Understanding Money: Functions, Types, and Inflation
Functions of Money
- Medium of Exchange: Money serves as a medium of exchange, an intermediary that facilitates trade and specialization in production.
- Store of Value: The merchant who accepts our money in exchange for bread does not have to spend it immediately but can save it for when they need it. Money is a store of value, a means to keep wealth that allows us to save.
- Unit of Account or Measure: Money enables us to measure the value of goods and services. Everything is worth money.
Three Types of Money
- Cash Held by the Public: This consists of notes and coins that we have at home. It constitutes a small portion of the money available.
- Money Deposited in Banks: This can be further divided into:
- Demand Deposits or Checking Accounts: These have immediate availability.
- Savings Deposits or Savings Accounts: These are less readily available and do not allow the use of checks.
- Fixed-Term Deposits: The depositor agrees not to withdraw the money, and if they do, they incur a penalty.
- Quasi-Money: This is invested in promissory notes, treasury bills, or similar titles. It can be retrieved in a very short time and without risk.
The Demand for Money
The demand for money exists for two primary reasons:
- Demand for Transactions: Families need money to make purchases, and businesses need it to pay for raw materials or wages. Therefore, they maintain an amount of money available.
- Demand for Precaution: Keeping money available to cope with unforeseen expenses. However, money has a peculiarity: it is only useful when we use it to exchange for goods.
When people demand money, they consider these factors:
- The Level of Prices: If prices go up, more money is needed.
- The Level of Income: An increase in income generates an increased level of spending, requiring more money.
- The Interest Rate: If the interest rate is low, it does not matter if a lot of money is idle. If the interest rate goes up, it is better to have money in a term deposit, bonds, etc.
- Risk and Expectations: The more risky it is to have money invested or the more uncertainty there is about the future, the greater the amount of cash that will be held.
The Creation of Deposit Money
Euro banknotes and coins are issued by the Bank of Spain for the European Central Bank. However, bank money is also created by banks through loans made with the money deposited by their customers.
Much of people’s savings are deposited in banks. The role of banks is to capture these deposits by paying interest. Depositors do not withdraw their deposits all at once. Withdrawals are often offset by new revenues. To meet the demands for money, banks keep a small part of their deposits in reserve. The Central Bank requires banks to maintain a minimum percentage of reserves, called the reserve requirement (currently 2%).
Total money created = initial deposit
Banking multiplier =
The Interest Rate
The interest rate is defined as the price of a loan. Ultimately, it is the price of money.
What is Inflation?
Inflation is defined as a widespread and sustained rise in the prices of an economy.
Types of Inflation
- Moderate Inflation: A slight increase in prices, less than 2 or 3%.
- Galloping Inflation: A rise above 10%.
- Hyperinflation: Prices rise by over 100% in a year. This results in a loss of control of prices and the collapse of the system because money has little value.