Part 1. The purpose of money

Money serves four main functions; these are:

A unit of account

A UK firm will present its profit and loss account and balance sheet in pound sterling; a US firm in US dollars. All assets, liabilities, income, expenses, goods and services will be declared in the chosen single unit. This is the unit of account principle. If the value of money, and hence unit of account, is fixed, then the unit of account is also a unit of measure; it measures value. Fiat currencies do not have a fixed value and hence do not represent a unit of measure. Past commodity and representative currencies tended to be debased over time and also ended up being poor units of measure.

A store of value

However, it is important that the value of money is relatively stable over long periods so that people and businesses can confidently save, lend and borrow. A currency that has a fixed value over time is a good store of value, as well as a unit of measure. One that depreciates is problematic for savers, and one that appreciates, for borrowers.

A medium of exchange

Generally, money acts as one side of every transaction in a modern economy — where a transaction is an exchange of goods or services (or financial instruments) between two individuals. People rarely exchange goods or services direct but exchange one good or service for money and then use that money to buy another good or service. In this sense, money flows in the opposite direction to the flow of goods and services as depicted in Figure 1.1 below.

Money Good or service

Figure 1.1. Money as a medium of exchange.

Of course, not all money transfers are for the exchange of goods or services. Money can be inherited, donated or moved to a savings account, for example, and, like goods and services, given as gifts.

A standard of deferred payment

Often people and businesses provide goods or services to other businesses and receive payment at a later date, sometimes weeks or months after the goods or services are supplied. This is the deferred payment function of money, and is a separate and important function.

By deferring payments to each other, businesses can build up debts independent of the money supply, and without knowing whether there will be sufficient money available to settle the debts. In theory, there is no guarantee that there will actually be sufficient money in circulation to cover all deferred payments when they are due to be settled*.

* As a side note, businesses could, in theory, settle deferred payments independent of the money supply and without the need for banks. If business A owed £1000 to business B, business B owed £1000 to business C, and business C owed £1000 to business A, then clearly businesses A, B and C could agree to cancel these debts between them.

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