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Subject ECONOMICS
Paper no and Title Paper 11: Money and Banking
Module no and Title Module 1: Definition of money
Module tag ECO_P11_M1
TABLE OF CONTENTS ,
Learning Outcomes
2. Introduction
3. Barter exchange
4. Functions of money
4.1 Medium of exchange
4.2 Unit of account
ECONOMICS PAPER No. : 11 MONEY & BANKING
MODULE No. : 1 DEFINITION OF MONEY
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4.3 Standard of deferred payment
4.4 Store of value
5. Money and liquidity
6. Physical properties of money
7. Definition of money
7.1 Functional definition
7.2 Legal definition
7.3 Narrow and Broad definition
7.4 Theoretical and Empirical approach
8. Evolution of money and banking
9. Classification of money
10. Summary
1. Learning Outcomes
After studying this module, you shall be able to
· Know about the importance of money in an exchange economy.
· Learn about the various definitions of money
· Identify the functions of money, its characteristics and classifications
· Evaluate the theoretical and empirical approaches
· Analyse the evolution of money and banking
2. INTRODUCTION
Economists have considered various aspects of money, such as the reason for its existence,
changes in its form, and its role in economic growth and development. Income and wealth are
often considered synonymous to money but while they may be expressed in terms of money they
are not the same thing. We therefore need to define money by its use in an exchange economy, in
terms of its specific functions within the financial system. By specifying precisely what it does,
we can distinguish money from all other assets in the financial system. We also need to know
how money comes into existence and what causes it to change over time. This requires an
analysis of its nature, role and origin.
3. BARTER EXCHANGE
DISADVANTAGES OF BARTER EXCHANGE
The first disadvantage would be a lack of double coincidence of wants. It would be extremely
difficult to find someone who wishes to purchase right now, exactly what you would like to sell.
Thus, exchange under a barter system is costly in terms of the search time and effort. Barter
presents even more serious difficulties when the articles to be exchanged are not of the same
value and cannot be divided without loss of value. This makes it an inefficient and cumbersome
way to conduct transactions. It raises the transactions costs and holds down the volume of
exchange in the economy.
ECONOMICS PAPER No. : 11 MONEY & BANKING
MODULE No. : 1 DEFINITION OF MONEY
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The second disadvantage of pure barter is the lack of any
common unit in terms of which to measure and state the values of goods and services. The value
of each good would be expressed in terms of each of the other goods. If there are n goods in the
barter economy, there would be n(n - 1) / 2 prices. No meaningful accounting system would
be possible in such an economy.
The third disadvantage of pure barter is the lack of any satisfactory unit in terms of which to write
contracts requiring future payments. These future payments would have to be stated in terms of
specific goods and services. Though this would be possible, it would lead to three difficulties (1)
regarding the quality of the good or service to be repaid (2) the parties would often be unable to
agree on the specific commodity to be used for repayment (3) both parties would run the risk that
the commodity to be repaid would increase or decrease in value over the duration of the contract.
The fourth disadvantage of pure barter, which results from its other shortcomings, is the lack of
any method of storing generalized purchasing power. People could store purchasing power for
future use only by holding specific commodities or claims against specific commodities. The
stored commodity may deteriorate or appreciate in value, its storage may be costly, and it may be
difficult to dispose off quickly without loss, if its holder wishes to buy something else.
All the disadvantages mentioned above make pure barter a highly inefficient means of trade and
to overcome these difficulties every society invented some kind of money, early in its
development. The development of money has passed through various stages in accordance with
time,place and circumstances with the progress of civilization....
This can be summarized as : Transaction costs associated with barter à encourages à
Development of Money à facilitates à Exchange Trading à facilitates à Specialization and
division of labour à facilitates à Economic Development.
4. FUNCTIONS OF MONEY
Money performs four specific functions, each of which obviates one of the difficulties of pure
barter. These functions are to serve as 1) a medium of exchange 2) a unit of value 3) a standard of
deferred payments and 4) a store of value. The first two are called the primary functions of
money. The last two are called the derivative or secondary functions because they are derived
from the primary functions.
