Module 2

BANKS MONEY and CREDIT MARKET

Money and Wealth

Money is a commodity accepted by general consent as a medium of economic exchange. It is the

medium in which prices and values are expressed. It circulates from person to person and
country to country, facilitating trade, and it is the principal measure of wealth.

Wealth measures the value of all the assets of worth owned by a person, community, company,
or country. Wealth is determined by taking the total market value of all physical and intangible
assets owned, then subtracting all debts. Essentially, wealth is the accumulation of scarce
resources. Specific people, organizations, and nations are said to be wealthy when they are able
to accumulate many valuable resources or goods. Wealth can be contrasted to income in that
wealth is a stock and income is a flow, and it can be seen in either absolute or relative terms.

Lending refers to when an entity or person gives away its resources to another entity or person
per predefined mutual terms. In contrast, borrowing refers to receiving resources by an entity or
person from another entity or person with predefined mutually agreed-upon terms.

The passage of time is an essential part of concepts such as money, income, wealth,
consumption, savings and investment.

Money – Money is a commodity accepted by general consent as a medium of economic

exchange. It is the medium in which prices and values are expressed. It circulates from person to
person and country to country, facilitating trade, and it is the principal measure of wealth. money
is something that facilitates exchange or called medium of exchange consists of bank notes or
anything used for purchasing and generally accepted by all.

Before money was invented, people bartered for goods and services. It wasn't until about 5,000
years ago that the Mesopotamian people created the shekel, which is considered the first known
form of currency. Gold and silver coins date back to around 650 to 600 B.C. when stamped coins
were used to pay armies. In 600 BCE, Lydia's King Alyattes minted what is believed to be the
first official currency, the Lydian stater. The coins were made from electrum, a mixture of silver
and gold that occurs naturally, and the coins were stamped with pictures that acted as
denominations.
Barter is an alternative method of trading where goods and services are exchanged directly for
one another without using money as an intermediary. It is an old method of exchange. People
exchanged services and goods for other services and goods in return.

Main Difficulties of Barter System

Money was not used in the early history of man. Exchanges were few since each family was self-
sufficient. Whatever exchanges there were, they took the form of barter, that is, exchange of
goods for the other goods. Various difficulties were faced by the people in the barter economy.
There was no acceptable means of payment for the direct purchase of goods and services in the
barter economy. In other words, in a purely barter system, there was no generally acceptable
medium of exchange in the form of a particular good or asset which could be used to buy goods
and services and do other types of transactions.

1. Double Coincidence of Wants:

Owning to lack of generally acceptable medium of exchange, a difficult problem of double

coincidence of wants was faced by the persons who wanted to sell and buy goods. For exchange
of goods persons desiring to exchange goods must specifically want those goods what others
offers in exchange. Thus, an individual who wants to have a good he must locate another person
who offers to give up the good wanted by him and who is willing to accept in ex-change the
good offered by him.

2. Lack of a Standard Unit of Account:

A barter economy lacked not only a common medium of exchange but also a standard unit of
account in which prices could be measured and quoted. In the absence of a common unit of
account, the number of exchange ratios (that is, prices of goods ex-pressed in terms of each
other) between goods would be very large. For example, two cows for one horse, one cow for
two quintals of wheat, one pen for three pencils and so on. Thus, lack of a standard unit of
account with which to measure values of different goods and services made exchange or trade
difficult.

3. Impossibility of Subdivision of Goods:

Another problem faced under the barter system for exchange of goods was impossibility of
subdivision of goods without loss of their value. For instance, if a person has a cow and wants to
have 5 kg of wheat, obviously, it is too costly to give one cow for 5 kg of wheat he requires.
4. Lack of Information:

Another problem found in the barter system was that in it traders re-quired a good deal of
information for exchange of goods. For example, if person wants to have a saw in exchange of a
wooden table which he has made. Not only should a person be able to assess the value of saw but
the maker of a saw should also be able to determine the value of the wooden table which a
person wishes to exchange. All this required a lot of information about goods for which people
must spend a good deal of time and resources to obtain such information.

