11. Money – Macroeconomics: Theory and Policy

11

Money

After studying this topic, you should be able to understand

  • Money evolved in a set pattern in the different societies as commodity money, metallic money, paper money and deposit money.
  • The conventional approach to the definition of money lays emphasis on the medium of exchange, function of money and the importance of money as a measure of value.
  • The Gurley and Shaw school of thought argues that the definition of money should be a weighted sum of the different financial assets.
  • The Central Bank view is to include in the definition of money not only all the existing means of payment but also the credit flowing to the borrowers.
  • Traditionally, only currency and demand deposits were included under money.
  • The primary functions of money include money as a medium of exchange and as a measure of value.
  • The secondary functions of money include money as a standard of deferred payments and as a store of value.
  • If money had not been invented, we perhaps would have been still in the ancient ages moving at a very slow rate of growth.
INTRODUCTION

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. The barter system, to be successful, requires a double coincidence of wants; for each party involved in the exchange must not only have the commodity which the other party requires, but it must also be in the right quantity and at the right time.

Barter can be successful in the initial stages of development. However, later on when man’s wants multiply and there are a large number of people, each engaged in a different profession, then the barter system is inadequate to cater to the variety of needs of the economy. What is required is a convenient form of exchange, which is possible only with money.

EVOLUTION AND FORMS OF MONEY

As to the evolution of money, there are no certain answers. However, it is of great interest to note that there seems to be a set pattern in which money evolved in the different societies. Let’s learn about its evolutionary stages:

Commodity Money

In the earlier stages, money took the form of commodity money. There were amazing varieties like seashells, furs, skins, rice, wheat, utensils and weapons. They certainly did not possess the essential qualities of money, namely divisibility, portability, durability and homogeneity.

BOX 11.1

Evidence does not support the existence of any economy that solely relied and functioned through the barter system. It is quite possible that barter like methods were used even 1,00,000 years ago. Mostly, the societies which existed functioned along the system of gift economics to the extent that though barter existed, it was mostly between strangers.

Metallic Money

As society progressed, money left its earlier abode in the form of commodities to move to metals. Initially pieces of iron, copper, brass, silver and gold were money. Later on, coins were issued which were initially very crude but as time progressed there was an improvement in their quality. Coins now are only token money because the intrinsic (metallic) value of a token coin is less than its face value.

Paper Money

It is believed that paper money originated with the advent of the receipts given by the goldsmiths to those who deposited their money with them for purposes of safe keeping. As time progressed, these receipts took the form of bank notes. Much later, it acquired the form of paper money issued by the government/banking institutions.

Deposit Money

As the banking system evolved, a development took place in the form of deposit money. Unlike coins and currency notes, deposit money cannot be passed on from hand to hand to transfer purchasing power. Deposit money or chequeable deposits are entries in the ledgers of the bank to the credit of the holder. These deposits can be transferred by cheques. It is in this respect that they serve as a medium of exchange or as a means of payment.

 

Deposit money or chequeable deposits are entries in the ledgers of the bank to the credit of the holder.

As both currency notes and coins are legal tender under the law, no one can refuse the same in the course of settlement of transactions. This is not the case for demand deposits, which are not legal tender money and are accepted on trust. A person has a right to refuse to accept a payment made through a cheque and can insist on a cash payment (though income-tax related laws in a country may penalize cash payments for transactions above a certain limit, as a means to counter black money).

RECAP
  • Deposit money are entries in the ledgers of the bank to the credit of the holder.
  • Deposits can be transferred by cheques and it is in this respect that they serve as a medium of exchange.
BOX 11.2

Paper money or currency notes are simply pieces of paper with no intrinsic value. Then what is the implication of the legend on the RBI’s currency note of, say, a hundred rupees, signed by the Governor of the RBI that ‘I promise to pay the bearer the sum of one hundred rupees’? It is interesting to note that this is in fact a legacy of the past when the currency notes were convertible into silver rupees. Today, it means that the notes can be converted into coins or other notes of some other denominations only.