4.1 MONEY AS A MEDIUM OF EXCHANGE
One of the unique function and in fact an essential and primary distinguishing characteristic of
money is that it is anything generally acceptable as a means of payment in the settlement of all
transactions, including debt. It is a commonly used medium of exchange or means of transferring
generalized purchasing power.
It is a device to permit people to exchange goods and services without need for conversion into
anything before being spent. Hence, ATM cards, property, gold, FDR’s are not money. However,
faith or belief or confidence in its general acceptability is very important. The assets which are
generally acceptable in exchange may vary from one country to another or from one period to
another within the same country.
ECONOMICS PAPER No. : 11 MONEY & BANKING
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Money saves time and energy and allows people to buy what
they want, how much, at the best bargain or terms, at the time
they think best. By economizing on the use of scarce real resources, money promotes
transactional or operational efficiency.
In addition, it promotes allocational efficiency by making it possible to exploit potential gains
from specialization in trade and production. It also leads to emergence of specialized markets in
all types of goods and services. By giving freedom of choice to individuals as a bearer of options,
it thereby promotes economic welfare.
By separating the act of sale and purchase, it replaces bilateral trading with multilateral trading
leading to specialization and division of labor. As one moves from a barter exchange economy to
one of monetary exchange, the length of transaction period and the total trading cost decrease.
The use of money for similar transactions also enhances competition. A monetary economy
eliminates the problem of double coincidence of wants.
4.2 MONEY AS A UNIT OF ACCOUNT / UNIT OF VALUE / STANDARD /
MEASURE OF VALUE
This is the second primary function of money where the monetary unit is the unit in terms of
which the value of all goods and services are measured and expressed. It therefore helps in
determining the price or the number of monetary units each good or service would exchange for,
making it possible to compare prices and have relative prices.
It simplifies the problem of measuring the exchange value of commodities and makes accounting
of national income, costs, profits assets and liabilities possible. It permits rational economic
calculations and transmits economic information about market preferences of consumers to
producers and makes possible specialization and division of labor. Unlike physical units which
are inter temporally and inter regionally constant, the value of money is inversely related to the
price level and hence does not remain constant in terms of the goods and services you can buy
with it, making money a poor unit of account.
4.3 MONEY AS A STANDARD OF DEFERRED PAYMENT OR UNIT OF
CONTRACT
Money serves as the standard or unit in terms of which deferred or future payments like interest,
rent, salaries, pensions etc. are stated. This is concomitant with the first two functions because the
person who pays cash later quotes money price as a unit of account. These contracts are for the
payment of principal and interest on debt where future payments are stated in terms of monetary
units. Money is a satisfactory standard of deferred payment if and only if its purchasing power,
that is, the value of money remains constant.
4.4 MONEY AS A STORE OF VALUE
This function is also concomitant with the other functions and since money as a medium of
exchange, separates the act of sales and purchase, the two are made at different points of time, i.e.
you can sell now, get money, store that money and purchase later. What you store is generalized
power that can be used any time. This is particularly relevant in a money using economy where
ECONOMICS PAPER No. : 11 MONEY & BANKING
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income and expenditure are discontinuous i.e. wages, interest,
salary etc. are got at one point of time and spent over the
month till the next receipt. Therefore, money is stored in the form of generalizing purchasing
power.
As a store of value, money scores over physical assets which may involve storage costs,
deteriorate or become obsolescent or have transaction or brokerage costs since they are not
acceptable in exchange for goods and services. Money is also a good store of value because it is
perfectly liquid.
5. MONEY AND LIQUIDITY
Liquidity is a term used by economists to describe how cheaply and easily an asset may be
converted into a medium of exchange. This has the following aspects:
A. MARKETABILITY – money is readily acceptable in exchange for goods and services.
B. PREDICTABILITY - money value can be anticipated for making payments in the future.
Unlike money, values of shares on stock exchanges are not predictable and hence considered
illiquid.
C. REVERSIBILITY – money value in payments and receipts are the same. Real assets as well
as financial assets lack reversibility as their purchases / sales are subject to tax. A car loses its
value once out of the showroom. Travelers’ cheques and mutual funds also lack reversibility as
commission charges and administrative charges are levied but not refunded.
