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Functions of Money

Finance is about money. So our first question is, what is money?

If you happen to have one on you, take a look at a $5 bill. Though this piece of paper — indeed, money itself — has no intrinsic value, it is certainly in demand. Why? Because money serves three basic functions:

1. a medium of exchange;
2. a measure of value; and
3. a store of value.

To get a better idea of the role of money in a modern economy, let us imagine a system in which there is no money. In this system, goods and services are bartered — traded directly for one another. Now, if you are living and trading under such a system, for each barter exchange that you make, you will have to have something that another trader wants. For example, say you are a farmer who needs help clearing his fields. Because you have plenty of food, you might enter into a barter transaction with a laborer who has time to clear fields but not enough food: he’ll clear your fields in return for three square meals a day. This system will work as long as two people have exchangeable assets, but needless to say, it can be inefficient. If we identify the functions of money, we will see how it improves the exchange for all the parties in our hypothetical set of transactions.

Source: Exhibit 1: Canadian money from Flickr.

Money is anything that is acceptable as payment for goods and services. It affects our lives in many ways. We earn it, spend it, save it, invest it — and often wish we had more of it. Businesses and government use money in similar ways. Both require money to finance their operations. By controlling the amount of money in circulation, the federal government can promote economic growth and stability. For this reason, money has been called the lubricant of the machinery that drives our economic system. Our banking system was developed to ease the handling of money.

What, Exactly, Is “Plastic Money”?

For financial transactions to happen, money must change hands. How do such exchanges occur? At any given point in time, some individuals, businesses, and government agencies have more money than they need for current activities; some have less than they need. Thus, we need a mechanism to match savers (those with surplus money that they are willing to lend out) with borrowers (those with deficits who want to borrow money). We could just let borrowers search out savers and negotiate loans, but the system would be both inefficient and risky. Even if you had a few extra dollars, would you lend money to a total stranger? If you needed money, would you want to walk around town looking for someone with a little to spare?

How Banks Expand the Money Supply

A pension fund is any plan, fund, or scheme that provides retirement income in the future to subscribers. Pension funds typically have large amounts of money to invest and are the major investors in listed and private companies.

Other Sources of Funds

Government  Financial Institutions and Granting Agencies

The Canadian government provides government funding support to businesses across the country. This funding support comes in the form of government grants, government loans, tax breaks, tax credits and other types of financial contributions. A number of provincial agencies also provide funding to developing business firms in the hope that they will provide jobs in the province. There are both federal and provincial programs supporting the agriculture industry and providing grants to business operations.

Some examples of federal agencies include:

• The Business Development Bank of Canada (BDC) makes term loans, primarily to smaller firms judged to have growth potential but unable to secure funds at reasonable terms from traditional sources. They also provide counselling services to support their clients.
• The federal government’s Export Development Corporation (EDC) finances and insures export sales for Canadian companies.
• The Canada Mortgage and Housing Corporation(CMHC) is involved in providing and guaranteeing mortgages. The CMHC is important to the construction industry.
• Crown-Indigenous Relations and Northern Affairs Canada (CIRNAC) and Indigenous Services Canada (ISC) provide numerous services to First Nations or Indigenous peoples.
• Futurpreneur Canada is a non-profit organization helping Canadians aged 18-39 become business owners with loan financing, mentoring and business resources.

International Banking and Finance

Foreign sources of funds have been important throughout the economic development of Canada. The Canadian capital market is one part of the international capital market. Canadian provinces borrow in foreign markets such as London and New York. Future projections of Canadian capital requirements indicate that organizations will continue to need these funds.

What roles do Canadian banks play in the international marketplace?

The financial marketplace spans the globe, with money routinely flowing across international borders. Canadian banks play an important role in global business by providing loans to foreign governments and businesses. Multinational corporations need many special banking services, such as foreign currency exchange and funding for overseas investments. Canadian banks also offer trade-related services, such as global cash management, that help firms manage their cash flow, improve their payment efficiency, and reduce their exposure to operational risks. Sometimes consumers in other nations have a need for banking services that banks in their own countries do not provide. Therefore, large banks often look beyond their national borders for profitable banking opportunities.

