Money in Economics: Functions and Types of Money

Photo of Money: Functions of Money, Types of Money and Uses in Economics

The concept of money in Economics refers to any commodity or item or material that can be used as a means of exchange for goods and services. The Functions and forms of Money as discussed in economics will be explained. For money to be used as a means of exchange, it must fulfill some criteria such as being acceptable by people for the exchange of goods or services and also for settlement of debts.

Money is any commodity that is generally acceptable in a community or society for payments of goods and services and also for the settlement of debts.

It is money that makes the world go around and every economy relies on it for the exchange of goods and services. It allows individuals to obtain what they need, which is the necessities for life. Money represents something that is of high value and it has helped in solving the problems that are associated with the barter system thereby raising the standard of living.

Money, over the years, has raised the level at which people live in luxury which was almost impossible under the barter system which was the oldest form of trade. As a unit of account, money is a standard unit, socially acceptable as a standard unit for measuring the prices of commodities. This is where the history of money started, we shall briefly explain the evolution of money below.

Definition of money by different economists

D.H Robertson defined money as “anything that is widely accepted in payment for goods or in the discharge of other kinds of business obligation, is called money.”

Seligman stated that money is“one thing that possesses general acceptability.”

Prof. Ely pointed out that “Money is anything that passes freely from hand to hand as a medium of exchange and is generally received in final discharge of debts.”

“Money is that money does,” says Prof. A. Walker.

Crowther defines money as “anything that is generally accepted as a means of exchange (that is, as a means of settling debts) and at the same time, acts as a measure and a store of value.”

Evolution of money

Historically, money evolved through different stages such as commodity money, metallic, paper, credit, and plastic money. This evolution took place according to time, place, and circumstances.

Commodity money

This was the barter system where every commodity that the people chose through mutual consent was acceptable as money. It was the exchange of goods for goods These commodities include salt, skins, utensils, etc, which was in the earliest period of civilization.

Metallic money

As human civilization kept progressing, commodity money evolved to metallic money where metals such as gold and silver were the means of exchange. Here, it was easier to handle them as well as ascertaining their quantity.

Paper money

Because of the risk and inconvenience, it takes to carry gold and silver from one place to another, the invention of paper money came about. This was the next stage of how money developed, which is an important stage. The central bank of each country is in control of this paper money.

Credit money

The emergence of credit money took place partly alongside paper money where people deposit their cash in banks. They can withdraw their cash anytime through the use of cheques. We can also refer to this stage as bank deposits.

Plastic money

This is the latest form of money which takes the form of credit cards and debit cards. This helps in reducing the burden of carrying cash to carry out transactions.

Trade by barter system

Trade by barter means the trade of goods and services between two or more parties without the use of money. In this system, people are involved in providing one good or service in return for another good from others. Say, two people have a negotiation to determine the relative value of their products and services, offering these goods to one another in an even exchange.

For example, one party has a goat and needs a yam. He will have to look for another party who has a yam and needs a goat. This implies that parties under this form of commerce exchange goods with one another on the basis of estimated equivalents on the prices of goods.

The barter goes smoothly if the parties involved agree with what the terms of trade imply, or enter into an agreement of trade. Though the system was not efficient enough, individuals, firms, and countries could benefit from it especially when they do not have hard currency to obtain the needed goods and services.

Before money developed, people engaged in barter to obtain the goods and services they need. This system made trading become inefficient because it does not provide the transferability and divisibility that will make trade efficient.

Now, this form of trade requires that the parties involved enter into an agreement and devise means of determining the number of yams that are worth certain parts of the goat.

Advantages of a trade by barter

With the existence of money, bartering can allow people to trade those goods that they own while saving their cash in hand for other expenses they cannot pay for through bartering.

It can build a stronger personal relationship between trading partners. In other words, it is of psychological benefits to the parties involved. It also assists with building professional networks as well as marketing their business.

Bartering is a way of obtaining needed goods and services without a need to pull out money from the pocket. In some cases, it can result in optimal resource allocation by the exchange of goods that represent similar worth. This can help economies achieve equilibrium, where demand is equal to supply.

Problems of a trade by barter

Double coincidence of wants

The barter system is associated with the problem of double coincidence of wants. Individuals face this problem thereby making it very difficult to exchange or sell goods and services. This is where a person who has one commodity and wants to obtain another must have to look for someone/ another party who has what he wants and wants what the initial person wants. In this case, the exchange takes place when the wants for the exchange of goods of different persons coincide.

