Sunday, June 16, 2013

Bank Deposits, Savings and function of Money

We will divert from our series a bit and get to an important aspect of Money which is its function.  However, Money performs two functions.

Raison d'etre of money
Money came into being to facilitate exchange of goods. Money split the old time barter (which was one transaction) into two transactions (goods-I-have for money and money for goods-I-want). This allowed for both transactions to achieve market efficiencies. Enabling transaction is the first function of Money. So money is medium of exchange. In this process Money conveys information about prices of goods. When the prices change, it conveys information about changes to the product or the environment or some other thing. This information function of money is as important as the second.

Second function of money is that of a store of value. Value of money means its purchasing power. Bank deposits are storing value. Technically, money should not be performing this function. But this function is inadvertently taken up by money when the information about the product or money itself changes the price levels and hence the purchasing power. Thus, for example, after exchanging goods-I-have for money, when I was having money with me, the price of goods-I-want halved. That means the purchasing power of money increased and thus money became more valuable.

Thus when we hold money and there is change in the information available leading to change in prices, the function of money is that of store of value.

What should money do?
  1. Money should enable transactions - so it must not hinder your transactions (by credit card not being available). Or by becoming so valuable itself that people want to post-pone their transaction to get a better deal.
  2. It should convey information about prices so that you can compare and match your funds, needs and compare alternative purchases (apples vs apples vs oranges etc). This information must be reasonably stable. So if I understand that price of a shirt is about $25 then tomorrow it cannot be $150 or $5 because that will create confusion. But it can be say $23 or $27 and it would not be much of problem.
  3. Money has no business being store of value by itself. However, the fact remains that money remains the only way to measure value. We do not have other unit to measure it.
Douglas Rushkoff (starting about 23 min) on money should push transactions.

Use of money and current and deposit accounts
So actually, money in our current account is actually money to be used for transaction as a medium of exchange while the money we have in time-deposits or other deposit accounts is actually money as a store of value. Now if you ask any lay person, if the amount of money in both the accounts reflects this functional segregation and you will find it does not. The way we use money mixes up the two functions of money.

One way to clarify the usage is to make it clear that current account is your money awaiting transaction while deposit account is your investment into the bank. This segregation will make it clear to users what exactly they are using money as. Thus, banks should provide the analysis of expenses from the account and that should indicate a certain current account balance. The rest should be into deposit accounts.

Now, from the level of deposit insurance available to the bank, there should be disclosure about the amount of your money protected by deposit insurance. When deposit insurance is applied it must be applied to current account first and then to deposit account.

Purchasing power of the money
In an ideal case the purchasing power of the money should remain perfectly the same. If the purchasing power remains exactly the same the productivity gains will result in lowering of prices which is also termed as deflation. Now we also do not want that because in a deflationary scenario, holding money becomes lucrative as its value only increases and this affinity for money creates a hindrance in transactions. As we discussed, ideally money should not hinder transactions in any way.

To overcome this, we settle for a slight inflation. If we do it right, then the inflationary force exactly balances out the productivity gains and therefore results in no change in the prices. But such ideal outcome is not possible. So the policy maker must err in his judgement. A better side to err (it is debatable) is on the side on inflation but only ever so slight inflation.

George Selgin on Good Deflation and Bad Deflation

In Sum
The function of money and our appreciation of the function itself has policy implication. We must understand the function of money before we understand monetary policy itself.

Note: This post is derived from my book Subverting Capitalism and Democracy. You can read the book at the link below.