5. Production of Large and Very Costly Goods not Feasible:

Another problem of barter economy relates to the production of large, costly goods. Suppose an
individual who has technical skill and equipment to manufacture a car will not have much
incentive to manufacture it in the barter economy. This is because he can exchange a car with a
person who has enough goods having a value equal to a car so that their exchange with a car can
take place. The car maker must obtain food, clothing and several other commodities of day-to-
day consumption in exchange for a car. It will be very difficult, almost impossible to find a
prospective buyer who has enough of these goods and services to give in return for a car.

Functions of money

The basic function of money is to enable buying to be separated from selling, thus permitting
trade to take place without the so-called double coincidence of barter. In principle, credit could
perform this function, but, before extending credit, the seller would want to know about the
prospects of repayment. That requires much more information about the buyer and imposes costs
of information and verification that the use of money avoids. If a person has something to sell
and wants something else in return, the use of money avoids the need to search for someone able
and willing to make the desired exchange of items. The person can sell the surplus item for
general purchasing power—that is, ―money‖—to anyone who wants to buy it and then use the
proceeds to buy the desired item from anyone who wants to sell it.

Primary Function

1. Medium of Exchange:

The most important function of money is that it serves as a medium of exchange. In the barter
economy a great difficulty was experienced in the exchange of goods as the exchange in the
barter system required double coincidence of wants. Money has removed this diffi-culty. Now a
person A can sell his goods to B for money and then he can use that money to buy the goods he
wants from others who have these goods. As long as money is generally acceptable, there will be
no difficulty in the process of exchange. By serving as a very convenient medium of exchange
money has made possible the complex division of labour or specialization-in the modern
economic organisation.

2. Measure of Value:

Another important function of money is that it serves as a common measure of value or a unit of
account. Under barter economy there was no common measure of value in which the values of
different goods could be measured and compared with each other. Money has also solved this
difficulty. Money serves as a yardstick for measuring the value of goods and services. As the
value of all goods and services is measured in a standard unit of money, their relative values can
be easily compared.

Secondary Function

3. Standard of Deferred Payment:

Another function of money it that it serves as a standard for deferred payments. Deferred
payments mean those payments which are to be made in the future. If a loan is taken today, it
would be paid back after a period of time. The amount of loan is measured in terms of money
and it is paid back in money. A large number of credit transactions involving huge future
payments are made daily. Money performs this function of standard for deferred payments
because its value remains more or less stable.

4. Store of Value:

Lastly, money acts as store of value. Money being the most liquid of all assets is a convenient
form in which to store wealth, that is, money can be held as an asset. Thus store of value function
is also called asset function of money. It is, therefore, essential that the good chosen as money
should be such as can be easily stored without deterioration or wastage. That is why gold was
popular in the past as money material.

Characteristics of Money

The characteristics of what serves as money depend somewhat on the degree of complexity in
the society. A relatively simple economy, with relatively few goods and services, few producers
and consumers, and few transactions, may be able to function with a form of money that would
not work in a more complex society. There are some general characteristics that are usually
important for whatever serves as money in a modern economy.

1 Durability - First, to serve as an effective medium of exchange and store of value, money must
be durable. Durability is when an item is able to withstand all the hardships and is still able to
maintain to be undamaged and usable after a long term of usage. Durability is crucial for money
to be able to perform the following functions of medium of exchange and store of value. Coins
and paper bills are made to perform and to act as the currency. Nowadays, Money is
manufactured with the materials such as paper, metal and plastics, which results to a long lasting
medium.

2. Portability, which also serves as a medium of exchange, means that money can be movable
from place to place to be used as monetary transaction to be exchanged for goods and services.
Portability also means that consumers are now able to carry money along with them to be used as
transactions for goods and services. In modern days, money is carried from one location to
another without needing much effort as all types of money such as cash notes, coins and cards
are carried easily in a wallet.

3. Divisibility is a characteristic which means the money can be divided into small units and that
it can be used in exchange for goods and services. As to function as the medium of exchange, as
it is divisible, it can be used to purchase all kinds of goods with different values. As money
functions as the medium of exchange it must have denominations to be traded for all goods and
services, and everything in between.

4. Uniformity means that all types of the same denomination of money must consist of
purchasing power. It is a characteristic to perform the function of standard of deferred payments.

5. Limited supply is a characteristic which helps in storing the value of money, meaning that
constraints on the amount of money in the monetary circulation ensure that values remain
constant for the currency. Currently most of the respective country‘s government has the
responsibility to control an adequate money supply based on market with their monetary policies,
such as expansionary monetary policy and contractionary monetary policy.

