Money should perform three roles: First it must act as a medium of exchange, second it should act as a unit of account, and lastly it should provide a store of value.
Medium of exchange
The primary function of money is to act as a medium of exchange. In this capacity money allows us to buy and sell goods and services without the need to barter.
Unit of account
Money also has to function as a unit of account. In this role money provides a common measure, or yardstick by which we can value the goods and services that we wish to buy or sell.
Store of value
Our money must also act as a store of value – a role which is less well understood.
To be a store of value, or wealth, money must maintain its purchasing power over extended periods of time, allowing us to postpone purchases until such times as we are ready to make them. Whether you wish to save for your children’s tuition fees, a new car or just a rainy day, you should be able to purchase the same quantity of goods or services in the years to come, as you can today.
The money we use today however, does not act as a true store of wealth and instead loses its purchasing power over time. This is because governments continually create and issue new money thereby diluting the currency already in circulation and as money becomes more abundant it takes more of it to buy the same quantity of goods.
United Kingdom M4 Money Supply 1984 to 2007
Money supply and inflation
It’s a commonly held belief, even among many economists, that inflation is rising prices. This is misleading however, since rising prices describe the symptom of inflation rather than the cause. The root cause of inflation is an increase in the supply of money and credit.
When you increase the amount of money in an economy but don’t increase the amount of goods and services, the price of those goods and services will sooner or later begin to rise. As Milton Freidman puts it, inflation can be described as “too much money chasing too few goods”. This gives the appearance of rising prices.
Money supply and inflation go hand in hand because an increase in the supply of money is what causes inflation.
The definition of inflation has become warped over time
The definition according to the Oxford or Webster’s English Dictionary from 1983, is “an increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices”.
But over the past 20 years or so, people’s understanding of the word inflation has changed. The 2007 Oxford English Dictionary defines inflation as “a general increase in prices and the fall in the purchasing value of money”. This new definition talks about the symptoms of inflation rather than the cause.
Reduction of purchasing power
Once we understand the true cause of inflation, we see that when governments print new money – think Quantitative Easing (QE) – they destroy the value of the money already in circulation. Holders of this money lose their purchasing power and their wealth diminishes.