No standard unit of account

An economy operating under the barter system lacks a standard unit of account. It is very difficult to measure and quote the prices of commodities. Usually, measuring the price of products was not accurate. Overrating or underrating the value of a commodity is usually unavoidable.

The problem of divisibility and transferability

People face the problem of the impossibility to divide or subdivide goods without losing their value. The impossibility of dividing goods for the purpose of the exchange was a great obstruction to the growth of trade. For goods that are perishable, there is a very high tendency of losing value or wastage.

Due to lack of transferability, trade by barter for goods becomes tiring, stressful, confusing, and inefficient. Even if the person in need of yam finds another person who is in need of a goat and has yam, the measure of value will be quite inefficient. This is because they may not consider some pieces of yam to be worth a complete goat.

Lack of information

The barter system requires a very great deal of information to facilitate the exchange of goods. Without relevant information, stress snd loss of value will be incurred. There has to be a medium of exchange to solve this problem.

The problem of large-scale and expensive production feasibility

Another problem that is peculiar to the barter system is that large-scale production is usually not feasible. Also producing costly goods is not feasible. For example, someone who has the technical know-how of producing a car will not have the incentives to do so. This is because, under this economy, it will be difficult to find a prospective buyer who has the resources sufficient to give out in return for the car. The carmaker also needs necessities of life such as clothing, shelter, and other commodities for daily consumption.

The range of products being produced has to be smaller than that of the modern economy. This is because, in the early barter economy, the primary aim of trade is to meet the needs of common units of account. It was from the problem of this system of trade that the need for a medium of exchange came about. The invention of money came about to overcome these difficulties.

Modern trade by barter

Though the barter system is commonly associated with ancient time commerce, it has been modernized. Modernization has reinvented the barter system through the internet, Here, the online barter system came into existence. It became more popular with small-scale businesses after the financial crisis in 2008 which amounted to a great recession.

The New York Times reported that trade by barter had a double increase in membership in 2008.

As prospects and sales decreased, most small businesses turned to barter trades to generate revenue. This enabled them to access more customers for their goods as well as accessing other goods and services by using unused inventory.

People also used custom currency which they could hoard and use to purchase other services like hotels lodging during vacations. During the financial crisis, the estimate stated that the barter system touched $3 billion.

Characteristics of money

Money must possess the following qualities;

Acceptability

Money must be generally acceptable to citizens of a country as a medium of payment and settlement of debts. everyone has to be confident that others will accept the commodity as a means of exchange of goods and services.

Homogeneity

Money has to be identical with others so that when others see it, they will know that it is money. Let the material for each unit of money be the same in size, shape, color, and quality.

Divisibility

Money must be divisible into smaller units or denominations. This is to make payments possible in smaller units based on the user’s desire.

Relative scarcity

Money must be relatively scarce in order for it not to lose its value. On the other hand, it must not be too scarce so that it will not be too valuable to exchange it for smaller goods.

Portability

Money should be easily transmissible. It should not be bulky, it should be light so that it will be easy for one to carry it from one place to another.

Stable value

The value of money must be relatively stable over a period of time. The value must not fluctuate at frequent intervals. When its value becomes unstable, people will lose confidence and this will affect its uses as a store of value and a standard for deferred payment.

Durability

Money should be durable, that is, one should be able to keep it for a long period of time without it getting spoiled or damaged. It should be able to withstand some levels of rough handling.

Recognizability

Members of jurisdiction should be able to recognize money on sight and be able to detect counterfeit ones.

Types of Money

There are different types of Money that were used in the olden days and also the types used in today’s world. The types of money consist of the old forms and new forms of money.

Old Forms of Money

These are the types of money used in the olden days. These forms of money are still available today but are not used again as means of exchange.

Examples of these old forms of money include;

  1. Beads
  2. Cowrie shells
  3. Manilla this was a form of money that looks like a bracelet.
  4. Elephant tusks
  5. Bars of metals
  6. Salt
  7. Cows
Cowries are types of money used in olden days. These are old forms of money.
Cowries are types of money used in the olden days. These are old forms of money.

 

These old forms of money were used in ancient times. The disadvantages of these old forms of money are: there is no scarcity and no form of control over the availability this means that anyone can go in search of cowries or metal bars, using them as a medium of exchange thereby making it common. When a form of money becomes too common, it tends to lose its value. Another problem with these old forms of money is that some animals were going into extinction because of the use of their parts as money this includes the use of the tusks of elephants and this caused people to kill more elephants because of the tusks.

