What is the Role of Money in a Capitalist Economy?

Money is the backbone of capitalism. Productive activity under capitalism is organised in the hope of reaping a rich monetary reward. Money moves and moulds the working of a capitalist economy.

An analysis of the framework and working of the capitalist economic system, as given below, would enable us to appreciate the significance of money in such an economy.

Broadly speaking, capitalist economy has the following characteristic features:

1. It is a free enterprise economy.

2. The means of production in this economy are owned and exploited by the private sector.

3. Under pure capitalism, there is complete economic freedom of choice as regards consumption, production, saving and investment. The customer is sovereign as he has immense freedom to make alternative choices in his consumption.

Similarly, a producer in a capitalist economy can put his productive resources land, labour, capital and entrepreneurial skill in any business where he finds a good scope.

4. Private entrepreneurs initiate production with a view to earning high profits. Thus production in a market-oriented free enterprise economy is usually profit-based rather than need-based.

5. Income distribution is made in a monetary form.

6. Capitalist economy is an unplanned economy.

In the capitalist type of economy, in the absence of any centralised planning, economic decisions as regards production and distribution of real income are dependent on the private sector’s initiative and choice.

It is, however, claimed that despite lack of preplanning, a capitalist society tends to attain an optimum level of equilibrium, having an optimum allocation of resources such that wants and resources of the community are adjusted in the most economical manner.

It may be asked how this is possible. The usual answer to this question is it is made possible by the working of the invisible hand of the market mechanism in a free economy under perfect competition.

It is the firm belief of the protagonists of pure capitalism that market mechanism ordains the functioning of the capitalist economic system.

The forces of market mechanism reflect their influence through the price system, which serves as a guide-post to the producers and consumers in making their economic decisions. The price system exists due to money; and herein lays the significance of money.

In a capitalist economy, consumers can make their choice of consumption, that is, an express consumer’s sovereignty, by spending money on the desired products.

When the consumers’ desires are translated into money, they become effective demand. Under capitalism, producer’s main motive being earning of maximum profit, they will produce just those goods in which there is a good scope of yielding high profits.

Profits, however, depend on price. And price, in turn, is determined by the interaction of market demand and supply. Hence, the producers will use their resources to produce such goods which have more demand and high profitability.

Overproduction in relation to demand obviously implies loss to the producers. Thus, producers will so determine their production as to cater to a given market demand which, in turn, is determined by effective desire to buy given quantities of goods at different prices which, in turn, tends to determine producers decisions as to what type of goods should to produced and in what quantities. Therefore, under capitalism, producers treat consumers as their masters.

When consumers demand for a commodity rise the initial market supply being inelastic, the market price rises, implying a rise in the profitability of its product.

Production being profit-oriented in a free enterprise economy, expansion of output of such a commodity will automatically be induced. Similarly, in respect of those goods in which consumers show a negative preference, the total demand for these goods contracts, hence price and thus profits will decline.

Eventually the producers will cut down the output of such goods and adjustment between demand and supply is brought about. Again the producers’ demand for productive factors such as land, labour and capital is derived from the demand for consumption goods by the community at large.

Hence, the allocation of economic resources to different sectors and industries is determined by the consumers’ demand expressed in terms of their money spending. And the effective desire of the consumers at large is revealed to the producers through the price mechanism.

Functioning of Price Mechanism:

The working of the price mechanism, in short, implies that changes in demand or preferences of consumers disturb the price equilibrium which in turn leads to a process of change in the demand and supply position in the market and to adjustments in the price which tends to restore the equilibrium to a new point in a free market economy.

Thus, a good performance of a free market economy is designed and directed by the price mechanism which is nourished by the supply of money.

To elucidate the point further, let us suppose that due to a change in the consumers’ preferences, the demand for commodity X has increased while that of commodity Y has decreased.

Consequently, the price of X would rise and that of Y would fall. Obviously, profitability in X industry then improves and production of Y would be relatively less profitable.

