Money

Money is one of the greatest inventions of mankind. It developed through

aUeral centuries and passed through several phases before it appeared in
its present form. According to Prof. Walker, "money is as money does".
This means the term money should be used to include anything which
performs the functions of money as medium of exchange, measure of
value, unit of account etc. It simplifies the exchange and production of
output. It is also accepted for repayment of debts.

There was no money in any economy in the initial stages of development.

The system which was prevalent was the barter system in which there
was a

direct exchange of one commodity for the other.

Barter System

A system in which goods and services are directly exchanged for other

goods without the use of money is called barter system In such an

economy, a person gives his surplus good and gets in return the goods he
need.

Difficulties of Barter System

In spite of its usefulness there are certain weaknesses of barter system

which

are explained below.

Lack of Double Coincidence of Wants

For a successful deal of goods, satisfaction of b both the parties is

essential. It means that a person having some good and I looking for its
exchange with the other good must get that. For example a person has a
piece of cloth: and he wants to exchange it with wheat, first of all he will
have to hunt for such a person who owns it and secondly he is willing tor
exchange. This exercise generally takes a long time and consumes energy
therefore this system did not succeed

Lack of Common Measure of Value

The second important drawback is the lack of common measure of value

Iftwo persons come across each other to cagerly exchange their goods,
then what will be the common yardstick to measure the value of different
goods for the purpose of exchange? For example if one person has meat
and the other has fuit. then how would this exchange take place as both
these goods are measured in diflerent units. Absence of a common
denominator in order to express exchange ratios create many difficulties.
Besides for every new transaction the determination of value will be
required afresh.

Indivisibility of Goods

In this system sometimes indivisibility of certain goods becomes a

problem due to which exchange of different goods do not take place. For
example a person having cycle and he wants to avail some cloth, oil and
rice. Now how would he allocate his cycle to avail different units of
different commodities? As a matter of fact the cycle in chunks is of no
value for those who possess the cloth, oil and rice.

Lack of Store of Value

It means people cannot store the value of goods because bulk of goods
when stored are either damaged or become less useful. For example
wheat, rice, sugar, etc. cannot be stored for a long tinme. Holding of
stocks of such goods involves costly storage also. However in the case of
money the value of any kind of good can be stored.

Inconvenience in Lending and Borrowing

in he system due to the time lapse, the value of goods may decrease
which affect those who generally lend because at the time when they lend
the goods may be of great value but it is very much possible when the
goods are returned after some time, it may not have the value as it had
before. For example at the time of scarcity, a person borrows some wheat
from another person and returns it back after some time when it is
abundant. Here the lender suffers because at the time of lending the
value of wheat was so high while at the time of return the value is
decreased.

Transfer of Wealth

Under the direct exchange, it is difficult to transfer certain goods from

one

place to another which in the case of money is quite easy. A person

having a house cannot shift it from one place to another while he can
transfer its value in the form of money.
Money-Meaning and Functions

Money can perform a number of functions such as a medium of

exchange, a unit of account, a store of value and a standard of deferred
payments. Therefore, money may be defined as "anything which is
generally acceptable by the people in exchange of goods and services or
repayment of debts"

Functions of money

1 Primary Functions (Main Functions)

2. Secondary Functions (Subsidiary Functions)

1. Primary Functions

Primary Functions include the most important functions of money, which

it must accomplish in every country,

1. Medium of Exchange

Money, as a medium of exchange, means that it can be used to make

payments for all transactions of goods and services. It is the indispensable
function of money. Money has the value of general acceptability so, all
exchanges take place in terms of money.

1. This function has removed the major difficulty of lack of double

coincidence of wants and inconveniences associated with the barter
system.

2. Use of money allows purchase and sale to be conducted independently

of one another.

3. This function of money simplifies trade and helps in conducting

transactions in an economy.

4. Money has no power to satisty human wants, but it commands

power to purchase those things, which have utility to satisfy

human wants.

