In the next three posts we will take a look at how different schools of thought have defined money. It is amazing the level of disagreement on the definition of money. We need to understand money as a cornerstone of wealth creation.
As we saw in yesterday’s posting many different goods or assets have been used as money atsome time or in some place. Goods are things that are valued because they satisfy people’s needs or wants, such asfood, clothes or books. An asset, such as machinery, is something that is valuable because it can be used to produce other goods or services. We have also noted that over time money changed into fiat (paper) money which is not supported by any underlying asset. One common way of defining money is through the functions it performs. This approach traditionally suggests that money should fulfil three important roles.
- Money is to be a store of value — something that is expected to retain its value in a reasonably predictable way over time. This generally holds unless there is a hyperinflation in which case the money cannot no longer store value because it is eroded by inflation. This is what happened to the Zimbabwe dollar. It no longer could store any value and so had to be de-monetized and replaced by the USD. Gold and some precious minerals are good stores of value but would fail the other functions of money listed below.
- Money is to be a unit of account — the thing that goods and services are priced in terms of, for example on menus, contracts or price labels. In modern economies the unit of account is usually a currency, for example, the USD in Zimbabwe. Obviously it would be difficult in a barter trade account to use goods as units of account. I remember when we were at St Augustine’s Mission in the early 1980s. Every Saturday we would be given bars of soap to do our laundry. However we would go to the local market in the school grounds where we would trade bars of soap or portions thereof with roasted groundnuts (mutetenerwa). So we attempted to use soap as a unit of account. This however results in a lot of inconsistences. So money as a unit of account provides something that is consistent and easily divisible to allow for change as well as fairness in the pricing mechanism.
- Money must be a medium of exchange — something that people hold because they plan to swap it for something else, rather than because they want the good itself. For example, in some prisoner of war camps during the Second World War, cigarettes became the medium of exchange in the absence of money. Even non-smokers would have been willing to exchange things for cigarettes; not because they planned to smoke the cigarettes, but because they would later be able to swap them for something that they did want.
These functions are all closely linked to each other. For example, an asset is less useful as the medium of exchange if it will not be worth as much tomorrow — that is, if it is not a good store of value.
To avoid a currency losing its store of value and undermining its role as medium of exchange, it is the role of the Central Bank to safeguard the value of its currency. Although the medium of exchange needs to be a good store of value, there are many good stores of value that are not good media of exchange. Houses, for example, tend to remain valuable over quite long periods of time, but cannot be easily passed around as payment.
Money is an essential part of moving from a subsistence economy, to an exchange economy. In a subsistence economy, everyone consumes only what they produce. In an exchange economy one uses money to trade or purchase what they need but cannot produce.
Source: “Money in the modern economy: an introduction”.By Michael McLeay, Amar Radia and Ryland Thomas of the Bank of England ’s Monetary Analysis Directorate