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Monday, 11 June 2012

Functions of money

Functions of money


Money performs the following three functions:



1        Unstable medium of exchange

2        Unstable store of value

3        Unstable unit of account



Unstable medium of exchange




Money has the basic function that it is an unstable medium of exchange. It overcomes the inconveniences of a barter economy where there must be a double coincidence of wants before a trade can take place. For a trade to take place in a barter economy one person must want exactly what the other person has to offer, at the exact time and place where it is offered.



In a monetary economy the real value of goods and services are measured in terms of unstable money, the unstable monetary medium of exchange, which is generally accepted to buy any other good or service. Without this function or attribute the invention cannot be money.



We use payment with unstable money instead of barter to exchange real values in our economies in the transactions we enter into when we buy and sell goods, services, ideas, rights and any kind of property whether physical, virtual or intellectual. Unstable money is the lifeblood of an economy even though it is continuously changing in real value. The creation and exchange of real value in an economy would be severely restricted without unstable money since it would be a barter economy.


Unstable store of value



Unstable money is an unstable store of real value. Unstable money is a depreciating store of value during inflation and an appreciating store of value during deflation.



Unstable money has to maintain most of its real value over the short term in order to be accepted as an unstable medium of exchange. It would not solve barter’s double coincidence of wants problem if it could not be stored over time and still remain valuable in exchange.



The fact that inflation is eroding the real value of unstable money means it is a store of depreciating real value during inflation. Money was a store of value right from the start. The first types of money consisted of gold and silver coins. The metals from which the coins were made had an actual real value in themselves and these coins could be melted down and the metal could be sold in its bullion form when the bullion price was above the coin price. Next money was not made of precious metals but money consisted of bank notes, the real value of which was fully backed by gold. Today depreciating or appreciating fiat money´s real value is backed by all the underlying value systems in an economy while the actual bank notes and coins are simply physical tokens of money since the materials the notes and coins are made of have almost no intrinsic value. Although the store of value function (legal tender) and permanently fixed nominal values of depreciating or appreciating bank notes and bank coins are legally defined, fiat money´s real value is in fact determined by all the underlying values systems in an economy. The daily change in fiat money´s depreciating or appreciating real value is indicated by the change in the Daily CPI.



The abuse of money’s store of value function led to inflation.



Money in the form of bank notes and coins and in the form of virtual real values in bank and credit card accounts are liquid media of exchange; i.e., they are readily available. It is normally easy to obtain cash on demand in banks in most economies under normal economic conditions. A property, e.g., a well–located plot of land with a well–maintained and well–equipped building, which is a variable real value non–monetary item, is also a store of value. It is however quite an illiquid store of value. The real value is not immediately available in easily transportable and divisible cash. Money’s high liquidity makes it more desirable as a store of value in comparison with other stores of value like gold, property, marketable securities, bonds, etc. Money is obviously not the best store of value in an inflationary economy where its real value is continuously being eroded by inflation. Money is normally available in convenient small denominations which facilitate everyday small purchases. As such, money is very user friendly. It is easily transportable especially with electronic transfer facilities (2012).



Inflation actually manifests itself in money’s store of value function since inflation always and everywhere erodes the real value of only money and other monetary items. Inflation does not manifest itself in money’s medium of exchange function in the case of spot transactions since (a) the exchange is made between money and the other item considered to be equal in real value to the money amount at the moment of exchange and also since (b) inflation only happens over time. Inflation also does not manifest itself in money’s unit of account function (the stable measuring unit assumption manifests itself in money´s unit of account function) which vindicates the fact that inflation can only erode the real value of money and other monetary items; i.e., inflation has no effect on the real value of non–monetary items. Money is always a medium of exchange of equal real value at the moment of exchange. Free market prices are adjusted in the market in a price setting process that takes the decreasing real value of money during inflation or the increasing real value of money during deflation into account (amongst many other factors) so that economic items - the product or service or right and the amount of money- of equal real value are exchanged at the moment of exchange.



Depreciating money has a constantly decreasing real value during inflation.  Depreciating ‘bank money’ deposits have the same attributes as depreciating money with the single exception that they are not physical depreciating bank notes and bank coins but accounted depreciating monetary items. The depreciating money represented by depreciating bank money also has a depreciating store of value function during inflation. Money and other monetary items appreciate in real value during deflation.


Unstable unit of account

Unstable money’s third function is that it is the unstable unit of account in the economy. It is a monetary standard of measure of the real value of economic items to facilitate exchange without barter in order to overcome the double coincidence of wants problem. Inflation erodes the real value of money and deflation increases the real value of money. Money has never been perfectly stable in real value over an extended period of time. However, money illusion makes people believe that money maintains its real value stable over the short to medium term. Money is the only standard unit of measure that is not a fundamentally stable or fixed unit of account. All other standards of measure are perfectly stable units.



Accounting transformed money illusion into a Generally Accepted Accounting Practice with the very destructive stable measuring unit assumption, also called the Measuring Unit Principle.



‘The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial reports.’



Walgenbach, Dittrich and Hanson 1973: 429



The very erosive stable measuring unit assumption is based on the fallacy that changes in the general purchasing power (real value) of unstable money are not sufficiently important to require adjustments to the basic financial reports; i.e., not sufficiently important to require financial capital maintenance in units of constant purchasing power during inflation and deflation.



In an inflationary economy depreciating money is used as a depreciating monetary unit of account to value and account economic activity. It is very tempting to state that it is very clear that you cannot have a unit of account in the economy that is not stable – not fixed – in real value for accounting purposes. However, we have been doing exactly that since the start of inflation in the economy; i.e., for about the last 3000 years. Accounting has been trying to overcome this problem for the last 3000 years by simply assuming money is perfectly stable in real value duirng inflation and deflation. However, a fact will eventually prevail over an assumption regarding it. The assumption in Historical Cost Accounting is that changes in the purchasing power of money are not sufficiently important to require financial capital maintenance in units of constant purchasing power during inflation and deflation. In practice that means that unstable money is assumed to be perfectly stable in real value during inflation and deflation. The fact is that money is not perfectly stable in real value during inflation and deflation. Financial capital maintenance in units of constant purchasign power during inflation and deflation implements this fact instead of the stable measuring unit assumption under Historical Cost Accounting. The stable measuring unit assumption is not implemented under financial capital maintenance in units of constant purchasing power (CIPPA). The problem stems from the difficulty in achieving zero inflation on a permanently sustainable basis - never achieved to date (2012) - and the difficulty in defining a universal unit of real value - also never achieved to date.



The only remedy to eliminate the erosion of real value in constant real value non-monetary items never maintained constant during inflation and deflation under HCA – besides permanently sustainable zero inflation – would be to change over to financial capital maintenance in units of constant purchasing power; i.e., the measurement of all constant items in units of constant purchasing power in terms of a Daily Index during inflation and deflation (CIPPA).



The only remedy to eliminate the erosion of real value in money and other monetary items – besides permanently sustainable zero inflation – would be inflation-adjusting the entire money supply on a daily basis under complete co-ordination. Chile is already 20 to 25 per cent (2011) of the way there according to the Banco Central de Chile.




Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.