Some Canadian banks have expanded into overseas markets by opening offices in Europe, Latin America, and Asia. They often provide better customer service than local banks and have access to more sources of funding.

For Canadian banks, expanding internationally can be difficult. Banks in other nations are often subject to fewer regulations than Canadian banks, making it easier for them to undercut Canadian banks on the pricing of loans and services. Some governments also protect their banks against foreign competition. For example, the Chinese government imposes high fees and limits the amount of deposits that foreign banks can accept from customers. It also controls foreign bank deposits and loan interest rates, limiting the ability of foreign banks to compete with government-owned Chinese banks. Despite the banking restrictions for foreign banks in China, some Canadian banking institutions continue to do business there⁶.

International banks operating within Canada have a substantial impact on the economy through job creation — they employ thousands of people in Canada, and most workers are Canadian citizens — operating and capital expenditures, taxes, and other contributions.

Political and economic uncertainty in other countries can make international banking a high-risk venture. European and Asian banks were not immune to the financial crisis of 2007–2009. In fact, several countries, including Greece, Portugal, Spain, and Ireland, continue to rebound slowly from the near-collapse of their economic and financial systems that they experienced a decade ago. Financial bailouts spearheaded by the European Union and the International Monetary Fund have helped stabilize the European and global economy.

Currency Values and Exchange Rates

Currencies are traded in the foreign exchange market. Like any other market, when something is exchanged there is a price. In the foreign exchange market, a currency is being bought and sold, and the price of that currency is given in some other currency. That price is expressed as an exchange rate.

When an exchange rate changes, the value of one currency will go up while the value of the other currency will go down. When the value of a currency increases, it is said to have appreciated. On the other hand, when the value of a currency decreases, it is said to have depreciated.

The Canadian dollar fluctuates against the American dollar between 65-70 per cent range. On November 2007, the CAD dollar was stronger than the US dollar, at US $1.09. After a few years of parity, the Canadian dollar retreated to approximately US $0.76 in June 2018^7. These fluctuations have an impact on businesses.

International Payment Process

International financial settlements between buyers and sellers are different in many countries. Canadian banks provide services to buyers and sellers to support their clients during global financial transactions. Country-to-country transactions rely on an international payment process that moves money between buyers and sellers in different countries. For example, payment from a Canadian buyer start at a local bank that converts funds from dollars into the seller’s currency, say British pounds sterling, to be sent to a seller in England. At the same time, payments and currency conversions from separate transactions are also flowing between British businesses and Canadian sellers in the other direction. A balance trade between the two countries implies that money inflows and outflows are equal for both countries. If inflows and outflows are not in balance at the Canadian bank or the British bank, then a flow of money — either to England or Canada — is made to cover the difference.

International Banking Structure – World Bank and International Monetary Fund

Policymaking and regulatory powers are different in every nation; local standards and laws also vary greatly, which means that banking systems vary greatly. These two United Nation agencies — The World Bank and International Monetary Fund — assist in financing international trade.

The World Bank

The World Bank is an important source of economic assistance for poor and developing countries. With backing from wealthy donor countries (such as Canada, the United States, Japan, Germany, and the United Kingdom), the World Bank provides loans, grants, and guarantees to some of the world’s poorest nations. Loans are made to help countries improve the lives of the poor through community support programs designed to provide health, nutrition, education, infrastructure, and other social services.

The International Monetary Fund

The International Monetary Fund (IMF) consists of 189 nations who, as a group, combine their resources to:

• encourage the development of a system for international payments;
• promote the stability of exchange rates;
• provide temporary, short term loans to member countries; and
• encourage members to cooperate on international monetary issues.

