Chapter 5 Money
Money
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Money TOPIC
1: Barter System and Money
Money is anything that is generally accepted as a medium for making exchanges.
Before money came into use, people traded goods for other goods. This type of trade was called the barter system. Such an economy is known as a C-C economy, where commodities are exchanged for other commodities. Economic transactions without the use of money are called barter exchanges.
Disadvantages of the Barter Exchange System
The barter system had the following limitations:
(i) Absence of Double Coincidence of Wants
This was one of the biggest issues in the barter system. It was very uncommon for one person to find another who wanted what he had to offer and also had what he wanted in return at the same time.
(ii) Problem of Indivisibility
In the exchange of goods, splitting a commodity was often difficult. For example, if a cow was to be traded for four goats but the cow owner only wanted two, the trade couldn’t occur because a cow cannot be divided.
(iii) No Facility to Store Value
Without money, people stored wealth in goods. However, storing goods had drawbacks like storage costs, risk of damage, value loss, and difficulties in transportation. Therefore, it was not easy to preserve purchasing power.
(iv) Absence of a Common Unit of Value
There was no single standard for measuring the value of goods and services. Due to this, accurate pricing was difficult. For example, cloth is measured in metres and milk in litres, so they can’t be valued using the same unit, which made exchanges more complex.
(v) Absence of a Standard for Future Payments
Deferred payments refer to payments made later. In the barter system, it was hard to repay in the future using goods of equal quantity and quality. Hence, settling future obligations like loans and interest became challenging.
Development of Money
To eliminate the flaws of the barter system and to make exchange smoother, a medium was needed that both the buyer and seller agreed upon. This medium is known as money.
Money is one of the most essential inventions.
It refers to anything that is accepted as a medium of exchange.
The money we use today has taken many forms through time. The major types of money in its evolution are:
(i) Commodity Money
Various items like pearls, seashells, and salt were once used for trade. These were known as commodity money.
(ii) Animal Money
Livestock like cows, goats, and horses were once used for transactions. This was referred to as animal money.
(iii) Metallic Money
Coins made from metals like gold, copper, and silver were called metallic money. Metallic money was of two types:
(a) Full-bodied money — Also called standard money, its face value was equal to the worth of the metal used.
(b) Token money — Its face value was much higher than the actual value of the metal it was made from.
(iv) Paper Money
Paper-based currency is known as paper money or currency notes. Paper money falls into three groups:
(a) Representative paper money — Backed by reserves of gold and silver in equal amount.
(b) Convertible paper money — If the Central Bank or government ensures that it can be exchanged for gold or silver at fixed rates, it is known as convertible paper money.
(c) Inconvertible paper money — If the government doesn’t guarantee conversion into precious metals, it is termed inconvertible paper money. This type of money is in use in India.
This form of currency is valued for its ease of carrying and printing.
(v) Credit Money
It includes the money people deposit in banks, which they can withdraw or transfer using cheques. Though cheques are not money themselves, they act like money, which is why they are considered credit money.
(vi) Plastic Money
The latest form of money includes debit and credit cards, commonly known as plastic money.
Meaning of Money
Money can be understood in two main ways:
1. Legal Meaning
This view defines money as anything the government declares valid for payments and debt settlement. So, coins and notes are recognized as money. According to Robertson, “Money is anything that is generally accepted for settling payments or debts.”
From a legal perspective, money is divided into:
(a) Limited legal tender — This type of currency can be used only up to a fixed amount. In India, coins fall into this category, and can be used up to ₹1000.
(b) Unlimited legal tender — This currency can be used for payment of any amount. In India, all currency notes are unlimited legal tender.
(ii) Fiduciary or Non-Legal Tender Money
Also called voluntary money, this type is accepted based on mutual trust and not by law. Examples include cheques, drafts, and bills of exchange.
2. Functional Definition
As per Crowther, “Money is anything widely accepted for exchange purposes and at the same time acts as a tool to measure and store value”.
India’s Monetary System
India currently follows the inconvertible paper currency system. The Reserve Bank of India (RBI) is responsible for managing and regulating this monetary setup. The rupee is considered the basic standard unit of money in India.
Currency notes ranging from ₹2 to ₹1000 are issued by the RBI’s issue department, which maintains a minimum reserve of gold and foreign exchange. One-rupee notes and all coins are produced under the minimum reserve system by the RBI on behalf of the government.
Money Supply
Money supply refers to the total quantity of money available with the public at any given moment. It is a stock variable. The RBI publishes data on four different types of money supply—M₁, M₂, M₃, and M₄.
These are defined as:
M₁ = CU + DD
Where CU stands for currency (coins and notes) held by the public, and DD stands for net demand deposits with commercial banks. The word ‘net’ excludes interbank deposits, which are not considered part of money supply.
M₂ = M₁ + Savings in post office saving banks
M₃ = M₁ + Time deposits in commercial banks
M₄ = M₃ + Total deposits in post office saving institutions (excluding NSCs)
M₁ and M₂ are referred to as narrow money and are based on the money’s role as a medium of exchange. M₃ and M₄, also known as broad money, emphasize money’s ability to store value.
Money Supply Approaches
Money supply can be studied from two perspectives:
(i) Traditional or Narrow View
This approach includes currency notes, coins, and demand deposits. It covers M₁ and M₂ types of money supply.
(ii) Modern or Broad View
This method includes currency, coins, demand and time deposits, financial assets with institutions like UTI, post office savings, bonds, credit cards, etc. It involves M₃ and M₄ types of money supply.
These categories (from M₁ to M₄) are listed in decreasing order of liquidity. M₁ is the most liquid and suitable for transactions, while M₄ is the least. M₃ is widely used to represent money supply and is called aggregate monetary resources.
Money Multiplier
The money or deposit multiplier shows how much money banks can generate from each unit of reserve. The formula is:
Money Multiplier=1LRR\text{Money Multiplier} = \frac{1}{\text{LRR}}
Here, LRR is the Legal Reserve Ratio, which includes CRR and SLR.
Note: A higher LRR leads to a smaller multiplier and reduced money creation, and vice versa.
Example 1. Calculate the money multiplier and total money created if the initial deposit is ₹1500 crore and LRR is 15%.
Solution:
LRR = 15% or 0.15
Money Multiplier = 10.15=6.67\frac{1}{0.15} = 6.67
Initial Deposit = ₹1500 crore
Total Deposit = ₹1500 × 6.67 = ₹10000 crore
High Powered Money
This includes cash held by the public and reserves with the RBI by commercial banks (including vault cash).
Thus, High Powered Money = Public Currency + Commercial Bank Reserves (including vault cash)