Wednesday, May 18, 2011

What are the basic functions of money? Explain in detail the derivative functions of money.

What are the basic functions of money? Explain in detail the derivative functions of money.

Answer. Money is anything that is generally accepted as payment for goods and services and repayment of debts. The main functions of money are distinguished as: a medium of exchange, a unit of account, a store of value, and occasionally, a standard of deferred payment.

Basic Functions

Money as medium of exchange

In the economy, all goods and services are purchased with money. This reflects the function of money as medium of exchange. There should be sufficient quantity of money supply circulating in the market for money to fully carry out this function.

In the liberal economy, money in circulation has cost. Money that has cost becomes limitation for production. It also leads to decrease in demand.

When through the system based on interest rate money is withdrawn from circulation (which is one of the key concepts in liberal economics), it hampers a normal exchange in the economy. Liberal economy creates obstacles to money return into the markets by means of additional money supply and opens the door for “money re-sellers”. This limits the ability of society to consumer and even meet the simplest human needs.

The population of Earth is growing. This growing population does not have satisfactory consumption not because the volume of production is not sufficient, but because people do not have money enough for consumption.

In the National Economic Model, money in circulation has no cost. Due to this money returns to the markets, it freely circulates and stimulates real economic activities. The National Economic Model promotes intensive exchange of goods and services and creates conditions for their fair exchange based on their true value.

In the National Economic Model, the supply and demand equilibrium is achieved through the money supply subject to mathematically calculated indicators of demand and supply. Such approach is a formula to secure sustainable economic growth, which is the main objective of economic policy.

Unit of account

A unit of account is a standard monetary unit of measurement of the market value/cost of goods, services, or assets. It is a well-known function of money. It lends meaning to profits, losses, liability, or assets.

A standard unit of account allows meaningful interpretation of prices, costs, and profits, so that an entity can monitor its own performance and its shareholders can make sense of its past performance and have an idea of its future profitability. In modern economies, money in the form of currency usually serves the role of the standard unit of account. The use of money, under conditions of price stability, vastly improves the efficiency of market economies.

Unit of account is the main way of calculating a carrier or Ship owners liability in relation to carriage of goods contracts in which the Hague-Visby Rules apply.

Historic examples of units of account include the livre tournois, used in France from 1302 to 1794 whether or not livre coins were minted. Another was the European Currency Unit, used in the European Union from 1979 to 1998; its replacement in 1999, the euro, was also just a unit of account until the introduction of notes and coins in 2002.

The use of a unit of account in financial accounting, according to the American business model, allows investors to invest capital into those companies that provide the highest rate of return. The use of a unit of account in managerial accounting enables firms to choose between activities that yield the highest profit.

In economics, a standard unit of account is used for statistical purposes to describe economic activity. Indexes such as GDP and the CPI are so broad in their scope that compiling them would be impossible without a standard unit of account. After being compiled, these figures are often used to guide governmental policy; especially monetary and fiscal policy.

Derivative functions of money

Standard of deferred payment

A "standard of deferred payment" is an accepted way to settle a debt – a unit in which debts are denominated, and the status of money as legal tender, in those jurisdictions which have this concept, states that it may function for the discharge of debts. When debts are denominated in money, the real value of debts may change due to inflation and deflation, and for sovereign and international debts via debasement and devaluation. As of 2009, the US dollar and the euro are the most generally accepted standards for international settlements.


Deferred payment is based on enforceability of debts and rule of law, and is not used or rarely used when debts are unlikely to be collectable. For certain kinds of transactions (such as for illegal goods like drugs or weapons), gold or diamonds may be preferred as the medium of exchange — there being no recourse in case of counterfeit currency being used — and there is rarely any deferral of payment: if there is, it will most likely be stated in dollars.

Historically, there have been many times when creditors have had to hide from debtors to avoid being paid off in near worthless currency, typically following hyper-inflation.

Time-based currency such as Ithaca Hours establishes fixed amounts of human labour as the only standard of deferred payment.

Store of value

To act as a store of value, a commodity, a form of money, or financial capital must be able to be reliably saved, stored, and retrieved - and be predictably useful when it is so retrieved.

When you work, you are paid a wage. The portion of that wage that you do not spend gets saved. By saving money, you are able to spend some now and some later. In this way, money serves as a store of value, allowing you to trade current consumption for future consumption. Imagine if you were paid in bananas. Any bananas that you did not eat or trade immediately would rot, rendering you unable to enjoy the fruits of your labor at a later time.

When currency is stable, money can serve all four functions. When it isn't, such as during times of hyperinflation or when complex and volatile forms of financial capital are involved, it becomes important to identify alternative stores of value, of which common ones are:
™ real estate - actual deeds in protectible land
™ gold - once the basis of the gold standard
™ silver - once the basis of the silver standard
™ precious stones, and precious metals
™ collectibles, e.g. original art by a famous artist or antiques
™ livestock

While these items may be inconvenient to trade daily or store, and may vary in value quite significantly, they rarely or never lose all value. This is the point of any store of value, to impose a natural risk management simply due to inherent stable demand for the underlying asset. It need not be a capital asset at all, merely have economic value that is not known to disappear even in the worst situation. In principle, this could be true of any industrial commodity, but gold and precious metals are generally favored because of their demand and rarity in nature, which reduces the risk of devaluation associated with increased production and supply.

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