What in Inflation (may’12)? What is money? Discuss the functions of money (May’12).

Q. What in Inflation (may’12)?

Inflation: Inflation can be defined as a sustained or continuous rise in the general price level or, alternatively, as a sustained or continuous fall in the value of money.

Several things should be noted about this definition. First, inflation refers to the movement in the general level of prices. It does not refer to changes in one price relative to other prices. These changes are common even when the overall level of prices is stable and the rise in the price level must be somewhat substantial and continue over a period longer than a day, week, or month.

Q. What is money? Discuss the functions of money (May’12).

Money: Money is any good that is widely used and accepted in transactions involving the transfer of goods and services from one person to another. Economists differentiate among three different types of money: commodity money, fiat money, and bank money.

The functions of money: The function of money can be categorized in two classes which are provides below:

1) Primary or main function

2) Secondary or Supporting function.

Primary or main function: Money is often defined in terms of the four functions or services that it provides. Money serves as a medium of exchange, as a Measure of Value, Standard of Deferred Payments and as Store of Value.

a) Medium of Exchange: The most important function of money is to serve as a medium of exchange or as a means of payment. To be a successful medium of exchange, money must be commonly accepted by people in exchange for goods and services. While functioning as a medium of exchange, money benefits the society in a number of ways:

(i) It overcomes the inconvenience of baiter system (i.e., the need for double coincidence of wants) by splitting the act of barter into two acts of exchange, i.e., sales and purchases through money.

(ii) It promotes transactional efficiency in exchange by facilitating the multiple exchanges of goods and services with minimum effort and time,

(iii) It promotes allocation efficiency by facilitating specialization in production and trade,

(iv) It allows freedom of choice in the sense that a person can use his money to buy the things he wants most, from the people who offer the best bargain and at a time he considers the most advantageous.

b) Measure of Value: Money serves as a common measure of value in terms of which the value of all goods and services is measured and expressed. By acting as a common denominator or numeraire, money has provided a language of economic communication. It has made transactions easy and simplified the problem of measuring and comparing the prices of goods and services in the market. Prices are but values expressed in terms of money.

Money also acts as a unit of account. As a unit of account, it helps in developing an efficient accounting system because the values of a variety of goods and services which are physically measured in different units (e.g, quintals, metres, litres, etc.) can be added up. This makes possible the comparisons of various kinds, both over time and across regions. It provides a basis for keeping accounts, estimating national income, cost of a project, sale proceeds, profit and loss of a firm, etc.

To be satisfactory measure of value, the monetary units must be invariable. In other words, it must maintain a stable value. A fluctuating monetary unit creates a number of socio-economic problems. Normally, the value of money, i.e., its purchasing power, does not remain constant; it rises during periods of falling prices and falls during periods of rising prices.

c) Standard of Deferred Payments: When money is generally accepted as a medium of exchange and a unit of value, it naturally becomes the unit in terms of which deferred or future payments are stated.

Thus, money not only helps current transactions though functions as a medium of exchange, but facilitates credit transaction (i.e., exchanging present goods on credit) through its function as a standard of deferred payments. But, to become a satisfactory standard of deferred payments, money must maintain a constant value through time; if its value increases through time (i.e., during the period of falling price level), it will benefit the creditors at the cost of debtors; if its value falls (i.e., during the period of rising price level), it will benefit the debtors at the cost of creditors.

d) Store of Value: Money, being a unit of value and a generally acceptable means of payment, provides a liquid store of value because it is so easy to spend and so easy to store. By acting as a store of value, money provides security to the individuals to meet unpredictable emergencies and to pay debts that are fixed in terms of money. It also provides assurance that attractive future buying opportunities can be exploited.

Money as a liquid store of value facilitates its possessor to purchase any other asset at any time. It was Keynes who first fully realised the liquid store value of money function and regarded money as a link between the present and the future. This, however, does not mean that money is the most satisfactory liquid store of value. To become a satisfactory store of value, money must have a stable value.

Secondary or Supporting function:

a) Transfer of Value: Money also functions as a means of transferring value. Through money, value can be easily and quickly transferred from one place to another because money is acceptable everywhere and to all. For example, it is much easier to transfer one lakh rupees through bank draft from person A in Amritsar to person B in Bombay than remitting the same value in commodity terms, say wheat.

b) Distribution of National Income: Money facilitates the division of national income between people. Total output of the country is jointly produced by a number of people as workers, land owners, capitalists, and entrepreneurs, and, in turn, will have to be distributed among them. Money helps in the distribution of national product through the system of wage, rent, interest and profit.

c) Maximization of Satisfaction: Money helps consumers and producers to maximize their benefits. A consumer maximizes his satisfaction by equating the prices of each commodity (expressed in terms of money) with its marginal utility. Similarly, a producer maximizes his profit by equating the marginal productivity of a factor unit to its price.

d) Basis of Credit System: Credit plays an important role in the modern economic system and money constitutes the basis of credit. People deposit their money (saving) in the banks and on the basis of these deposits, the banks create credit.

e) Liquidity to Wealth: Money imparts liquidity to various forms of wealth. When a person holds wealth in the form of money, he makes it liquid. In fact, all forms of wealth (e.g., land, machinery, stocks, stores, etc.) can be converted into money.