2) Measure of Value (Unit of Value)

Money as measure of value means that money works as a common

denomination, in which values of all goods and services are voiced.

1.By reducing the value of all goods and services to a single unit (1.e.
price), it becomes very easy to find out the exchange ratios between them
and comparing their prices.

2. This function eases maintenance of business accounts, which would be

otherwise impossible.

3. Money helps in computing relative prices of goods and services. As a

result, it is regarded as a Unit of Account'. For example, "Rupee' is the unit
of account in India, Pound' in England and so on.

2. Secondary Functions

These denote those functions of money which are supplementary to the

primary functions. These functions are derived from primary functions
and, therefore, they are also known as Derivative Functions'.

The major secondary functions are

1.Standard of Deferred Payments

Money as a standard of deferred payments or delayed payments

immensely simplifies borrowing and lending operations because money
maintains a constant value through time. Every day, nmillions of
transactions take place in which payments are not made immediately.
Money encourages such transactions and aids in capital formation and
economic development of the economy.

This function of money is significant because:

1 Money as a standard of deferred payments has simplified the borrowing

and lending operations.

2. It has led to the creation of financial institutions. Money is the link

which connects the value of today with those of the future.

(ii)Store of Value

Money as a store of value means that money can be used to transfer

purchasing power from present to future. Wealth can be stored in terms of
money for future. It serves as a store of goods in liquid form. Although
wealth can be stored in other forms also, but money is the most
economical and convenient way. It provides security to individuals to meet
contingencies, unpredictable emergencies and to pay future debts. Under
barter system, it was difficult to use goods as a store of wealth due to
perishable nature of some goods and high cost of storage.

Money as store of value has the following advantages

1.Money is available in fractional denomination,

2. Money is easily moveable, So, it is casy and economical to storemoney

as its storage does not require much space,

3. Money has the value of general acceptability so; it can be easily

exchanged for goods at all times.

4. Savings in terms of money are much more secured than in terms of

goods.

To understand the problems of saving in a barter economy let us consider

an example, if a coal miner wanted to set aside a certain amount of coal
each week for the same purpose, he would have problems of finding
enough storage space for all his coal. By using money, such problems can
be overcome and people are able to save for the future. Modern form of
money (like coins, notes and bank deposits) permit people to save their
surplus income.

Significance of money
Money occupies a unique position in a modern capitalist economy. In its
absence, the whole prosperous economic life would collapse like a pack of
cards.

1. Money has overcome drawbacks of barter system. The barter system

suffers from four main drawbacks, each of which is overcome by a

specific function of money as explained below:

(i) Money as medium of exchange resolves the barter's problem of lack of

double coincidence of wants as money has separated the acts of sale and
purchase. one can sell goods for money and can also buy goods.Money is
accepted as medium of exchange. People exchange goods and services
through medium of money when they buy goods or sell goods. Thus,
money becoming intermediary answers barter's problem of double
coincidence of wants.

ii) Money as measure (unit) of value or a unit of account solves the

barter's problem of absence of common measure of value. Money serves
as a unit of value or unit of account and acts asa yardstick to measures
exchange value of all commodities. The value of each good or service is
expressed as price (i.e. money units) which guides both consumer and
producer to make a transaction Thus money makes keeping of business
account possible.
 (ii) Money as store of value solves the barter's problem of difficulty in
storing wealth. Furthermore, money in convenient denominations solves
the barter's problem of absence or lack of divisibility.

(iv) Money as standard of deferred payments helps to solve the barter

problem of lack of standard of deferred payment. Again, it helps to make
contracts which involve future payments. Doubtlessly money helps in
removing the difficulties of barter system.

2.It facilitates exchange of goods and services and helps in carrying on

trade smoothly. The present highly complicated economic system will not
exist without money.

3.Money helps in maximising consumers satisfaction and producers profit.

It helps and encourages saving.

4..Money promotes specialisation which increases productivity and

efficiency..