Eventually, the producers would tend to reduce their investment in Y industry and employ the released resources in X industry. In this way, in a free enterprise perfectly competitive economy, economic decisions pertaining to the exploitation of resources in an optimum way, is automatically made under the compulsion of the forces of market mechanism.

Again, money also serves as a means of attaining an optimum distribution of income. As money is generally acceptable in the settlement of all kinds of debts and payments to the productive forces, income is earned by factors of production in terms of money. Rewards for the services of these factors are measured in terms of money, depending upon their demand and supply position.

Since all incomes are received in the form of money in a modern capitalist economy, consumers outlays, savings and investments are also made in the form of money. The rate of interest is purely a monetary phenomenon which is a significant factor in determining savings and investment flows at an equilibrium level.

Money in a capitalist economy influences the operative forces of the economy; it does not remain just a technical device of exchange. Money tends to release the latent resources of the economy into productive channels.

Thus, hoarding and dishoarding of money can have profound influences upon the functioning of the capitalist economic system. A change in the flow of money may significantly affect the total volume of investment, employment, output, pattern of consumption and production and distribution of income and wealth in the capitalist society.

Though money by itself is sterile as it can create no value it can strongly influences the creation of utilities, owing to its ability to facilitate exchange and specialisation in a modern economy.

As Leontyev puts, “Developed commodity production is inconceivable without money.” Money propels the all-round economic links and connection of the commodity producers and trade transactions for the mutual satisfaction of people’s wants in a modern capitalist society.

A modern capitalist government finds, money a convenient instrument with which to run the public administrative machine in a smooth manner. In a modern economy, a government’s financial activities are reflected through its annual budgets.

Public revenue, public expenditure, public debt and deficit financing etc. are all expressed in terms of money. Through appropriate fiscal policies and fiscal management (which operate through money), a modern government can effectuate economic growth in a decisive manner and influence the entire economic life of the capitalist society.

In short, the growth of money economy has caused the growth of economic liberalism, leading to the progress of modern capitalism as we see it today.

Indeed, money has occupied a strategic place in the culture of a modern capitalist society. Most economic activities today relate to nothing but earning and spending money. Money has become the measuring rod of values and welfare in the economic life of a modern man.

Money has made efficient accounting and budgeting possible. It simplifies and signifies choices between work and leisure, spending and saving, hoarding and investing through the pricing process.

It is through the functioning of price mechanism that the pricing processes in different markets are interrelated and equilibrium is reached in a capitalist economy.

The capitalist economy, however, tends to be inherently unstable due to the instability in the price level caused by the instability in the flow of money.

The capitalist economy is subject to wide economic fluctuations if money is not well managed and things are left completely uncontrolled. The flow of money is inherently unstable under the capitalist set-up of banking; so it will not manage itself in the best interests of society.

Money unwittingly has given birth to many social evils like concentration of wealth in the hands of a few, inequalities of income distribution among the community, resulting in the widening of the gap between the rich and the poor, inflation and deflation, lopsided economic development, deterioration in general welfare, poverty amidst plenty, decline of public morals, etc.

To quote D.H. Robertson: “Money which is a source of so many blessings to mankind, becomes also, unless we can control it, a source of peril and confusion.” Thus money must be managed wisely for the efficient working of the economic machine.

It must be remembered that though money is the life vein of modern economy, its significance should not be exaggerated. Flow of money will activise the productive resources, but the real growth of economy and rise of national income are conditioned by the availability of real resources rather than money supply.

Money supply in a capitalist economy, or for that matter in any economy, cannot make up for any deficiency or scarcity of real resources.

The flow of money may be helpful in maintaining the rate of production near the potential productive capacity, but money by itself cannot raise the potentiality of the real resources available in a country.

What money can utmost do is to cause a fuller utilisation of the given natural resources and keep the wheels of economy moving smoothly along the right road, provided the monetary system is well managed.