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Functions of Money and its Demand

Last updated date: 04th Mar 2024
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Functions of Money and its Demand in Detail

Money has changed its face and forms through the ages, yet its importance in human life can never be denied. In ancient times, people used cowry shells in Africa, wampum (strings of beads) in America, and stone wheels in Yap in exchange for goods and services. The significance of money lies in the fact that it lets you have more control over your life. Money allows you to give back to your community in ways that you would like to.

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Introduction of Functions of Money and its Demand

Money is that commodity which you can use to run your life. In earlier days, you could exchange goods for goods, but now it is money which one exchanges for any product or service. People save up for the future since they realize the significance of money. Few important facts about money are:

  • Money can serve as a good servant, but not a master - You should be the one controlling money, do not let money control you.

  • You can earn money in many ways but sustaining it is an art.

  • Money stays in the hands of people who know its value.

We use money in our everyday life by earning and spending it. The economic definition of money says it is a commodity that can be used as a final payment for goods and services worldwide.

Money is not an end in itself, you cannot eat rupees. Money has its use in purchasing and selling goods and services. Buyers and Sellers both must accept money as a medium of exchange to give it any value.

Functions of Money

In earlier days, people exchanged goods or services for another, which was called the barter system. In the modern economy, the barter system has proved to be highly inefficient. In an economy where no money exists, two parties should want the things that each has to offer. If one party does not have things that are needed by another party to obtain their goods or services, then an exchange is not possible. Money has solved all the issues which revolved around the barter system with the four main functions money performs in our lives:

  1. Store of Value:

If you earn 10,000 rupees, you can hold it with you till you want to spend it, or keep it in the bank and earn interest. In contrast, any other commodity like corn would rot if you hold on to it. For that matter, if you own a pair of shoes and want to use it for exchange, it might go out of style and have no value to exchange it with anything you want at a later point in time. Money, you know, will hold its value the next day or next year too. So, you need not spend it immediately. Money is an efficient store of value though it has its pitfalls. Money is sure to lose its buying power over time, and inflation can erode the purchasing power of money with time.

  1. Unit of Account:

Money is like a ruler or yardstick which helps you measure other values in an economic transaction.  It is a common denominator or accounting method which makes trade-offs easy to understand. For example, for 1000 rupees you can pay an engineer to fix your laptop or buy two shoes for 500 rupees each. This is a measure of value that is the same across commodities and services.

  1. The Medium of Exchange:

Buyers and sellers use money as an intermediary between their transactions. So, instead of paying someone for his services in corners, one now pays in money. The transaction demand for money makes you confident that when you walk into a store, the cashier will accept money for the items you buy.

  1. Standard of Deferred Payment:

You can make purchases today which you can pay at a later date in the form of money. Any future agreement like a loan is stated in monetary terms. This nature of money allows us to buy goods and services today and defer its payment to a future date.

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What is Demand for Money?

The demand for money alludes to the amount of money an individual wishes to hold on to. This holding of assets in the form of money could be either cash or in banks. The demand for money depends on many factors like the income of an individual, interest rates, inflation, uncertainty about the future, etc. Demand for money is also termed as liquidity preference.  The image below depicts that the demand for money is inversely proportional to the rate of interest, which means two things:

  • If interest rates are high, people prefer to hold on to bonds rather than money. Bonds give a high-interest payment.

  • When interest rates go low, bonds do not give as many returns hence people like to hold money.

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There are three major kinds of demand for money:

  1. Transaction Demand for Money - Money is needed for most of the transactions in our day to day life. As per the quantity theory of money, the transaction demand for money is a function of income and price, given the circulation velocity remains stable. So if there is a rise in income, it will lead to a rise in the demand for money.

  2. Precautionary Motive - Money might be needed for unexpected expenditures or emergencies (like medical, car repair, etc.) in the future. So, the demand for money is based on payments which are needed immediately; hence people need to hold on to money to be able to do that.

  3. Speculative Motive - Money is a form of asset, and like any asset, its demand depends on the rate of return and opportunity cost. In general, money does not provide any rate of return, and inflation causes money to depreciate. Its opportunity cost depends on how much interest rate one can gain by lending money to someone else. The speculative motive for demanding money comes into play in scenarios when holding money is less risky than using it to lend it or invest in any other asset. For example, if someone speculates the stock market to crash, they would sell their stocks to hold on to money since the stock values are going to decrease and give them losses.

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FAQs on Functions of Money and its Demand

Q1. What is Meant by Representative Money?

Ans: A certificate or a token that can be exchanged for commodities is called representative money. For example, you might have gold which you keep in a bank vault and carry a paper certificate to denote the value of the gold you have in the bank. This certificate is good to be redeemed for gold at any time. A certificate is also a safer and easier way to carry your actual gold asset. People, over time, have come to trust the paper certificate as much as they trust gold. Representative money is what gave way to fiat-money, which is used in modern economies of today.

Q2.  Is the Demand for Money Stable?

Ans: We have seen that the demand for money fluctuates with interest rates and incomes. Apart from these factors, few others can affect the demand for money:

  • Changes in Technology - With the advent of debit cards, easy access to current accounts, etc., holding cash has lost its value. Technology enables people to hold less cash.

  • Credit Availability - The precautionary motive of demand for money falls if people have the ease to borrow to take care of their short term difficulties.

  • The Behaviour of Asset Prices - Sometimes, psychological factors like over-exuberance can cause volatile markets. These are called bubble periods during which demand for assets increases, and the demand for holding money decreases.