D. DIVISIBILITY – money can be denominated in the smallest unit in which exchange dealings
can take place in an asset. This is an important determinant of the flexibility and divisibility of the
asset in exchange
.
Marketability, reversibility, divisibility and predictability are all relevant attributes in the
definition of a liquid asset
Since liquidity is a collection of characteristics which may be present in varying degrees in
various assets, it is a multi dimensional and subjective concept . Different individuals may have
different evaluations about marketability and predictability of assets. However, since the
characteristics of liquidity, marketability, predictability and divisibility of assets are designated in
terms of cash, money is liquidity par excellence, making the relationship between money and
liquidity, bi directional.
6. PHYSICAL PROPERTIES OF MONEY
Here, we need to conceptualize what are the desirable physical properties that any commodity
should have to be a good choice to serve as money. It needs to have the following characteristics
1. PORTABILITY – i.e. it should have high enough value relative to its weight to make
transportation easier, and. it should be valuable in small quantities. This was the reason why gold
and silver coins as currencies were better compared to rice, horses, cows etc. in the evolution of
money.
ECONOMICS PAPER No. : 11 MONEY & BANKING
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2. DURABILITY – i.e. it should not deteriorate with time or
wear down when handled.
3. DIVISIBILITY – into fairly small units to facilitate transactions of various sizes. Here we
may find that diamonds may be durable and portable,but they are not divisible as compared to
gold and silver.
4. INTRINSIC OR RECOGNIZABLE VALUE – to be accepted in transactions. This was
possible with gold coins stamped by authority with respect to value or even paper currency
7. DEFINITION OF MONEY
Having considered the various functions performed by money, the question arises as to what
things are included and what things are excluded in money. Money needs to be defined precisely
7.1 LEGAL DEFINITION
We could have a legal definition where money is defined in purely legal terms that is, money is
what the law states it to be. Laws can help a thing to achieve general acceptability by proclaiming
it to be money. It may grant legal tender powers by ensuring that refusal to accept it would be
punishable by law. However, things that are not legally defined as money may still come to be
generally acceptable in payment for example chequable deposits at banks are a part of money but
they are not legal tender
Legal tender or fiat money serves as money on the fiat or order of the government. It has to be
accepted or it cannot be refused in settlement of payments of all kinds. However, small coins are
usually limited legal tender for a certain maximum amount beyond which they cease to be legal
tender. Rupees two and above currency notes are unlimited legal tender. Demand deposits of
banks are fiduciary money and are accepted as money on trust only and are non legal tender. A
payee can legally refuse to accept payment from demand deposits made through a cheque because
it may be dishonoured at the issuer’s bank. Here there may be insistence on payment in cash.
7.2 FUNCTIONAL DEFINITION
The functional definition of money includes in it all those things that perform the functions of
money and excludes all others. Since the derivative or secondary functions of money can be
performed by a variety of assets, all economists agree that money supply should include all those
things that are in fact generally acceptable in payment of debt and as payment for goods and
services. A thing that is generally acceptable in payment and generally used as a medium of
payments is MONEY whatever its legal status may be
7.3 NARROW AND BROAD DEFINITION OF MONEY
The narrow definition of money is based on the function of money as a medium of exchange and
includes in it only currency and chequable deposits .There may be other assets which have a high
degree of moneyness or liquidity, but are not generally acceptable in payment or there is a delay
or cost involved in exchanging them for money. These assets which are widely used as a store of
value like saving and fixed deposits at banks are called NEAR MONEYS and are frequently
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included only in a broader definition of money. Since all assets
possess the quality of moneyness to some degree, any broad
definition is likely to have troublesome borderline cases.
7.4 THEORETICAL AND EMPIRICAL APPROACH TO DEFINITION OF
MONEY
There are two approaches for defining money
(1) A priori or theoretical approach
(2) the empirical approach
In the theoretical approach, money is first conceptualized in the form of specific functional or
institutional attributes and then the corresponding measure of money is obtained by aggregating
relevant financial assets possessing those specific attributes like medium of exchange, unit of
value, standard of deferred payments and store of value i.e. distinction should be made between
the concept of money and the measure of money where conceptualization should be distinguished
from and precede its measurement.
