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Functions and definitions of money

Money acts as a medium of exchange, a store of value and a measure of value.

People use money as a medium of exchange to buy goods and services because it is readily acceptable, has known value, is easily divisible, has a high value to weight ratio and is difficult to counterfeit. Money is a store of value because it is non-perishable, and people have a belief that its value would not fall. Further, since all goods and services can be converted to money, it offers a single measure of value and reduces the number of prices quoted in a market.

Narrow money vs broad money

Money stock typically consists of coins and notes plus deposits that can be readily used to make purchases of goods and services.

Narrow money means the currency in circulation plus very highly liquid deposits, while broad money equals narrow money plus all other liquid deposits which may be used to purchase goods and services.

For example, in the US, there are two measures of money, M1, which refers to coins and notes, traveler’s cheques plus deposits on which cheques can be written; and M2, which equals M1 plus savings and money market deposits, time deposits (up to $100,000) and retail and mutual fund accounts. Similarly, in the Eurozone, there are three measures, M1, M2, and M3.

MCQs

Which of the following is least likely correct about the functions of money?

A) It reduces the number of prices quoted in an economy.
B) It enables governments to influence business cycles.
C) It allows the transfer of wealth across location and time.

Show answer

B is correct. While central banks may influence an economy using monetary policy, it is not a core function of money. The measure of value function of money reduces by the number of prices that are needed to be quoted in an economy. The store of value function allows the transfer of wealth between locations and across time.


Which of the following is least likely a requirement that an item must meet to be considered an effective medium of exchange?

A) It has a high value to weight ratio.
B) It cannot be easily counterfeited.
C) It has a low cost of production.

Show answer

C is correct. While a low cost of production can be a practical consideration when selecting money, it is not a precondition for it to act as a medium of exchange.


These notes are intended to help you prepare LOS 16b of Level 1 of the CFA program.

by Obaidullah Jan, ACA, CFA on Tue Feb 11 2020

This article can help you prepare for Reading 16 LOSb.

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