Understanding Money: Functions, Creation, and Value
Definition of Money
Money is an instrument that facilitates exchanges within the market’s economic system. It serves as the counterpart in all purchases and sales. Without money, trade would rely on the direct exchange of goods or services, a mechanism known as barter.
Characteristics of Money
For a good to be considered money, it must meet the following characteristics:
- Durability: It should be made of a material that endures over time.
- Portability and Manageability: Money must be easily transportable and usable by the entire population.
- Divisibility: It should be divisible enough to measure the prices of all goods in monetary units, allowing access to the entire product of the economy.
- Limited Supply: The amount of money must be controlled to prevent significant variations in its value.
Alternatives to Cash
Various means of payment can be used as replacements for cash, primarily:
- Check: A payment method where one person authorizes another to receive a specific monetary amount. The only requirement is that the person signing the check has sufficient funds in their checking account.
- Credit Card: A personal, non-transferable payment instrument used for various transactions, including purchasing goods and services and obtaining cash.
- Debit Card: Similar to a credit card, it allows for purchases and cash withdrawals. The difference is that payment is immediately debited from the customer’s checking account.
Functions of Money
- Unit of Value: Money sets the value of all other assets in the economy, allowing for homogenization of a country’s production and consumption. It is an indispensable tool in economic analysis.
- Store of Value: Money is a way to store wealth, both for individuals and countries.
- Standard of Deferred Payment: Money is used in trade over time, although this is not a unique characteristic of money.
The Process of Money Creation
There are two main types of money: legal tender and bank money. This refers to a double process of money creation.
The Process of Creating Legal Tender
Legal tender consists of notes and coins in circulation. In Spain and other countries in the Eurozone, the euro circulates as the currency.
The Process of Creating Bank Money
Bank money is constituted by deposits held by the public, primarily in savings banks. The process of creating bank money involves banks accepting deposits from customers and lending them to other clients. This mechanism creates money, as both the depositor and the loan recipient have access to funds.
The Value of Money
Money is distinct from other assets, and its value is determined through what is called the interest rate.
Types of Interest Rates
There are different interest rates depending on the agents involved and the funds provided:
- Interbank Market Interest Rate: When banks lend to each other.
- Government Debt Interest Rate: When people buy government bonds from the government or autonomous communities.
- Mortgage Market Interest Rate: When a person requests a mortgage loan (to purchase a home).
Factors Influencing Interest Rates
Differences between interest rates are due to several factors:
- Transaction Risk: The likelihood of recovering the loaned funds. Higher risk leads to higher interest rates.
- Term of Operation: The date at which the borrowed funds are recovered. Longer terms generally result in higher interest rates (unless there are guarantees that can reduce it).
- Liquidity of the Operation: The ability of the lender to enforce the operation before maturity.
Inflation and Explanatory Theories
The value of money is always linked to the value of assets that can be acquired with it (purchasing power). It should be noted that the same goods cannot be obtained through time due to the phenomenon known as inflation.
Effects of Inflation
- One of the main effects of inflation is a loss of money’s purchasing power. Therefore, holding cash has opportunity costs.
- The loss of purchasing power for individuals whose incomes do not increase in tandem creates uncertainty in the economy. This is one reason why governments try to control price growth.