Second is the empirical approach which however does not rely on any pre conceived notion of
money and instead it directly arrives at a measure of money as an aggregate of financial assets
which when introduced in certain functions gives the best results in terms of specific criteria like
the highest correlation with national income or having a stable and sturdy demand function.
Among the two approaches, the theoretical approach has a greater analytical appeal and as a
sequence, you should empirically only test the adequacy of concepts and verify theoretical
hypothesis. This implies that the empirical stage comes only after the relevant concepts have been
defined and hypothesis derived from a suitable economic model.
The empirical approach confuses empirical verification with hypothesisation and therefore
forecloses the possibility of generating a testable hypothesis capable of empirical verification as a
theory, the Theretical approach is more scientific because it first develops an appropriate concept
of money as an analytical entity followed by suitable measurement of money.
We should start with a behavioral hypothesis and subject it to empirical testing. Given the
analytical superiority of the theoretical approach the next logical step is to identify the specific
attributes with which to conceptualize money. As a statistical construct, money should reflect
assets with monetary characteristics and should be specific liquid liabilities of a particular set of
financial intermediaries.
8. EVOLUTION OF MONEY
Having discussed the various functions and roles of money, one could discuss the evolution of,
and changes in the monetary system. Such is the importance of money that the breakdown of one
monetary system was immediately followed by the development of another system.
Primitive economies overcame the inconvenience of barter by the use of uncounted metals like
copper, gold and silver as means of exchange because they were generally acceptable in payment.
ECONOMICS PAPER No. : 11 MONEY & BANKING
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This could be, because they possessed the above mentioned
properties of having high value relative to its weight, durability
and portability etc. However these metals continued to be used for non monetary purposes also
and hence metal flowed freely into and out of monetary uses. The use of bullion as money had
serious disadvantages of short weighing and adulteration. Coinage solved the problem with an
official certification as to the weight and purity of the metal by the issuer who could be the king.
Though an important innovation, coinage still had the disadvantage of danger of theft and storage
problems, costs of long distance transportation along with the absence of any interest or return.
To remove this problem, people started keeping these coins with a custodian who could be a
goldsmith who kept them in a safe box and issued an I.O.U. Initially one would have to go to the
goldsmith to get the coins to make payments. Later with faith in the goldsmith the, I.O.U was
given as payments to others and passed several hands. The I.O.U as a written order authorized
that the goldsmith would pay the specified amount of metal to whosoever presented it. This was
the birth of the BANK and BANK NOTES.A debt or a promise to pay, evidenced by a piece of
paper. These paper claims were acceptable because they were believed to be fully backed by the
metal. These papers could be transferred and used as payments for goods and services. Initially
the goldsmith/bank held gold to cover all possible redemptions of bank notes and deposits. This
was 100% reserve banking because the reserves/gold was equal to the total value of outstanding
bank notes and deposits. The only profit that the goldsmith/bank got was charging fee for deposits
or trade gold for bank notes.
At another step in this evolution of money, the person leaving gold or silver with the banker
would not receive a paper representing the debt of the banker but simply a deposit credit
evidenced by an entry on the banks books. For making payments an order could be written on the
banker to pay someone else. Thus these deposit claims came to be used as a means of payment
The emerging bankers soon realized that to meet their promises to pay in specie on demand they
did not need to hold gold and silver equal to 100% of their outstanding debts in the form of
deposits and bank notes. Instead they could hold specie equal to only a fraction of their liabilities.
This was the birth of FRACTIONAL RESERVE BANKING. This principle gave banks the
power to increase or decrease the total money supply which was not there when they issued bank
notes and deposits only in exchange for an equal value of gold and silver. That was mere
substitution of one type of money for another in the hands of the public. With fractional reserve
banking, banks held some deposits as reserves in the vault but loaned out the remainder to people
in need of funds. The bank could charge interest on this loan and hence had a second source of
revenue in addition to the storage charges assessed on deposits. Here Banks are financial
intermediaries because they are accepting deposits and lending those funds to borrowers
In the evolution of banking. Bank deposits emerged as the primary medium of payments.