5. It facilitates planning of both production and consumption.

6.Money can be utilised in reviving the economy from depression

7.Money enables production to take place in advance of consumption

8. It is the institution of money which has proved a valuable social

instrument of promoting economic welfare. The whole economic science is
based on money; economic motives and activities are measured by
money.

Quantity Theory Of Money.

This theory was developed by the classical thinkers like Adam smith,
Ricardo, J.S.Mill and was popularized by Irving Fisher.

The quantity theory of money states that there is a direct relationship

between the quantity of money in an economy and the level of prices of
goods and services sold. In its extreme form, the theory states that , other
things remaining equal, the changes in the general price level are directly
proportional to changes in the supply of money. According to QTM, if the
amount of money in an economy doubles, price levels also double,
causing inflation . The consumer, therefore, pays twice as much for the
same amount of the good or service.

In its simplest form, it states that the general price level (P) in an
economy is directly dependent on the money supply (M);

P= f(M)
 If M doubles, P will double. IfM is reduced to half, P will decline by e Same
amount. This is the crux of the quantity theory of money. Though the
theoy Was tirst stated in 1586, it received its complete popularity at the
hands o e Fisher in 1911. Later, an alternative approach was given by a
group of Cam-bridge economists. However, the basic conclu-sion of these
two theories is similar that price level varies directly with and
proportionally to money supply.

Implications of the Theory

The above statement implies the following relationships:

1. The money supply i.e. quantity of money and the general price level

are directly functionally related. P=f(Ms)

Where p= price level and Ms= money supply

If money supply increases, the price level also increases and with the
decrease in money supply, the price level also decreases. Moreover, the
change in the price level is exactly in the same proportion.

2. The money supply i.e. quantity of money and the value of money i.e
purchasing power of a unit of money are inversely related. l/p-f (Ms)

Where 1/p=value of money and Ms= money supply

It implies, if the quantity of money rises, the value of money falls and
with the fall in the quantity of money the value of money rises. Further,
the quantity of money and the value of money are proportionately related.
That means, if the quantity of money is doubled, the value of money is
halved and on the other hand if the quantity of money is halved, the value
of money is doubled.

Quantity Theory of Money- Fisher's Version

Like the price of a commodity, value of money is determined by the

supply of money and demand for money. In his theory of demand for
money, Fisher attached importance on the use of money as a medium of
exchange. In other words, money is demanded for transac -tion purposes.

The transaction version of the quantity theory of money was presented

by Irving Fisher in the form of an equation of exchange:

MV =PT

Supply of Money-Demand for Money

Where

M= total stock of money in an economy;

V= velocity of circulation of money, that 1s, the average number of times

a unit of money changes its hand; P=general price level or index of

prices;

T= total volume of f transactions of goods and services during a given

period

of time.

This equation states us that the total stock of money used for
transactions must equal to the value of goods sold in the economy. In this
equation, supply of money consists of nominal quantity of money
multiplied by the ve-locity of circulation.

The stock of money, thus, defines the price level. People hold money more
than their need for transactions when money supply increases. Holding of
money is impractical. So they spend money. This extra expenditure, given
full employment, raises the price level.

Obviously, a rise in the price level means an increase in the value of

transactions and, hence, demand for money rises. The process will last
until the equality between de-mand for and supply of money is rebuilt.
Modified Equation

The above equation was criticized by some of the monetary experts for
ignoring credit money and its velocity. Therefore,

Fisher's cash transaction version can be extended by including bank

deposits in the definition of money supply. Now money supply comprises
not only legal tender money, M but also bank money, M'. This bank money
has also a stable velocity of circulation, V'.

Thus the above equation can be written as

MV +M'V'= T

OR

MV +M’V’

P= ----------------

Assuming V, V', T and the ratio of M and M constant, an increase in M and

M' will cause P to rise also by the same percentage.

"Other things remaining unchanged, if the quantity of money is doubled,

the value of money i.e. the purchasing power of a unit of money is halved
and on the other hand if the quantity of money is halved, the value of
money is

doubled.

