, your wealth includes the total value of your holdings of real estate, stocks and bonds, cash on hand, money deposited in banks or other financial institutions, cars and even textbooks, minus the amount you owe to others. In contrast income refers to a flow of earnings over some given time interval, say, a week, month or year. Your wealth is like an “inventory” of everything you own minus debts owed to others while your income represent the “change” in the inventory that occurs during a given time period.
Functions of money
Having an overview of what money is and recognizing the distinctions among money, income, and wealth. We now examine four roles of money in an economy. Money serves as:
i. A medium of exchange
ii. A unit of account
iii. A store of value
iv. A standard of deferred payment
Medium of exchange
The primary function of money in an economy is to serve as a medium of exchange. This simply means that when you buy goods, serves or financial instruments (such as stocks and bonds), you pay with money.
It is hard to envision/imagine life without money as the medium of exchange. Imagine a barter economy i.e. an economy that has no money in which goods are traded directly for other goods. If a baker wants shoes, it is not enough to find a shoemaker but the baker must find a shoemaker willing to trade shoes for bread. Barter transaction requires a double coincidence of wants i.e. each individual must have something the other desires. If this happens, exchange will take place. The shoemaker will get bread and the baker will get shoes. But if the baker does not want shoes, or vice versa, no exchange will take place. In this case, the two parties will have to continue to search for someone who wants what they have for trade.
Thus, we see that barter is highly inefficient, since the baker would have to spend considerable time searching for someone willing to accept breads as payment for some other good. This search time is a transaction cost. i.e. cost borne in making an exchange.
When money is used as the medium of exchange, the baker can use money to buy shoes from the shoemaker even if the shoemaker does not want bread the shoemaker, in turn can use the money received to buy whatever he or she desires from the third party.
In monetary economy all individuals find money useful because money satisfies the double coincidence of wants. Therefore, one main advantage of a monetary economy (an economy that uses money as a medium of exchange) is that it eliminates the problem of finding a double coincidence of wants, that is, it reduces the transaction costs of exchange.
Unit of account
Money serves as a unit of account i.e. the values of goods and services are stated in units of money, just as time is measured in minutes and distance in fact. Accountants record the revenue and costs of companies in terms of money. Similarly, individuals budget their expenditure and income flows in terms of money.
In a monetary economy, the medium of exchange nearly always also serves as the unit of account. Because the medium of exchange is common to virtually all transaction, it is convenient to state the price of goods and services in terms of the medium of exchange. In Kenya the unit account is the Kenya shilling, which is also the medium of exchange.
The use of money as the unit of account reduces the amount of information individuals need to make purchase decisions. In monetary economy prices are quoted in terms of the unit of account (is it dollars, shillings or yen). If there are 1,000 goods for sale, there are 1,000 prices one for each good. Each price specifies how many units of money must be given up to receive one units of each good.
In the absence of a common unit of account, there would be more price than goods in the economy. To see this imagine you live in a simple barter economy with only four goods; apples, oranges, shoes and bread. Apple sellers would have to quote three different prices. One price tag would indicate how many oranges it takes to buy an apple, a second price tag would state how many pairs of shoes it takes to buy an apple and third price tag would reveal how many oranges it takes to buy apple. Similarly other sellers will have to quote third prices.
If millions of goods were available, as in our economy, there would be millions of price tags to put on each item. It would be costly to figure out whether you could afford to buy an item when each item had millions price tags
In a monetary economy we use money as unit of account and each good has a single price tag. The presence of money as a unit of account reduces the amount of price information you need to buy goods in the market place, and this too reduces the transaction cost associated with exchange.
Store of value
Money serves as a store of value, that is, it is a mean of storing today‟s purchasing power to purchase, say, a house or a car tomorrow. In the absence of money or other assets as a store of value, individuals and companies would have to maintain stocks of goods to use to trade in the future. This approach would be inefficient for two reasons:
1. Some commodities, like fruit and milk are perishable and would be of little or no value if stored for future use.
2. Even when a commodity is not perishable, a car for instance, it can be very costly to use it to store value over time. General motors‟ would find it very costly to maintain inventory of extra cars to pay their workers. General motor workers, in turn, would find it useless to be paid with engine parts or transmissions, for they would have a difficult time finding someone willing to accept an engine part or a transmission as payment for food or housing.
Money is not the only store of value. Indeed, other assets such as savings accounts, stocks and bonds are often better stores of value than money. These assets pay interest or dividends, whereas currency and many checkable deposits do not. Thus, while money provide a convenient store of purchasing power, it is not wise to use money as a store of value over long periods of time. However, money is unmatched others assets in its liquidly which gives it an advantage over other assets as a temporary store of value.
Liquidity is a term economist use to describe how cheaply and easily an asset may be converted into a medium of exchange.
Standard of deferred payment
Money serves as a standard of deferred payment; that is, a payment that is differed to the future is usually stated as a sum of money. For example, if you owe money to a friend and plan to pay it back in a week, you usually state the amount you owe in money terms. In the absence of money, you would have to plan on making payment in term of some other good. Having a common standard for deferred payments, which is the same as the medium of exchange and unit of account makes it relatively easy to determine exactly how much a deferred of payment will be. There are efficiencies in thinking of payments today and payment tomorrow or next year in terms of a common item, money. However, money is a standard of deferred payment, but not necessarily the best standard for all purposes.