However the advances in computer technology and the rapid growth in credit and debit card
usage, we may be moving to a chequeless or cashless society and ELECTRONIC MONEY or
BITCOINS a virtual or electronic alternative currency that uses technology to facilitate instant
payments.
The main development is the movement from commodity money such as gold coins to credit
money, such as cheques deposits to electronic money.
9. BASIS OF CLASSIFICATION OF MONEY
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1. Physical characteristics of the material of which money is
made of i.e. whether money is in the form of gold, paper or any
commodity.
2. Nature of the issuer i.e. whether money has been issued by the government, central bank or
commercial bank.
3. Relationship between value of money as money and the value of money as a commodity,
according to which we could have
(a) Full bodied money i.e. money whose value as a commodity for non monetary purposes is as
great as its value as money e.g. rice, wool, cattle, gold coins.
(b) Representative full bodied money, which by itself may have no significant commodity value
but it represents in circulation an amount of metal with a commodity value equal to the value of
money.
( c) credit money / debt money – this is any money except representative full bodied money that
circulates at a face value which is greater than the commodity value of the material from which it
is made. It is also called fiduciary money or money that circulates as money on the basis of trust
commanded by its issuers.
This could take the form of
i) token coins like 50 paise or one rupee coins which are a small proportion of money supply
ii) representative token coins – which represent the receipt of token coins or an equal weight of
metal deposited with the government and is usually made of paper.
iii) Circulating promissory notes issued by the government. This is also called fiat money and is
usually made of paper and at present is inconvertible into anything of value except small change.
iv) Circulating promissory notes issued by private banks. This was present initially in the
evolution of money but this right was later taken away.
v) Circulating promissory notes issued by centralized banks. These are presently in the form of
notes of Rupees two and above issued by RBI.
vi) Checking deposits with banks which form a major part of money supply and are bank deposits
payable on demand and transferable by cheques and are acceptable in exchange for goods and
service. They are mere entries in the ledgers of the bank to the credit of their holders.
10. SUMMARY
In this module we examined that in the history of mankind societies learnt that
1. Money was indispensable for the efficient functioning of the economic system as barter
exchange had many problems.
ECONOMICS PAPER No. : 11 MONEY & BANKING
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2. Money served as a medium of exchange, a unit of
account, a store of value and as a standard of deferred payments of which the first two
were its primary functions and the latter two its secondary functions
3. To perform these functions, Money should have the properties of durability, divisibility,
portability and being easily recognizable in value.
4. Money is perfectly liquid as it has the properties of Marketability, Reversibility,
Predictability and Divisibility It can easily be converted into other assets or commodities
with no transaction cost.
5. Functional definition of money includes in money all assets which perform the functions
of money .There could be a narrow definition which incorporates only the primary
functions while a broader definition could include near moneys too which perform the
secondary or derivative functions.
6. Money is what the law states it to be in the Legal definition of money. Chequable bank
deposits are a part of money but are not legal tender.
7. The Theoretical approach to the definition of money first conceptualizes the relevant
attributes to be included in the definition of money and then aggregates all those assets
possessing those attributes. The measurement follows later. The Empirical approach
specifies a criteria like stability of the demand for money and then aggregates all assets
which satisfy that criteria.
8. The types of Money evolved from Full bodied to Representative Full Bodied to Credit
Money. Faith or general acceptability is an important feature for this. The emergence of
money as a medium of exchange led to the need for banks as depositaries. Demand
deposits and Bank notes developed to reduce transaction costs. Fractional Reserve
banking provided a means by which banks could create money and function as
intermediaries..
ECONOMICS PAPER No. : 11 MONEY & BANKING
MODULE No. : 1 DEFINITION OF MONEY
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ECONOMICS PAPER No. : 11 MONEY & BANKING
MODULE No. : 1 DEFINITION OF MONEY