A Manilla is a metallic bracelet that was used as an old form of money in west africa.
A Manilla is a metallic bracelet that was used as an old form of money in West Africa.

 

New Forms of Money

These are the forms of money used in modern days or the new era. The new forms of money have greater advantages than the old forms, they came about as a result of the limitation of the old forms of money.

The following are the lists of new money;

  1. Coins
  2. Banknotes
  3. Bank deposit
  4. Quasi-money (near money)

1. Coins

A coin is a type of money that is made from metals such as Gold, Silver, Copper, Zinc, etc. The values of these metals are not the same because some are more expensive than others.  This brought about two types of coins namely the standard coins and token coins.

A Standard gold coin. This type of money has its face value printed on it. The number printed on it is equivalent to the amount of gold used in making it. Most coins that are used today are token coins and no more standard coins.
A Standard gold coin. This type of money has its face value printed on it.

A Standard gold coin. There is a face value printed on this form of money. The number printed on it is equivalent to the amount of gold used in making it. Most coins that are used today are token coins and no more standard coins.

 

A Standard coin

There is usually a face value printed on the standard coin. This means that if the amount of 1 gram of gold costs 10,000, then 1 gram of gold would be used for making a coin and $10,000 would be printed or stamped on it. If 1 gram of silver costs $100, then 1 gram of silver will be made into a coin and 100 would be printed on it.

A Token coin

a token coin does not contain the face value of the amount printed on it and the face value of the amount printed on it is always higher. This means Zinc could be used for making a $10 coin but the weight of the zinc used for making the coin is not worth $10.

Most of the coins used these days are token coins but the first coins were initially made of gold and silver they were stopped because people started adding inferior metals to the precious metals used initially, making the face value of coins to be less than the amount printed on them; hence the creation of token coins in today’s world.

2. Bank Notes

Banknotes are forms of money made of paper and designed in a unique way to make it difficult to make counterfeit. Banknotes are usually printed by the central bank of a country and the amount of the money is printed on the designed paper. When banknotes were first printed, they were printed according to the amount of gold a country has in store. Which means that if America has 2 billion dollar worth of gold, they will make different amount of banknotes only up to 2 billion dollars combined. But with time, the government increases demands for money, and the scarcity of gold made countries start printing banknotes to exceed the amount of gold they hold in store. Therefore, the Fiduciary issue is the amount of money that that gold or precious metal does not back up. We can say that money is on Gold standard if gold backs up all the paper money in a country. In reality, there is no country on a gold standard in this era but there was some years back when paper money was first used.

Naira notes: these are bank notes, which are paper types of money used in Nigeria
Naira notes: these are banknotes, which are paper types of money used in Nigeria

 

3. Bank deposits (or Bank money)

This type of money refers to deposits kept in current accounts of commercial banks that can be withdrawn with cheques.

4. Quasi-money (near money)

Quasi money is not a real type of money. It is not backed by the law of the country. They are created to increase flexibility and are used on a particular platform to make transactions easier. When you want to make use of quasi-money to buy or sell in real life, you have to convert it to the banknote that is backed by the country before withdrawing and using it.

Examples of quasi-money include bills of exchange, money orders, postal orders, cheques, and promissory notes. Some new forms of quasi-money used online today include Amazon gift cards, skrill, and cryptocurrency (bitcoin, ethereum, etc). These forms of quasi-money are not backed by the law and transactions with these forms of money are only used on the platforms you can only convert them to real money before using it to buy in real-world markets.

Any form of money that is backed by the law and which people are compelled by law to use as a means of exchange is called legal tender. These include coins and banknotes issued by the central bank of a country. Coins can be used as legal tender but the more the amount, the heavier and cumbersome they become and so may not be used as legal tender up to a certain amount but banknotes or paper money can be used as legal tender up to any amount because it is easier to carry and has higher notes than the coins.

Functions of Money

The 5 major functions of money include a medium of exchange, a measure of value, store of value, a standard for differed payment, and unit of account. Other functions include an increase in productivity and one-way payment. The uses of money are being explained in detail below.

Medium of exchange

The use of money has increased flexibility in buying and selling goods and services and has helped to overcome the problem of double coincidence of wants found in the barter system. You are free to spend it on goods and services at your convenience because it is generally acceptable. This saves time, effort and prevents frustrations.