DEFINITION OF MONEY

Economists have come up with innumerable definitions of money, emphasizing different aspects of money. Broadly speaking, we can group them under two different approaches:

The Conventional Approach

This is perhaps one of the oldest approaches to the definition of money. It basically lays emphasis on the most important functions of money, namely, the medium of exchange function and the importance of money as a measure of value.

According to this approach, any commodity that satisfies these two functions would be termed as money, irrespective of the fact that it may not have any backing of the government. Thus, various things which have served as money include courie shells, cows, goats, rice, silver and gold pieces, etc. They were treated as money as long as they satisfied the two functions, which money was supposed to perform.

The Modern Approach

Lately, it has been felt that the conventional approach to the definition of money is too restrictive. Money certainly does much more than being just a medium of exchange and a measure of value. It performs many other functions and any definition of money, it is felt, should reflect these functions of money.

Broadly speaking, there can be three schools of thought:

The Chicago School of Thought

Associated with the monetarists led by Milton Friedman, Schwartz and many others, this approach lays emphasis on extending the conventional definition of money to include not only currency and demand deposits but time deposits also. The traditional approach is against the inclusion of time deposits in the definition of money because, according to the protagonists of this approach, time deposits cannot be spent directly and hence are not money.

This group has put forward two arguments in support of the inclusion of time deposits in the definition of money, which are as follows:

  1. There exists a correlation between the national income and money. This correlation is higher if time deposits are included in the definition of money.
  2. The definition of money should include the close substitutes of money and time deposits certainly fall in this category.

Gurley and Shaw School of Thought

Attributed to John G. Gurley and Edward S. Shaw, this approach goes a step ahead in that it attempts to include the liabilities of non-bank financial intermediaries in the definition of money.

The approach argues that these are alternative stores of value but differ in the degree of their substitutability to currency and demand deposits. Thus, the definition of money should be a weighted sum of these different financial assets including currency, demand deposits, time deposits and the liabilities of non-bank financial intermediaries like post office saving deposits. The weights should be assigned to the financial assets on the basis of their substitutability to money. In spite of the theoretical superiority of this approach, its practicality is very limited as it is very difficult to assign weights to the different assets as it is difficult to determine and assess their closeness to money.

The Central Bank View

This is a much broader view of the whole concept. The Radcliffe Committee of the United States had put forward this approach to include in the definition of money not only all the existing means of payment but the credit flowing to the borrowers also. Thus, under this definition all credit funds which are lent to the borrowers is a part of money. The committee argued that as credit can be substituted for money without any limit, all credit outstanding is relevant in the definition of money.

This approach is more practical as it realizes the importance and the influence of the varied financial assets in the formulation of the monetary policy of an economy. On the basis of this approach, depending on the economy’s objectives and the monetary policy, the central bank of a country may come up with different measures of money supply. In India, the RBI publishes data on M1, M2, M3 and M4, which quantify the money supply in the economy under four escalating categories.

 

Money is anything that is generally accepted as a means of payment in the settlement of transactions.

For the sake of convenience, we can define money simply as anything that is generally accepted as a means of payment in the settlement of transactions. Money is acceptable in any transaction because of the conviction that later on in the course of any another transaction the same would be accepted in payment by others. This implies that money can take any form starting from courie shells to goats to gold and silver pieces to currency notes. One of the most important features of money is that it is generally acceptable. Money alone is acceptable by all in the settlement of transactions. It does not need to be converted into something else.

RECAP
  • The conventional approach is against the inclusion of time deposits in the definition of money.
  • The Chicago school of thought extends the conventional definition of money to include not only currency and demand deposits but time deposits also.
  • The Gurley and Shaw school of thought goes a step further in that it attempts to include the liabilities of non-bank financial intermediaries in the definition of money.
  • The Central Bank view is that all credit outstanding is relevant in the definition of money.
MONEY AND NEAR MONEY

Traditionally, economists often differentiated between money and near money assets. Only those monetary assets–namely, currency and demand deposits—which could be used as a medium of exchange and in addition as a store of value were included under money. Non-monetary assets like stocks, bonds, time deposits and treasury bills, which are stores of value but do not circulate as a medium of exchange and are not used for making payments were all treated as near money. It was felt that as near money is just a claim over money, they should be treated separately from money.

