The three functions of money and the first terms of finance: inflation, interest and liquidity shown on a family's savings

Dilnoza and Sardor from the first lesson saved 18 000 000 soum in a year. Now they face a new question: should they leave this money on the card, put it in a bank deposit or buy something with it? Before answering, we need to understand what money itself does and learn a few words that finance people use.

What three functions does money perform?

Economists usually distinguish three main functions of money. Let us see them in the family's everyday life:

Some sources, including the summary in Encyclopaedia Britannica, also list a fourth function separately: the standard of deferred payment, that is, debts and future payments are also set in the same monetary unit. In this lesson we treat it as an extension of the measure of value function.

Without money people would have to live by barter, that is, by exchanging goods for goods. Then the butcher would have to need exactly what you have, otherwise there would be no trade. Money solves this problem.

The third function has a weak spot: the longer money lies idle, the less it may be able to buy. This is where the first terms of finance are needed.

Seven key terms

1. Money. A medium of exchange that everyone accepts; it performs the three functions above. Mini example: Dilnoza receives her salary in soum and pays the utility bills in soum too.
2. Currency. A country's monetary unit. In Uzbekistan the national currency is the soum, and money of other countries is foreign currency. Mini example: before going on a trip, Dilnoza and Sardor exchange soum for another country's money.
3. Inflation. A rise in the general level of prices. As a result, the same money buys less than before. Mini example (hypothetical): if prices rise by 10% in a year, a basket of goods that costs 18 000 000 soum today will cost 19 800 000 soum a year later. The money lying on the card, meanwhile, stays at 18 000 000 soum.
4. Interest rate. The size of the fee paid for a loan or deposit as a percentage, usually calculated for one year. Mini example (hypothetical): 18 000 000 soum placed in a deposit at 15% a year earns 2 700 000 soum of interest in a year, making 20 700 000 soum in total.
5. Time value of money. The principle that a soum today is worth more than the same soum in the future, because money today can be used to earn income. Mini example: if a relative tells Sardor «I will repay your loan not now but in two years, in exactly the same amount», Sardor loses out: over those two years he could have put the money in a deposit and earned interest.
6. Liquidity. The ability to turn property into money quickly and without losing value. Mini example: money on a card can be used instantly. If some item is bought and kept, then when money is needed a buyer has to be found, and if it is sold in a hurry, it may go cheaply.
7. Cash flow. The movement of money coming in and going out over a certain period. Mini example (hypothetical): in December Sardor received a bonus and the family's income was 10 000 000 soum, while spending on a wedding and gifts was 9 000 000 soum. The net cash flow for that month is 1 000 000 soum.

The glossary page for each term is in the links at the end of the page.

Three ways to keep savings: the terms in practice

Let us assume prices rise by 10% in a year and the deposit pays 15% a year (both are hypothetical; tax on deposits and other conditions are not taken into account):

The table shows one idea: the value of money should be judged not only by its amount but together with price changes, interest and liquidity. Which way is better depends on real rates, the term and the family's goal.

In the next lesson

In the third lesson we will see how the financial system is built: how money circulates between families, businesses, banks and the state.