The IMF loans money to countries with troubled economies, such as Mexico in the 1980s and mid-1990s, and Russia and Argentina in the late 1990s. There are, however, strings attached to IMF loans; in exchange for relief in times of financial crisis, borrower countries must institute sometimes painful financial and economic reforms. In the 1980s, for example, Mexico received financial relief from the IMF on the condition that it privatize and deregulate certain industries and liberalize trade policies. The government was also required to cut back expenditures for such services as education, health care, and workers’ benefits.²⁵

Some nations have declined IMF funds rather than accept the economic changes that the IMF demands. In 2021, according to the IMF website, the IMF had about $1 trillion available for loans. Despite the fact that the U.S. has been instrumental in promoting global free trade for decades in 2018, it was rumoured that under Trump’s administration the U.S. would withdraw from the World Trade Organization (WTO). This did not happen but the instability caused by such news was damaging to the WTO.

Digital Currencies

Digital currencies are currencies that are only accessible with computers or mobile phones because they only exist in electronic form. Digital money is not physically tangible like a dollar bill or a coin. It is accounted for and transferred using online systems. The difference between digital currencies and cryptocurrencies is that digital currencies are centralized, meaning that transaction within the network is regulated in a centralized location, like a bank. Cryptocurrencies are mostly decentralized, and the regulations inside the network are governed by the majority of the community.

The Bank of Canada revealed in 2016 that it was developing the CAD-coin as a digital version of the Canadian dollar, a move in response to the rise in popularity of bitcoin and other blockchain-based digital currencies. The initiative will involve issuing, transferring and settling the central bank’s monetary assets by way of a computerized ledger rather than by way of printed dollars. Research and experiments have been ongoing since 2016. Some major banks in Canada are participating in this new initiative, including Royal Bank of Canada, CIBC and TD Bank Group, and institutional partners such as Payments Canada and TMX Group.

Despite their claim of being the money of the future, current private digital currencies, like bitcoin, do not work well for making payments or saving for the future. Because of their fluctuating values and slow clearing times, very few merchants accept them. It is possible that in the future digital currencies could at least partially solve these problems, leading to greater adoption. But widespread adoption of private digital currencies would carry important risks to both the economy and the financial system. The issuer could go out of business or fall victim to cybertheft; either situation could cause a loss of confidence in the payment system.

Exploring the idea of a central bank digital currency makes sense. In theory, it could provide the safety of cash, with the convenience of modern electronic payments. It could take many forms, but two broad approaches are:

• value-based — people transfer money from their bank account to a card or a phone app; or
• account-based — people or businesses open accounts at the central bank.

Either way, payments made using a central bank digital currency could allow payments to remain private to the parties involved, just like cash but traceable to law enforcement, just like bank accounts.

Central bank digital currencies could give consumers more choice while maintaining competition among financial service providers like banks, the way cash does now. Depending on their design, they could even act as a backup if other payment methods become temporarily unavailable.

Basically, central bank digital cash would act like current electronic payment methods, the only difference being that it would not be tied to a commercial bank the way bank accounts and debit cards are. ^8.

Source:  https://www.bankofcanada.ca/2019/04/the-road-to-digital-money/

Comprehension Check

1. Define the following terms:

• money;
• M1 and M2 money supply;
• electronic funds transfer (EFT); and
• digital currency.

2. What are the crucial properties of money?

3. What services do financial institutions provide in Canada?

4. List the functions of the Bank of Canada.

5. Explain the balance of trade between two nations.

References

This Chapter is adapted from Introduction to Business — licensed under a Creative Commons Attribution 4.0 International CC BY-NC-SA (Attribution NonCommercial ShareAlike) license, which means that you can distribute, remix, and build upon the content, as long as you provide attribution to OpenStax and its content contributors. The chapter differs from the original to reflect Canadian content.

The section on the Functions of Money is adapted from – Exploring Business and is adapted from a work produced and distributed under a Creative Commons license (CC BY-NC-SA) in 2010 by a publisher who has requested that they and the original author not receive attribution. This adapted edition is produced by the University of Minnesota Libraries Publishing through the eLearning Support Initiative.

Image – Measuring the Money Supply M1-M2 from Open textbook Principles of Economics