Recent innovations in the financial sector, however, portray a different scenario. The non-monetary assets like stocks, bonds, time deposits and others have, over time, become quite liquid just like the monetary assets. On the other hand, monetary assets are gaining popularity as stores of value and, hence, are in no way less than non-monetary assets as stores of value.

The public often finds it easy to switch from one type of asset to another. This has implications for the policy makers in that it dilutes the effect of the policy. As these non-monetary assets are not subject to the same stringent requirements as the monetary assets, they may often complicate matters for the policy makers.

BOX 11.3

Fiat money is the money the value for which is determined legally. It serves as money on the fiat or order of the government. In India, coins and currency are the fiat money because they serve as money on the order or fiat of the Government of India.

RECAP
  • Non-monetary assets like stocks, bonds, time deposits and treasury bills were all treated as near money.
FUNCTIONS OF MONEY

The functions of money can be, broadly speaking, grouped into two categories, which are as follows:

Primary Functions of Money

These refer to the basic functions or what we can call the original functions of money. These include:

Money as a Medium of Exchange

This is the primary function of money. Money alone can perform this function, which is a distinguishing characteristic of money and which differentiates it from near money. In fact, all the other functions of money can be derived from this basic function of money.

The use of money as a medium of exchange has certain advantages. Some of them are as follows:

  1. It avoids the wastage of time and resources involved in exchange and are thus an essential ingredient of a barter economy. Hence, it promotes a transactional efficiency in the exchange of goods and services.
  2. It promotes an allocational efficiency in that there exists specialization in the trade and production of goods and services.

Money as a Measure of Value or as a Unit of Account

Money serves as a common denominator in terms of which the value of all other commodities is expressed. All the prices are quoted in terms of money. These values, per unit of the good or service, expressed in terms of money are what we call the price of a good or service.

The use of money as a measure of account has certain advantages. Some of them are as follows:

  1. As price of the goods and services are expressed in terms of a common denominator, money, it is easy to compare them and calculate the rate of exchange between the two goods. In a system where money does not exist, there will be an innumerable number of such ratios between the different goods.
  2. The use of money makes it possible to have meaningful accounting systems by adding up the value of goods and services, which are of a wide variety and measured in terms of different units.
  3. Important estimates of value totals like the national income can be compared across time and between nations by comparing the different exchange rates that are all expressed in terms of a common denominator, money.
  4. Production, consumption and distribution all can be expressed in terms of money, which facilitates a comparison between them.

    The disadvantage of money as a measure of value is that it may not be very accurate. This is because the value of money is itself subject to change and keeps varying over time. This is not so with the physical measures like meter, kilogram, etc.

Secondary Functions of Money

These, though important functions of money, are actually derived from the primary functions of money.

Money as a Standard of Deferred Payments

Deferred or future payments include payment of interest, rents, salaries, insurance premium, pensions and loans. All these are expressed in terms of money. Thus, money is used in long-term transactions. During the barter system such payments did exist, but they lacked the general acceptability, durability and homogeneity of money.

It is to be noted that the use of money as a standard of deferred payments is laden with problems in that its value itself is subject to fluctuations through inflation or deflation.

Money as a Store of Value

The public holds or stores its wealth in the form of money. Thus, money is an asset that retains value over time. This function of money has actually been derived from the function of money as a medium of exchange.

 

Liquidity can be defined as the ease with which an asset can be converted into cash at short notice and without any/least loss. It is obvious that money is the only asset, which is perfectly liquid.

In a barter system there existed only one transaction, a simultaneous purchase and sale. However, under a money economy this gets split up into two separate transactions consisting of a sale and a purchase. This is possible only if money can not only serve as a medium of exchange but also serve as a store of value.

Salaries, rents and loans are payments all of which are a part of a money using economy. They are received in the form of money at time intervals and are spent gradually. This is possible only if money is a store of value.