6. Acceptability supports the function of medium of exchange. The essential quality of money is
that it must act as an item being acceptable to all, without having any hesitation in the exchange
for goods and services. Acceptability means that everyone must be able to accept the money for
transactions. Money is universally accepted around the world as a universal mean for transaction.
7. Non-counterfeitability which functions as the store of value means that money cannot be
easily duplicated. As money cannot be easily duplicated, it prevents the unrestricted and illegal
creating of duplication of money. Besides, preventing the duplication of money to happen is one
of the main reasons of government existence.

Functional definitions of money

Functional definition of money refers to money that performs four basic functions. 1. Serves as
medium of exchange, 2 standard unit of value, 3 standard deferred payments, 4. Store of value.
According to this definition

Narrow definition of money

Narrow money is a category of money supply that includes all physical money such as coins
and currency, demand deposits, and other liquid assets held by the central bank. Also known as
M0, narrow money refers to physical money, such as coins and currency, demand deposits, and
other liquid assets, that are easily accessible to central banks. Narrow money is a subset of broad
money that includes long-term deposits and other deposit-based accounts.

Broad money is a category for measuring the amount of money circulating in an economy. It is
defined as the most inclusive method of calculating a given country's money supply, and
includes narrow money along with other assets that can be easily converted into cash to buy
goods and services. Broad money is the most flexible method for measuring an economy's
money supply, accounting for cash and other assets easily converted into currency. The formula
for calculating money supply varies from country to country, so the term broad money is always
defined to avoid misinterpretation. Central banks tend to keep tabs on broad money growth to
help forecast inflation.

Money Supply and measures of money supply

The total money held by the public of a country at a specific point of time is known as Money
Supply. It consists of both cash and deposits that can be easily used as cash. The money supply
of a country has a major impact on its economy. If there is a rise in the money supply of an
economy, it will be shown as a decline in interest rates and the price of goods and services.
However, if there is a decline in the money supply of an economy, it will be shown as a rise in
the interest rates and price of goods and services, along with an increase in the bank reserves.
Money Supply is a Stock Concept. It means that the money supply is concerned with a particular
point of time.

Measures of Money Supply

Till 1967-68, only the narrow measure of the money supply was used by the Reserve Bank of
India (RBI). However, since 1977, four measures of money supply have evolved in the economy,
i.e., M1, M2, M3, and M4.

1. M1

The first and basic measure of the money supply is M1, which is also known as Transaction
Money. It is called transaction money because this measure can be directly used to make
transactions. The three different components of M1 are Currency and coins with public, Demand
deposits of Commercial Banks, and Other deposits with RBI. All of these components can be
easily used as a medium of exchange; therefore, it is the most liquid measure of the money
supply.

M1 = Currency and coins with public + Demand deposits of commercial banks + Other deposits
with Reserve Bank of India

2. M2

The second measure of the money supply is M2, and is a broader concept as compared to M1. It
includes M1 and savings deposits with the post office savings bank. One cannot withdraw
Savings Deposits with Post Office Saving Bank through cheque; therefore, it cannot be included
in demand deposits with the bank, resulting in the evolution of M2.

M2 = M1 + Savings Deposits with Post Office Saving Bank

3. M3

The third measure of the money supply is M3 and is a broader concept as compared to M1. It
includes M1 and Net Time Deposits with Bank.

M3 = M1 + Net Time Deposits with Banks

4. M4
The last measure of the money supply is M4, and is a broader concept as compared to M1 and
M3. It includes M3 and Total Deposits with Post Office Saving Bank, but does not include NSC
(National Saving Certificate).

M4 = M3 + Total Deposits with Post Office Saving Bank

Important Facts related to the Measures of Money Supply

1. All four measures of money supply represent a different level or degree of liquidity. M1 is the
most liquid measure of supply, and M4 is the least liquid measure of supply.

2. M3 is also known as Aggregate Monetary Resources of the Society and is widely used as a
measure of supply.

3. M1 and M2 are usually known as Narrow Money Supply Concepts; however, M3 and M4 are
known as Broad Money Supply Concepts.

high powered moneyis money produced by the RBI and the government. it includes 1. cash held
by the public and 2. cash reserves with banks

Wealth

What Is Wealth?

