Money: barter, functions, qualities, demand and value

Imagine trading a goat for a bag of rice: you would have to find someone who has rice and wants a goat at the same moment. Money solves that problem, which is why every economy uses it. This lesson explains what money is, what it does, why people hold it and what decides its value.

Learning objectives

By the end of this lesson you should be able to:

• explain barter and its problems
• state the functions and the qualities (characteristics) of good money
• describe the types of money in use today
• explain the motives for holding money (the demand for money)
• explain the value of money and the quantity theory of money

Barter and its problems

Problems of barter:

1. Double coincidence of wants: each trader must want exactly what the other offers.
2. No common measure of value: how many fish is a goat worth?
3. Indivisibility: a cow cannot be split to buy a small item.
4. Difficulty of storing wealth: many goods spoil or lose value.
5. No standard for deferred payments: debts cannot easily be repaid in future.
6. Cost of carrying goods to market.

The functions of money

Some writers add transfer of value (paying someone far away, for example by bank transfer or mobile money) and unit of account (keeping records in money).

Qualities of good money

1. General acceptability: people must be willing to take it.
2. Portability: easy to carry.
3. Divisibility: can be broken into small units without losing value.
4. Durability: does not wear out quickly.
5. Homogeneity (uniformity): every unit of the same value is identical.
6. Scarcity (limited supply): if there is too much, it loses value.
7. Stability of value: its purchasing power should not change sharply.
8. Recognisability and difficulty to forge.

Types of money

• Commodity money: goods used as money in the past, such as cowrie shells, iron bars and salt.
• Metallic money (coins): today's coins are token money, worth more as money than as metal.
• Paper money (bank notes): issued by the central bank. Sierra Leone's notes and coins are issued by the Bank of Sierra Leone.
• Bank deposits: money in current accounts, spent by cheque, card or transfer. In modern economies this is the largest part of the money supply.
• Electronic and mobile money: balances held on phones, such as Orange Money and Afrimoney, used to pay and transfer money.

The demand for money

The demand for money is the desire to hold wealth in the form of money (cash and current accounts) instead of buying goods or other assets. Keynes gave three motives:

1. Transactions motive: to pay for everyday purchases between paydays. It rises with income.
2. Precautionary motive: to meet unexpected needs, such as illness or accidents.
3. Speculative motive: to hold money while waiting for a better chance to buy bonds or other assets. People hold more money when interest rates are low (little is lost by not lending it) and less when rates are high.

The supply of money

The money supply is the total amount of money in the economy: notes and coins held by the public plus bank deposits. It is controlled mainly by the central bank (see the next lesson).

The value of money

The quantity theory of money

Irving Fisher expressed the link between money and prices as:

$$MV = PT$$

where $M$ is the money supply, $V$ the velocity of circulation (how many times each unit is spent in a period), $P$ the general price level and $T$ the volume of transactions.

The theory says that if $V$ and $T$ are fairly stable, an increase in the money supply causes a proportional rise in prices. Critics note that $V$ and $T$ can change, especially when the economy has idle resources.

Key points

• Barter needs a double coincidence of wants and has no measure of value.
• Money is a medium of exchange, measure of value, store of value and standard of deferred payment.
• Good money is acceptable, portable, divisible, durable, homogeneous, scarce and stable.
• People hold money for transactions, precautionary and speculative motives.
• The value of money falls when prices rise; MV = PT links the money supply to prices.

WASSCE examination focus

Quick check

1. What is the "double coincidence of wants"?
2. Which function of money is used when a loan is repaid in instalments?
3. Name Keynes's three motives for holding money.
4. If $M$ = 600, $V$ = 4 and $T$ = 300, what is $P$?

Answers: 1. In barter, each trader must have what the other wants and want what the other has. 2. Standard of deferred payment. 3. Transactions, precautionary and speculative. 4. $P = \dfrac{600 \times 4}{300} = 8$.