Money is able to store value only because it is a medium of exchange and acceptable to all as a general purchasing power and the only asset, which is perfectly liquid. Other assets like bonds and stocks also serve as store of value. However, the unique feature of money that differentiates it from other such assets is that it alone is perfectly liquid, unlike the other assets which must be converted into money first.

Liquidity can be defined as the ease with which an asset can be converted into cash at short notice and without any/least loss. It is obvious that money is the only asset, which is perfectly liquid.

However, it is to be noted that the use of money as a store of value is again subject to the same problems in that its value itself is subject to fluctuations that may strongly influence it in performing its role as a store of value.

RECAP
  • The unique feature of money is that it alone is perfectly liquid.
  • The main problem in the use of money is that its value itself is subject to fluctuations.
SIGNIFICANCE OF MONEY

In today’s world, money plays an important role. It is not true to say that an economy cannot survive without money. The so-called mythical barter economy where every transaction involved an exchange of goods for goods did survive for years and years without money. However, what is to be emphasized is that had money not been invented we perhaps would have been still in the ancient ages moving at a very slow growth rate.

In a modern economy, money performs several functions; some of them are as follows:

  1. Resource allocation in an economy: In a modern economy, it has been possible to produce the large variety of goods only with the advent of money. The role of money starts right from the purchase of the factors of production and the raw materials to the evaluation of the cost of production and the estimates of profits. Thus, money plays a crucial role in solving the three basic economic problems of what, how and for whom to produce.
  2. Consumption in an economy: In a barter economy, due to the double coincidence of wants, the consumer could not get all that he desired. However, the existence of money makes it possible for the consumer to maximize his utility, given his income and the prices of the goods. He is able to assert the full power of money by satisfying his needs to the utmost within the constraints of the money he has at his disposal. Certainly with the power of money, the consumer feels no less than a king.
  3. Distribution in an economy: The distribution of incomes to the different factors of production—wages to labour, rent to land, interest to capital and profits to the entrepreneur—are all possible because money is there to reward each according to his marginal productivity.
  4. Development of an organized credit and money market in an economy: In a barter economy, borrowing was possible in the form of goods. This limited the borrowings and prevented a credit market from emerging. The arrival of money encouraged and provided the avenue for some to borrow and others to lend.
  5. Introducing dynamism in an economy: To some extent the credit for bringing dynamism in any economy goes to the monetary authorities, which by the efficient utilization of their credit and monetary policies, are able to not only trigger growth but are also able to sustain this growth. The different economies of the world are, at present, trying to experiment with their credit and monetary policies to try to come out of the recession, which is affecting the growth of almost all the economies of the world.
RECAP
  • In a modern economy, money performs several functions like resource allocation in an economy and distribution of incomes among the different factors of production.
SUMMARY
INTRODUCTION
  1. The barter system was prevalent in the initial stages of development.
  2. The barter system to be successful requires a double coincidence of wants.
EVOLUTION AND FORMS OF MONEY
  1. There seems to be a set pattern in which money evolved in the different societies.
  2. In the earlier stages, money took the form of commodity money.
  3. As society progressed, money left its earlier abode in the form of commodities to move to metallic money.
  4. It is believed that paper money originated with the advent of the receipts given by the goldsmiths to those who deposited their money with them for purposes of safe keeping. As time progressed, these receipts took the form of bank notes.
  5. As the banking system evolved, a development took place in the form of deposit money.
DEFINITION OF MONEY
  1. Economists have come up with innumerable definitions of money. We can group them under two different approaches.
  2. The Conventional Approach is perhaps one of the oldest approaches to the definition of money and lays emphasis on the most important functions of money, namely, the medium of exchange function and the importance of money as a measure of value.
  3. The Modern Approach where there can be three schools of thought.
  4. The Chicago school of thought lays emphasis on extending the conventional definition of money to include not only currency and demand deposits but time deposits also.
