It does this by stimulating both saving and investment and facilitating transfers of funds out of the hoards of savers and into the hands of borrowers, who want to undertake investment projects but do not have enough of their own money to do so. Financial markets give savers a variety of ways to lend to borrowers, thereby increasing the volume of both saving and investment and encouraging economic growth.
People who save are often not the same people who can see and exploit profitable investment opportunities. In an economy without money, the only way people can invest (for example, to buy productive equipment) is by consuming less than their income (saving). Similarly, in an economy without money the only way people can save-that is, consume less than their income-is by acquiring real goods directly.
The introduction of money, however, permits the separation of the act of investment from the act of saving: Money makes it possible for a person to invest without first refraining from consumption (saving) and likewise makes it possible for a person to save without also investing. People can now invest who are not fortunate enough to have their own savings.
In a monetary economy, a person simply accumulates savings in cash because money is a store of value. Through financial markets, this surplus cash can be lent to a business firm borrowing the funds to invest in new equipment, equipment it might not have been able to buy if it did not have access to borrowed funds. Both the saver and the business firm are better off: The saver receives interest payments, and the business firm expects to earn a return over and above the interest cost. And the economy is also better off: The only way an economy can grow is by allocating part of its resources to the creation of new and more productive facilities.
In an advanced economy such as ours, this channeling of funds from savers to borrowers through financial markets reaches highly complex dimensions. A wide variety of financial instruments, such as stocks, bonds, and mortgages, are utilized as devices through which borrowers can gain access to the surplus funds of savers. Various markets specialize in trading one or another of these financial instruments.
And financial institutions have sprung up-such as commercial banks, savings banks, savings and loan associations, credit unions, insurance companies, mutual funds, and pension funds-that act as intermediaries in transferring funds from ultimate lenders to ultimate borrowers. Such financial intermediaries themselves borrow from saver-lenders and then turn around and lend the funds to borrower-spenders. They mobilize the savings of many small savers and package them for sale to the highest bidders. In the process, again both saver-lenders and borrower-spenders gain: Savers have the added option of acquiring savings deposits or pension rights, which are less risky than individual stocks or bonds, and business-firm borrowers can tap large sums of money from a single source. None of this would be possible were it not for the existence of money, the one financial asset that lies at the foundation of the whole superstructure.
Uncontrolled, money may cause hyperinflation or disastrous depression and thereby cancel its blessings. If price inflation gets out of hand, for example, money ceases to be a reliable store of value and therefore becomes a less efficient medium of exchange. People become reluctant to accept cash in payment for goods and services, and when they do accept it, they try to get rid of it as soon as possible. As we noted above, the value of money is determined by the price level of the goods money is used to purchase. The higher the prices, the more dollars one has to give up to get real goods or buy services. Inflation (rising prices) reduces the value of money. Hyperinflation (prices rising at a fast and furious pace) reduces the value of money by a lot within a short time span. Hence people don’t want to hold very much cash; they want to exchange it for goods or services as quickly as possible. Thus if money breaks down as a store of value, it starts to deteriorate as a medium of exchange as well, and we start to slip back into barter. People spend more time exchanging goods and less time producing, consuming, and enjoying them. A severe depression causes different but no less serious consequences.
So once we have money, the question constantly challenges us: How much of it should there be?