This article describes the four basic functions and forms of money. It also explains the main measures of the money supply including Narrow Money and Broad Money.
Functions of money
Money has four main purposes. To be considered as money something must be:
- A medium of exchange
- A unit of account
- A store of value
- A standard for deferred payment
1. A medium of exchange
Money is used to buy and sell goods and services and must be an acceptable form of payment to parties in a transaction. Before money was used as a medium of exchange people were forced to barter, the exchange of goods. In fact, bartering is inefficient since the item you have to trade may not have value at that moment in time. For example, you may have eggs to trade for milk, but the person with surplus milk does not require your eggs.
2. Unit of account
Money acts as a measure of the value of goods and services and provides consumers with signals as to the value of goods and services and what good may be rare. Additionally, money tells suppliers when there is a shortage or surplus in the market. In a barter system, or at times of very high inflation, money is not a useful unit of account.
3. Store of value
Money has to retain its value as households do not spend their money as soon as they receive it. Usually households prefer to keep their money and spend when it is convenient. However individuals only do this when the value of what they can buy in the future is the same or almost equal to what they can buy today. In times of high inflation money fails to store its value.
4. Standard for deferred payment
A bank, business or person will only lend money if it is believed they can receive the full value back. For example, a firm will only accept delayed payment (give trade credit), if they believe the value in the future will be roughly equal to the current value. In times of high inflation, money fails to act as a standard for deferred payment.
Forms of money
In a modern economy, there are many things classified as money including:
- Cash. Notes and coins, the most liquid form of money.
- Current accounts. Money in current accounts. This is money paid into the bank and can be withdrawn immediately.
- Near money. These are assets which are less liquid than current accounts or cash. It includes money in deposit accounts and savings which are hard to access such as long term savings accounts. Withdrawal from such accounts requires several weeks before money can be obtained and used.
- Non-money. Assets such as machinery or vehicles, shares of stock in private limited companies and public limited companies as well as property such as house or apartment are all financial assets that can be converted into money.
Measures of the supply
The money supply is defined as the total amount of money and money substitutes in an economy. In fact, there are in fact many ways of measuring the money supply, but in the UK the most common types are ‘narrow’ and ‘broad’ money.
A. Narrow money. Money which can be used as a medium of exchange e.g. cash and current accounts. In the UK, narrow money is formally referred to as M0. In fact, M0 is the calculation of money held as cash by the public, banks, business and even the central bank such as Bank o England. The M0 figure is important since it helps keep account of consumer demand and spending. Knowing this allows banks and business to be able to keep up with demand. Demand for money is the amount which you want to keep in liquid form at one particular time.
B. Broad money. Narrow money plus ‘near money’. Broad money is referred to as M4 in the UK. It includes physical cash in the form of notes and coins but is so much more. It also includes money held in deposits such as public cash in bank accounts and money held by banks ready for lending.
M0, M1, M2, M3, M4 represent different measures of money supply.
M0: A material currency – cash itself.
All notes, coins and bearer certificates convertible on demand – depositor reserves of banks kept in physical cash.
M1: M0 + checking deposits.
M2: M1+ short-term deposits and money market funds with within 24-hour maturity.
All the money in savings accounts, certificates of time deposits in banks up to USD$100,000 (or equivalents) and money market accounts.
M3: M2 + long-term deposits and money market funds with over 24-hour maturity.
All large time deposits in banks, institutional money market funds, short-term repurchase agreements (repos) and larger liquid assets.
M4: M0 + cash in bank accounts.
All the cash not just notes and coins in circulation.
In summary, money has various forms, not only notes and coins, but also savings and deposits. Money allows exchange, spending and payment to be delayed and has value. M0 (‘narrow’) and M4 (‘broad’) money are different ways of looking at the money supply.