  5. Gurley and Shaw school of thought goes a step ahead in that it attempts to include the liabilities of non-bank financial intermediaries in the definition of money.
  6. Central Bank view includes in the definition of money not only all the existing means of payment but also the credit flowing to the borrowers.
MONEY AND NEAR MONEY
  1. Traditionally, economists often differentiated between money and near money assets.
  2. Money includes currency and demand deposits.
  3. Non-monetary assets like stocks, bonds, time deposits and treasury bills were all treated as near money.
  4. Recent innovations in the financial sector portray that though the non-monetary assets have, over time, become quite liquid, the monetary assets are gaining popularity as stores of value.
FUNCTIONS OF MONEY
  1. Primary functions of money include medium of exchange and measure of value or a unit of account.
  2. Medium of exchange is the primary function of money, which differentiates it from near money.
  3. Measure of value or a unit of account is where money serves as a common denominator in terms of which the value or price of all other commodities are expressed.
  4. Secondary functions of money are derived from the primary functions of money. They include money as a standard of deferred payments and as a store of value.
  5. Deferred or future payments include payment of interest, rents, salaries, insurance premium, pensions and loans, all of which are expressed in terms of money.
  6. The public holds or stores its wealth in the form of money. Salaries, rents and loans are received in the form of money at certain time intervals and are spent gradually.
  7. The unique feature of money that differentiates it from other such assets is that it alone is perfectly liquid.
SIGNIFICANCE OF MONEY
  1. Money performs the function of allocation of resources in a modern economy and helps in solving the three basic economic problems of what, how and for whom to produce.
  2. It performs the function of consumption in an economy. The consumer is able to assert the full power of money by satisfying his needs to the utmost within the constraints of the money he has at his disposal.
  3. It performs the function of distribution of incomes to the different factors of production in an economy rewarding each according to its marginal productivity.
  4. It leads to the development of an organized credit and money market in an economy.
  5. It introduces dynamism in an economy by the efficient utilization of credit and monetary policies.
REVIEW QUESTIONS
TRUE OR FALSE QUESTIONS
  1. The barter system, to be successful, requires a double coincidence of wants.
  2. Commodity money had the essential qualities of money, namely divisibility, portability, durability and homogeneity.
  3. Coins now are only token money.
  4. Traditionally, non-monetary assets like stocks, bonds and time deposits were all treated as money.
  5. Had money not been invented, we perhaps would have been still in the ancient ages.
VERY SHORT-ANSWER QUESTIONS
  1. What is the barter system of direct exchange?
  2. Name the different forms in which money has evolved over time.
  3. What are the views of the Chicago school of thought regarding the definition of money?
  4. Why is the function of money as a medium of exchange said to be the primary function of money?
  5. Name the five functions performed by money in a modern economy.
SHORT-ANSWER QUESTIONS
  1. Write short notes on commodity money and metallic money?
  2. What is the conventional approach to the definition of money?
  3. Write a short note on the primary functions of money.
  4. Write a short note on the secondary functions of money.
  5. Write a short note on the Central Bank view to the definition of money.
LONG-ANSWER QUESTIONS
  1. Discuss the evolution of money throwing light on the different forms of money, which have emerged at different periods of time.
  2. Define money by using the different approaches that economists have put forward.
  3. What are money and near money assets? Differentiate between the two.
  4. What are the primary and secondary functions of money? Which among the two are the more important functions of money?
  5. What is the significance of money in an economy? How important is money for an economy to function?
ANSWERS

TRUE OR FALSE QUESTIONS

  1. True. Each party, which is involved in the exchange must not only have the commodity which the other party requires, but it must also be in the right quantity and at the right time.
  2. False. Commodity money certainly did not posses the essential qualities of money, namely divisibility, portability, durability and homogeneity.
  3. True. Coins now are only token money as the intrinsic metallic value of a token coin is less than its face value.
  4. False. These non-monetary assets like stocks, bonds and time deposits that are stores of value but do not circulate as a medium of exchange were all treated as near money.
  5. True. Had money not been invented, we perhaps would have been still in the ancient ages moving at a very slow growth rate.