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The Nature and Functions of Money

Thus far in this lesson we have been defining capital very broadly to include
human skills, knowledge and technology as well as buildings, machines, etc. One
form of capital that has yet to be mentioned is money. Yet it is the asset that is
probably most referred to in ordinary conversation---witness the statement "Bill
has a lot of money". What is really being said here is that Bill has a lot of assets
that he could convert into money by selling them if he wanted to.
The reason why people holds their capital stock in a wide range of different types
of capital assets with only a small part of it as money is that they earn a better
return in the form of interest, dividends, and capital gains on other assets than they
earn on their money holdings.
The question is why anyone would hold money---cash in pocket and deposits in
non-interest bearing chequing accounts---at all? If money is to be regarded as a
part of one's capital stock, it should earn a return that makes it worth holding.
Visualize a world without money. When you go to McDonalds to buy lunch, what
are you going to give in payment for your Big Mac? At a wage rate of $10 per
hour, an appropriate payment might be to wash dishes for 20 minutes. But what if
you are a lawyer who earns $2000 per day in court? You could offer to defend the
owner of the franchise for 3 minutes on his forthcoming impaired driving charge.
But then, how is the owner of McDonalds going to pay his staff---give them all the
food they can eat?
Without money, all exchanges must take the form of barter. And barter won't work
unless there is a double coincidence of wants. Each party to the exchange must
want to buy what the other party wants to sell.
A possible way to get around this problem would be to establish a network of
IOU's in the economy. When you buy a hamburger at McDonalds, you sign an IOU
sheet. When the owner of the McDonalds franchise pays his employees he marks
them down as the receivers of IOU's. Then at the end of every month or year, there
could be an economy-wide IOU settlement in which everyone's debt to everyone
else is taken care of.
This scheme has some obvious difficulties. Apart from the problem of maintaining
records of every purchase and sale, however small, there is the question of people's
credit-worthiness. What is to stop one from spending more than one's income?
It should now be clear from the above discussion that the basic function of money
is to save labor and other resources that would otherwise have to be used up in

making transactions. This enables society to produce more consumption and


investment goods with its existing stock of human and physical capital. The
return from holding money to the person that holds it is the resources that
now can be used for productive employment and leisure rather than for
checking people's credit ratings, informing others of his/her own credit rating,
processing records, collecting bad debts and looking for people to barter with.
So money represents an additional component of the communities' capital stock.
The return off this component is the increase in the fraction of the output of the
other types of capital that can be used for consumption and investment as a result
of being able to use money to make exchange.
In order to make exchange, settle debts, and so forth, one must have a unit of
account. Money provides this. In Canada, the monetary unit and unit of account is
the dollar. Its acceptability for this purpose is established by law. Dollars are legal
tender---that is, one must legally accept them in exchange for goods and in the
discharge of debts.
In situations where there is no legal tender, people will adopt a monetary unit by
convention. For example, in German prisoner-of-war camps in World War II
cigarettes were used as a medium of exchange---one cigarette became one unit of
money. In nineteenth-century frontier gold-mining camps where paper money was
scarce, one oz. of gold often represented the monetary unit.
The total quantity of money in the Canadian economy is the stock of dollars
available for making transactions. What counts as a dollar available for making
exchange is often difficult to define. Dollar bills and coin in pocket are clearly part
of the stock of money. Chequing account balances, which can be transferred to
other people in the payment of accounts by cheque, are always treated as part of
the stock of money. Savings account balances, which can be withdrawn and made
available for use in transactions or simply transferred into a chequing account by
telephone, are also frequently considered to be part of the money stock, but the
conversion costs make them less desirable as a means of payment than cash.
Some other assets, such as Canada Savings Bonds, are easily convertible into
money but more costly to convert than savings account balances. Unused credit
card limits can also be viewed under some circumstances as a form of money
because they can be used in making some types of transactions as easily as
cheques, though never as easily as cash. Assets can be ranked on a scale according
to how easily they can be converted into a quantity of cash that can be estimated in
advance with some precision. Assets that are less costly to convert into cash than
other assets are said to be more liquid.
Liquidity is thus the property of being cheaply convertible into a defined
amount of cash. Money in pocket is, of course, the most liquid of all assets

because it is cash. Chequing accounts are the second most liquid of assets because
they can be, in effect, converted into cash by the writing of a cheque. Savings and
other non-chequable deposits have lesser liquidity because one has to make a trip
to the bank to cash them in. One's house or car is a very illiquid asset because it
takes a considerable amount of time to sell an asset of this sort for a price that is
both reasonable and can be estimated with some accuracy in advance.
It's time for a test. Have your own answers in mind before looking at the ones
provided.