Money and money supply.
Meaning of money
Money is what money does. Money is defined as anything that is generally accepted as a
medium of exchange. It’s a commonly accepted means of payment.
Barter system
In olden days, goods were exchanged for goods. This system of exchange was known as Barter
system of exchange. But with a multiplicity of wants this system proved to be an inefficient system
of exchange. There are many difficulties inherent in the barter system. Following are the
difficulties:
Barter requires double coincidence of wants – It means the seller has to find someone who
wants to buy what he has, buy the buyer must also have what seller wants.
Barter lacks a common unit of value – The price of each commodity would have to be quoted in
terms of every other commodity.
No suitable system of storing wealth – Storing wealth means storing the purchasing power for use
in future. Since its not perishable, requires less space to store, its readily acceptable, and easily
portable.
Goods cannot serve as a standard of payment contracted to be made in future – It is very difficult
to any good to serve as a standard of deferred payments.
Function of money
Medium of exchange is the basic function of money. As narrow concept, money includes only
notes, coins and demand deposits. Or, it includes only those things which function as money in
terms of:
Medium of exchange
Measure of value
Store of value
Standard of future/ deferred payments.
As a broad concept, money also includes time deposits/ term deposits/ fixed deposits with the
banks (or post office). These are ‘near money assets’. Thus ‘money assets’ and ‘near money
assets’ together make up a broad concept of money. Functions of money are classified into two
categories:
Primary or main functions.
Secondary or subsidiary functions
Primary or Main Functions:
1. Money as a medium of exchange.
Money as a medium of exchange means money as a means of payment for exchange of goods and
services. Goods and services are exchanged for money when people sell or buy things. It solves the
problem of double coincidence of wants inherent in the barter system of trade.
2. Money as a unit of account.
The unit of account function of money is also called the measure of value function. Money as a
unit of account means a standard unit for quoting prices. It makes money powerful medium of
comparing prices of goods and services. The unit of account function of money makes possible the
keeping of business accounts. It would be impossible to keep the business accounts unless all
business transactions are expressed in money.
Secondary or Subsidiary Functions:
1. Money as a store of value.
Money as a store of value means that money is an asset and can be stored for use in future. One
can hold one’s earnings until the time one wants to spend it. It was not convenient to store value
in the barter system of exchange, as goods tend to wear out or perish. The advantage of money is
(i) It comes in convenient denominations these denominations rage from multiples to fractions of
basic monetary unit. (ii) Money is easily portable. (iii) It is easily exchanged for goods at all times as
its value remains relatively stable. (iv) It needs much less space for storage. (v) it is generally
accepted for exchange of goods and services.
2. Money as a standard of deferred payment.
Money as a standard of deferred payment means standard of payment contracted to be made at
some future date. Thus it facilitated the borrowing and lending activities and it has led to the
creation of financial institutions.
3. Transfer of value.
Money also serves as a convenient mode of transfer of value. Goods are purchased from far off
places both for consumption as well as investment. You need to transfer purchasing power from
the place of your residence. Money performs this function very well. With this function it
promotes both consumption expenditure as well as investment expenditure across all parts of
world.
Thus, money is defined as anything that is generally accepted as a medium of exchange, a store
of value, a unit of account, a standard of deferred payment and transfer of value.
Forms of Money:
Some important forms of money are described as:
Fiat money and fiduciary money
Full bodied money and credit money.
Fiat money and fiduciary money:
Fiat money refers to that money which is issued by order/ authority of the government. It
includes all notes and coins which the people in country are legally bound to accept as medium
of exchange.
Fiduciary money which is accepted as a medium of exchange because of the trust between the
payer and the payee.
Eg. Cheques are fiduciary money.
Full bodied money and credit money:
Full bodied money refers to money in terms of coins whose commodity value is equal to the
money value as and when these are issued. Coins made of gold and silver in past were full
bodied money. Thus,
Money value = commodity value
Credit money refers to that money of which money value is more than commodity value. The
market value of the metal that the rupee coin is made.
Money value > commodity value
Money supply and measures of money supply.
Money supply of a country is the stock of money on a specific day (a stock concept). Supply of
money includes only that stock of money which is held by people, other than suppliers of money
(Govt. and banking system) themselves. Thus, supply of money (producers of money) refers to that
stock of money which is held by those, who demand money, not by those, who supply money. It is
popularly known as M1, M2, M3, M4. The two most common measures are M1 (narrow money)
and M2 (broad money). M1 includes those assets which can be directly used for transactions. It is
also called transactions money. Thus,
M1 = C + DD + OD…………………(i)
C = Currency that is notes and coins held by public.
DD = Demand deposits that is chequeable deposits which can be withdrawn and
transferred on demand.
OD = These are other deposits with RBI of financial institutions and foreign central
banks. Demand deposits of international financial institutions like IMF and World Bank.
OD does not include – Deposits of govt with RBI, deposits of commercial banks with RBI.
i. Currency – It includes notes and coins. These notes are also called paper money. Currency
is also called fiat money which means money which, by law, must be accepted for all debts.
M1 does not include the currency held by bank, it includes the currency held by public only.
ii. Chequeable deposits – A chequeable deposit is any deposit account on which a cheque can
be written. Normally, such accounts are with banks. Writing cheques enables the
depositors to make payment directly to a party, or get cash and then make payment. In
technical language of banking, chequable deposits are called demand deposits, as the
amount in such deposits is payable on demand.
M2 measurement
It is a boarder concept of the supply of money compared to M1. Besides all the
components of M1, it also includes savings of the people with the post offices. Thus,
M2 = M1 + Deposits with Post Office Saving Bank Account.
M3 measurement
It is also a broader concept of money supply compared to M1. Besides all the components
of M1, It includes net time deposits of the people with the commercial banks. Thus,
M3 = M1 + Net Time Deposits with the Commercial Banks.
M4 measurement
M4 concept of money supply is still broader. It is broader than M3. It also includes total
deposits with the post offices. Thus,
M4 = M3 + Total Deposits with Post Offices.
Who supplies money?
Suppliers of money include –
1. Central bank of the country (RBI)
2. Commercial bank
3. The government.
Money is mainly supplied by the RBI which is the central bank of the country. It issues
currency on the basis of Minimum Reserve System. Under this system, RBI maintains a min.
reserve of Rs 200 cr in the form of gold and foreign securities. Of this reserve, value of gold
must be Rs 115 cr.
Commercial banks create credit on the basis of demand deposits, and on the basis of their
cash reserves. When the commercial banks provide credit to the people, they add to the
supply of money. On the other hand, when they reduce the provision of credit, the supply
of money is reduced. Expansion or contraction of money supply by the commercial bank is
governed by the monetary policy of the RBI. Money created by commercial banks by way of
demand deposits is called Bank Money.
Government is the third source of money supply in the country. In India, the ministry of
finance issues one-rupee notes and coins of all denomination.
Bank money – It refers to demand deposits (or chequeable deposits) of the people with the
commercial banks.
High powered money – It is the sum total of –
1. Currency held by the people.
2. Vault cash of the commercial bank.
3. Cash reserves of commercial banks with RBI.
This is called ‘monetary base’ or ‘base money’ in the economy.
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