Money and Banking

Functions of Money and Its Demand

Can you even imagine a world without money? How would we conduct everyday transactions? How would we price items? Money has great significance in an economy as it performs four important functions. Let us learn more about these functions of money as well as the demand for money.

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Functions of Money

Economists define money via four of its basic functions. These functions will help us understand the importance and need of money as far as the economy is concerned.

Unit of Account

Say you went to a shop and started browsing around. You see the price of the products on display. They are all expressed in terms of money (rupees in this case). The cake is a hundred rupee, the pencil is ten rupees, the sneakers are a thousand rupees and so on. So as you can see, money is the basic unit of account or measurement of everything in an economy.

It is very important to have a uniform unit of account in an economy. The barter system does not work in all cases. So it is highly efficient and convenient to have a uniform base for all transactions, i.e. money. It is the foundation of every economic transaction happening anywhere around the world.

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Medium of Exchange

This is what most economists consider the most important function of money. Money has the ability to satisfy all your unlimited needs and wants. You want the cake, or the pencil, or the sneakers, or all of them. The money will give you the ability to buy it all.

One can argue you can also barter for the goods. But then you would have to have some service or product that the shop owner wants. And it also has to be of equal value. Say the shop owner wants 5 pairs of socks in exchange for the sneakers but you do not possess them. Then you cannot buy the sneakers. The exchange can only take place if there is a double coincidence of wants. This is why money is of such essence, it makes these transactions possible with minimum effort and maximum ease.

Store Value

Money means liquidity, i.e. it is the most liquid asset. It is the most convenient way to store wealth since you can use to buy any goods or products directly. It requires no conversion. This is what we call the store value of money.

If one was to store their wealth in other commodities, like gold or shares, there is a risk. These commodities do not have a stable value. However, money does not fluctuate in value, it’s value/worth remains stable. This is one of the biggest advantages of storing the value in money or currency.

Standard for Deferred Payment

Deferred payment is any payment that is to be made in the future. Like if you have taken a loan or buy goods on credit. The payment of these transactions has to be made on some date in the future. So these amounts are measured in terms of money. And they are ultimately paid in money as well. This is because the value of money remains stable in any economy. And so one of the most important functions of money.

Image result for money

(Source: Moneycontrol)

Demand for Money

We will be seeing here the Keynesian approach for calculating the demand for money. Money is the most liquid asset in the world. We can exchange it for any commodity or service and so people prefer to hold on to their cash. But then there is also the opportunity cost of money. Instead of preferring liquidity if the money was invested it would earn interest. And so the demand for money is the balance between these two motives.

Transaction Motive

Money is a medium of exchange and this function of it’s gives rise to the transactional motive for demand for money. We regularly need money to pay for goods and services. And such financial transactions can be of two types – income motive and business motive.

The income motive is to bridge the gap between the receipt of the income and its eventual disbursement. And the business motive is to bridge the gap between the time when costs are incurred and the time when you receive the sale proceeds. If these time gaps are smaller, the person will hold less cash for his transactions and vice versa.

There may be other factors involved for the changes in transactional demand for money like the expectation of income, interest rate, business turnover etc. And from the above factors, we conclude that transactional demand for money is a directly proportional function to the level of income. We express this as

L1 = kY

Where L1 is transactional demand for money, k is the proportion of income kept for transactions and Y is income.

Speculative Motive

Demand for money: Speculative Motive

(Source: economicdiscussion)

The other important function of money is that it is a store value of wealth, i.e. it is an asset. And the demand for any given asset depends on its opportunity cost and its rate of return. Now money does not have a rate of return but it has an opportunity cost. The opportunity cost of holding money is the interest it could earn by being invested in some bond.

The speculative motive for demand for money arises when investing the money in some asset or bond is considered riskier than simply holding the money. The speculative motive for demand for money is also affected by the expected rise or fall of the future interest rates and inflation of the economy.

If interest rates are expected to raise the opportunity cost of simply holding the money will also rise and reduce the speculative motive. And if inflation is expected to rise, money will lose its purchasing power and again speculative income will drop.

Solved Question for You

Q: Transactional demand for money is ______ proportional to the level of income

  1. Directly
  2. Inversely
  3. Depends on the situation
  4. Not proportional

Ans: The correct option is A. Transactional demand for money is a directly proportional function to the level of income. It is expressed as L1 = kY.

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