Assumptions of Fisher's Equation

Fisher's equation of exchange is based upon the following assumptions:

1. The price level “p" is a passive factor in the equation of exchange. That
means price is affected by other factors in the equation but does not
affect change in those factors.

2. T and V remain constant during the short period.

3. The theory further assumes that the ratio of bank money to legal
tender

money remains constant.

Note --- ( I have also given this theory and it’s diagram in the class in
easierversion.

You can refer to the same )

Supply of Money
Money supply means the total amount of money in an cconomy. The
supply of money means the total stock of all forms of money i.e paper
money, coins and demand deposits of bank which are held by the public
at any particular point

of time.

Different measures of money supply denoted by M1, M2, M3 and M4 as

follows:

Among these measures M1 is the most commonly used measure of

money supply because its components are regarded as most liquid assets.

MI =C+ DD + OD
 Here C denotes currency held by public. Currency includes paper currency
and coins that is notes issued by the RBI and one rupee and other small
coins issued by the Government of India. DD stands for demand deposits
in banks and OD stands for other deposits in RBI. Demand deposits are
deposits which can be withdrawn at any time by the account holders.
Current account deposits are included in demand deposits. But savings
account deposits are not included in DD.OD stands for other deposits with
the RBI which includes demand deposits of public financial institutions,
demand deposits of foreign central banks and international financial
institutions.

M2 = M1 + Savings deposits with post office saving banks

M3 = Ml + net timne deposits of banks

M4 = M3 + total deposits with post office saving banks.

Each definition of money supply from MI to M4 has its believers; but by

and large most economists prefer the most common sense and most
acceptable definition of money or money supply, that is, M1-because it
includes everything that is generally acceptable as a means of payment.

M1 and M2 treated as measures of narrow money whereas M3 and M4 are

measures of broad money.

High powered money and measurement of money

supply
It should be noted that money supply is not always policy determined. In
fact, money supply is determined jointly by monetary authority, banks and
the public.

High powered money or powerful money refers to that currency that has
been issued by the Government and Reserve Bank of India. Some portion
of this currency is kept along with the public while rest is kept as funds in
Reserve Bank.

Thus, we get the equation as

H=C+R

Where H= High Powered Money

C=Currency with the public (Paper money + coins)

R= Government and bank deposits with RBI

Thus the sum total of money deposited with the public and the funds of
banks is termed as powerful money. It is mainly created by the central
bank. Since funds of commercial banks play an important role in the
creation of credit, so it is very important to study about funds.

Reserve Fund is of two types

(1)Statutory Reserve Funds of banks which is with the central bank (RR),
and
(2) (ii) Extra Reserve Fund(ER).

Thus H=C+RR + ER

High powered money is also known as secured money (RM) because

banks

keep with them Reserve Fund(R) and on the bases of this Demand
deposits (DD) are created. Since the bases of creation of credit is Reserve
Fund (R) and R is obtained as a part of high powered money (H) Security
fund so high powered money is termed as Base money.

The following are the important components which determine high power
money:

1. Currency with the public 2. Other Deposits with RBI 3. Cash with Banks

4. Banker's Deposits with RBI.

High powered Money (H) includes currency with Public (C), important
reserves of Commercial banks and other reserve (ER).

Thus we get the equation H=C+ RR + ER

The following are the sources of High Powered Money:

(1) Claims of Reserve Bank of India:

Reserve Bank also provides loans to the government. This loan is in the
form of investment in government securities by the Reserve Bank. After
deducting the deposits of government from quantity of loan of Reserve
Bank quantity of net bank credit to government is calculated. It is also a
source of High Powered Money

2.Net Foreign Exchange Assets of Reserve Bank

It is the work of Reserve Bank to make arrangement for foreign exchange

funds. When, Reserve Bank purchases foreign securities by paying the
money of the country, then the quantity of foreign exchange increases
which increases high powered money. On the contrary, when Reserve
Bank sells foreign securities, then the quantity of foreign exchange with
the central bank of the country decreases. It results decrease in high
powered money.
(3)Government's Currency Liabilities to the Public
Finance Ministry of the Indian Government is responsible for printing
one rupee note and also for coinage. This function is done through the
government for completing money related responsibilities towards the
public. Thus with the increase in these liabilities, quantity of supply of
money will increase and the quantity of High Powered money will also
increase.