Wealth measures the value of all the assets of worth owned by a person, community, company,
or country. Wealth is determined by taking the total market value of all physical and intangible
assets owned, then subtracting all debts. Essentially, wealth is the accumulation of scarce
resources. The concept of wealth is usually applied only to scarce economic goods; goods that
are abundant and free for everyone provide no basis for relative comparisons across individuals.
Wealth is an accumulation of valuable economic resources that can be measured in terms of
either real goods or money value. Net worth is the most common measure of wealth, determined
by taking the total market value of all physical and intangible assets owned, then subtracting all
debts. The concept of wealth is usually applied only to scarce economic goods; goods that are
abundant and free for everyone provide no basis for relative comparisons across individuals.
The term wealth is also sometimes used in a broader sense immaterial aspects such as health
skills and ability to earn an income.

Human capital - Human capital consists of the knowledge, skills, and health that people invest
in and accumulate throughout their lives, enabling them to realize their potential as productive
members of society.

Income
What Is Income?

The term ―income‖ generally refers to the amount of money, property, and other transfers of
value received over a set period of time in exchange for services or products. There is no single,
standard definition: income is defined according to the context in which the concept is used.
Income refers to the money that a person or entity receives in exchange for their labor or
products. Income may have different definitions depending on the context—for example,
taxation, financial accounting, or economic analysis. For most people, income means their total
earnings in the form of wages and salaries, the return on their investments, pension distributions,
and other receipts. For businesses, income means the revenues from selling services, products,
and any interest and dividends received with respect to their cash accounts and reserves related
to the business.

Disposable income - Disposable income is the amount of money left to spend and save after
income tax has been deducted. Individual consumers can use disposable income to help build
their budget and understand how much money they can allocate to certain expenses. Income
remaining after deduction of taxes and social security charges, available to be spent or saved as
one wishes.

Gross Income - Gross income for an individual—also known as gross pay when it‘s on a
paycheck—is an individual‘s total earnings before taxes or other deductions. This includes
income from all sources, not just employment, and is not limited to income received in cash; it
also includes property or services received. For companies, gross income is interchangeable with
gross margin or gross profit. A company‘s gross income, found on the income statement, is the
revenue from all sources minus the firm‘s cost of goods sold (COGS). gross annual income is the
amount of money a person earns in one year before taxes and includes income from all sources.
Difference between wealth and Income

Personal wealth means a stock of valuable possessions: anything from cash under your mattress,
through shares and bonds, to the value of your house or your car. Income, on the other hand, is a
flow of money you receive, such as wages for employment. Professor Boulding discussed the
national income of any given country or economy in line with the water level in a bathtub. The
water level rises with an inflow of production and creativity and the water leaks with
consumption.

As we have seen, wealth often takes physical forms such as a house, or car, or office, or factory.
The value of this wealth tends to decline, either due to use or simply the passage of time. This
reduction in the value of a stock of wealth over time is called depreciation. Using the bathtub
analogy, depreciation would be the amount of evaporation of the water. Like income, it is a flow
(you could measure it in litres per year), but a negative one. So when we take account of
depreciation we have to distinguish between net income and gross income. Gross income is the
flow into the bathtub (remember that income means disposable or after-tax income), while net
income is this flow less depreciation. Net income is the maximum amount that you could
consume and leave your wealth unchanged.

Net income =Gross income –Depreciation

Expenditure

The tub also has an outflow pipe or drain. The flow through the drain is called consumption
expenditure, and it reduces wealth just as net income increases it. An individual (or household)
saves when consumption is less than net income, so wealth increases. Wealth is the accumulation
of past and current saving. One form that saving can take is the purchase of a financial asset such
as shares (or stocks) in a company or a government bond. Although in everyday language these
purchases are sometimes referred to as ‗investment‘, in economics, investment means
expenditure on capital goods, which are goods such as machinery or buildings.

The distinction between investment and purchasing shares or bonds is illustrated by a sole-
proprietor business. At the end of the year, the owner decides what to do with her net income.
Out of the net income, she decides on her consumption expenditure for the year ahead and saves
the remainder. By default, the saving would take the form of bank deposits since her income
would be paid into the bank. With her savings, she could buy financial assets such as shares or
bonds, which provide funds to businesses or the government. Or, instead, she could spend on
new assets to expand her business, which would be considered an investment.