Thursday, 16 October 2008

Functions of money and its buffering action

The operation of money is often described in terms of three of its functions, namely as a unit of account, a means of exchange, and a store of value. There are questions whether these functions are sufficient to describe all the economic operations of money in a modern society. For example, risk pooling, where different risks of economic loss are collected by one economic agent and the risk of extreme losses becomes less likely, is facilitated by money and certainly needs the three basic characteristics to operate but also requires that the pooling does not alter the riskiness of the underlying economic events. So risk pooling may be considered an additional, independent function of money.

The recent financial turmoil in the world's markets emphasise another function of money, as a buffer against the real economy. As the real economy is experiencing some event, it is generally considered possible in many circumstances to offset the event through adjustment of the money supply. A commonly occurring example is counter-cyclical fiscal and monetary policy where during a recession, government debt may rise and interest rates fall in order to help the economy recover. There are other examples in trade, government financing, and elsewhere in the economy.

In recent years, demand for world goods has been supported by the ready availability of credit in developed countries. With the debt crisis and the anticipated decline in aggregate demand and the world economy, it is possible that recent monetary supply has been pro-cyclical rather than anti-cyclical. However, it is also possible that monetary policy has been anti-cyclical for several years, buffering against a relatively low global aggregate demand for goods. The speed of monetary expansion has arguably been unhelpful, with monetary policy substantially defined relative to short term inflationary targets in independent central banks, longer term macroeconomic fluctuations being less important. However, the distribution of demand and other global imbalances make the judgement on monetary (and stabilising fiscal) policy difficult at the moment.

This post is a mish-mash as I am trying to sort out the issues myself, but I trust some half-decent idea has clambered from the mire.

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