Monetary Economics/Economic Uses of Money

The Classical Function of Money
Classical economists modelled the demand for money in terms of its use as a unit of account. Money can be used to denote the value of goods, enabling participants in a transaction to measure the value of the transaction item in a common factor. This reduces transaction costs, especially information costs, as there is less possibility of adverse selection.

Under a barter system with no common unit of accounting, a successful transaction depends on the occurrence of a coincidence of wants. This could be surmounted by one party giving credit to another, that is, for the party to accept payment in kind in the future for a good sold today. Even if there were no credit risk (i.e. payment could be strictly enforced) the selling party would still have to gather information regarding the future worth of the good he is contracted to be paid in.

In addition, the selling party would have to know the values of all goods in the economy, denominated in the values of every other good. This causes the information costs required to trade to rise significantly.

Example - the generalised case of n commodities
If there are 2 commodities in the economy, for trade to take place only one price need be known by the trading parties. If there are 3 commodities, the price of commodity A in terms of commodities B and C must be known, and the price of commodity B in terms of commodity C, giving a total of 3 prices. And so on, as the number of commodities rises. For $$n$$ commodities the number of prices is given by:

$${n(n-1)} \over 2$$

Given the presence of a universal denominator of value however, the number of prices that must be known is reduced to $$n$$. (Meltzer, 1998)

The Price Level
Transactions denominated in a common unit of account would determine prices, and it would then be possible to aggregate these prices into a price level for the economy. Given the price level, it is therefore possible to determine inflation. Here money does not affect the real value of the transactions in the economy. Money would therefore be said to be neutral, if the unit of account function were the only function of money in the economy.

The Standard of Deferred Payment
A related function is the standard of deferred payment, whereby money is defined as that entity used to specify future payments for current transactions. Here there is a relation to the store of value function, as the nominal value of money now and at the payment time in the future is invariant, making the contracted future payment affected by the interest rate. Of course, the real value of the future payment is also affected by inflation.

Money under the Unit of Account Function
Put simply, anything that enables transactions to be valued. The definition of money used here can constitute the money stock, bank deposits, etc etc. There is a slight distinction between the money stock defined under the function of money as a means of exchange and the function of money as a unit of account, as prices need not be defined in the currency used as a means of exchange. However in this case an exchange rate between the currency used as a means of account and the currency used as a means of exchange must be known. The money stock is the amount of money as defined under the means of exchange function.

Example - The island of Yap
On the island of Yap in Micronesia, large stones were used as money. Due to the problems associated with transporting such stones, islanders soon moved to an exchange system whereby claims on the stones were used in a transaction. Here the unit of account was the stones, while the means of exchange was the claims (written down on paper). However, there was a well defined exchange rate between claim and stone.

The money supply here does not encompass both the stock of claims and the stock of stones however. It consists of the stock of stones, or the stock of claims as defined by the exchange rate between claim and stone.

Money and Bonds
To analyse this motive for holding money properly we need to distinguish between 'money' and 'bonds'. Bonds here are defined as any sort of asset that pays interest, while money does not pay any interest income. We further assume that the asset allocation choice is purely between money and bonds, that is, a person can only hold either money or bonds, implying that holding money incurs a cost - that of interest income foregone.

The Speculative Motive
Economic agents who hold money for this motive hold it because there is the price of money is invariant to the rate of interest, unlike bonds. It protects the agent from any risk associated with changes in the interest rate.

In this instance, money acts as a store of value, allowing the agent to transfer real purchasing power from the present to the future (assuming inflation is zero). Bonds are not as useful as money here because their value changes with fluctuations in the interest rate.

Money under the Asset Function
So what constitutes money under this definition? Essentially, anything that doesn't pay interest income, but can be used as a store of wealth, and does not change its nominal value under changes in interest rates. In this case, interest bearing bank deposits are not counted as money. The definition of money is likely to be confined to the money stock and non-interest bearing bank deposits.

The Transactions and Precautionary Motives
These motives for holding money were initially postulated by Keynes. The transactions motive is simply that money is required in order to make transactions, and therefore any economic agent who wants to make transactions will want to hold money.

The precautionary motive is related to the transactions motive. In an economy where there is uncertainty regarding the timing of economic transactions, i.e. agents are not certain when they will be able, or want, to make a transaction, an economic agent will want to hold a certain amount of money at all times in order to have some on hand each time he decides to make a transaction. It also means holding of money for a certain purpose like: paying salary/wages to the workers, primarily intended to meet expenditures of the company.

Money under the Means of Exchange Function
Here, anything that can be used in a transaction can be considered money. This definition is fairly broad, encompassing the money stock, bank deposits, mutual funds, funds deposited in checking accounts, etc.