Measure of value

Since the value of goods and services are expressed as prices, money can be used to measure the value of these goods and services according to their prices. This means that the higher the price, the more valuable it is.

Unit of account

Because the value of goods and services are measured by their prices, the records of the number of goods in the store can be kept in the form of prices and we can also use it to keep records of transactions. You can estimate the number of transactions according to the amount of money in an account and the price of each good and service.

Store of value

Money is the most convenient commodity used for storing wealth as it can be used anytime and can be stored over a long period without getting spoiled. This is a different case from the barter system where the exchanged goods can get spoiled.

The standard for deferred payments

Due to the existence of money, payments on credit are available, which is a deferred payment. You can collect goods on credit and pay later.

Money increases productivity

Money makes it possible for division of labor to occur and therefore shortens the time frame it takes to achieve the same project that would have taken much time if it were to be done by one person. Take for example, when building a house, you need an architect, builders, carpenters, electricians, and interior designers money has made it possible to settle all those involved with just a medium of exchange (which is money) unlike in the barter system where you would have had serious difficulty in getting all those involved and exchanging goods with their services. By being able to get services in time and all working on the same project, productivity is increased and time is saved.

One-way payments

not all transactions involving buying and selling. Things such as payment of tax involve giving money to the government getting anything instant in return; the same applies with giving gifts no reciprocal payment in return. This one-way payment is made possible with money and the person receiving it can instantly use it to get what he or she desired immediately without having to look for someone who needs what has been donated to exchange for what is desired.

Currency

In the most specific sense, a currency is a medium of exchange for goods and services. Specifically, it is money that comes in any form when in use/circulation generally acceptable at its face value as a means of exchange usually issued by the government. It is primarily a medium of exchange in today’s world which replaced the barter system of trading.

A clearer u understanding of currency is that it does not just imply money, it is a generally accepted medium of exchange that the government issues, and it circulates within its jurisdiction. This means that every jurisdiction (country) has its own currency. These currencies do not circulate outside their own jurisdictions.

The value of a currency is not stable as it fluctuates constantly in relation to other currencies. Here the currency exchange market exists to facilitate international trade and balance currency differences. Also, these markets exist as a means of generating profits from these fluctuations.

Examples of currencies include the Nigerian Naira (NGN), the US Dollar ($), Euro, Pounds, etc.

Currency exchange

Currency exchange refers to a licensed business that allows customers to have access to exchange one currency for another. Usually, currency exchange of physical/tangible money takes place at teller stations over the counter. These stations are present in places like banks, airports, hotels, and resorts. Now, currency exchange generates its profit by charging a nominal fee or through the bid-ask spread in a currency. Well, currency exchange is not the same as a foreign exchange which is popularly known as Forex.

While currency exchange allows customers to swap or exchange one currency for another, forex trade is a market where traders and financial institutions trade in currencies. Currency exchange can either be physical or online, while forex trading is usually online.

In currency exchange, you convert your local currency to a foreign currency in order to facilitate international trade.

Currency conversion

Currency conversion is the measure of a nation’s currency against that of another country. A country’s money value can become either weaker or stronger against other currencies. A currency conversion rate is a ratio between currencies usually in the international/foreign market.

The convertibility of a currency is essential in a global economy and it is relevant for international trade. When it becomes difficult to convert a currency, it amounts to trade barriers to foreign investment and tourism.

Exchange rate

The exchange rate is the current value of a country’s currency versus the current value of another country’s currency. That is a currency’s value in exchange for the currency of another nation. Exchange rates are not constant, they fluctuate in response to the economic and political events in a nation. These fluctuations are the factors that create the market for the trade/exchange of currencies.

An example of an exchange rate is a Nigerian buying $1 at N475 (1 Dollar at 475 Naira).

An exchange rate consists of the free-floating or restricted currency. The rise and fall of a free-floating exchange rate depend on the changes or forces in the foreign exchange market. Restricted currencies usually have their values based on government standards.

Frequently asked questions

What are the 4 types of money?

The new forms of money came in four major categories; Coins, banknotes, bank deposits, and quasi-money (near money).

What is money in simple words?

Money is anything or commodity that is generally accepted as a medium of exchange.

What are the uses of money?

Money serves as a store of value, medium of exchange, standard for deferred payment, measure of value, unit of accounts, one-way payment, and increase in productivity. See the functions of money above.

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