(4) Net Non-Monetary Liabilities of Reserve Bank

The non-monetary liability of Reserve Bank is in the form of capital

introduced in national fund and statutory fund. Its main items are-Paid up
Capital, Reserve Fund, Provided Fund and pension fund of the employees
of Reserve Bank of India.

Non-monetary liabilities of Reserve Bank are inversely proportional to

high Powered Money i.e. with the increase in non-monetary liabilities,
there will be a decrease in the quantity of new high powered money

Note ( Sources of high powered money is extra Information.

Not mentioned in syllabus

I hv included just if asked in section 2 ).

Demand for Money:

The amount of wealth everyone in the economy wishes to hold in the

formof money balance es is called the demand for money.

Kevnes in his book "The General Theory of Employment and Money

(1936)" introduced a different term for demand for money and called it
Liquidity Preference.

He does not disagree with the classical and neo-classical concept that
money is demanded as a medium of exchange but he varies on the point
that money is demanded only as a medium of exchange. Keynes observed
that money has a ready purchasing power and can be transformed into
any commodity when wanted, then why to prefer liquidity or cash
balance. The Neo-classical economists failed to recognize this.

Keynes viewed that money is demanded due to three main motives:

1. Transaction Motive (Mt)

 It is the demand for money to meet daily transactions. It depends directly
on the level of income. Mt -f(Y).

The need for holding money arises because this a time gap between
receipt of income and expenditure. Income received weekly,monthly or
annually but spent almost regularly or when need arises. For
eg. ,individuals getting their salary on monthly basis doesn’t spend entire
income on first day of month.

They hold some money for telephone and electricity bills and house tax to
be Paid when demand is received.

Thus, transaction demand is positively related to the level of income.

Also whatever the rate of interest ,people cannot stop paying grocer’s
bill ,house rent ,electricity bills etc.

So analysis of keynesian theory is based on assumption that transaction

dema d for money is interest inelastic.

2. Precautionary motive (M p) It is the demand for money for meeting

future contingencies. This depends directly on the level of income.
Individuals and firms both desire to hold cash balances for covering
events of a more uncertain nature, like accidents , prolonged illness ,
replacement of a machinery.

damage by an accident etc. like transactions motive, precautionary

demand for money is also closely related to the level of income. At higher
level of income, individuals and fims may keep more cash balances for
meeting unforeseen situations.

Higher the level of income ,the higher the demand for money for
precautionary motive.

Mp = f(Y)

2. Speculative Motive (Msp)

In a dynamic society there is no certainty regarding future. In such a

situation, the store of value function is more important. It is this second
function of money which gives rise to "asset demand for money", This
leads to speculative motive for hoarding money, a new approach debated
by Keynes.
It is termed as speculative motive because it depends on the hopes of
gains and fears of loss in future. It relates to the desire to hold one':
resources in liquid form in order to take advantage of the market
movements regarding future change in the interest rate. The amount of
money held for speculative motive will depend on the interest rate When
the rate of interest is low people will demand more cash and at higher
rate of interest, they will like to convert their cash into income earning
assets.

Msp= f(i)

Therefore we have two separate demand for money: the speculative

demand as a function of the rate of interest and the transactions/
precautionary demand determined by the level of income.

Liquidity Trap
 We can think of a situation in which rate of interest falls to such a low
level that it becomes totally unattractive to invest money in bonds. In
such a situation.

demand for money becomes perfectly elastic. The demand curve

assumes the

Shape of a horizontal straight line curve parallel to the X axis. This

situation is called as liquidity Trap.