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chapter 6

Money is a universally accepted medium of exchange that serves multiple functions including a measure of value, store of value, and standard for deferred payments. The document discusses the evolution of money from barter systems to commodity, metallic, paper, and bank money, highlighting the challenges of barter and the characteristics of effective money. It also outlines the primary, secondary, and contingent functions of money, emphasizing its importance in facilitating economic transactions and stability.

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0% found this document useful (0 votes)
19 views4 pages

chapter 6

Money is a universally accepted medium of exchange that serves multiple functions including a measure of value, store of value, and standard for deferred payments. The document discusses the evolution of money from barter systems to commodity, metallic, paper, and bank money, highlighting the challenges of barter and the characteristics of effective money. It also outlines the primary, secondary, and contingent functions of money, emphasizing its importance in facilitating economic transactions and stability.

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Meaning and Functions of Money

Meaning of Money

Money is a thing which is commonly accepted as a medium of exchange. Money is an instrument which
serves as a medium of exchange, a measure of value, a store of value and a standard for deferred
payments.

Difficulties of the Barter System


The barter system is a system where goods were
exchanged for goods in the olden days. The sale and
purchase of goods occur at the same time, and their
value also remains equal at that point. After money
came into existence, a person could purchase or sell
goods with cash without selling or purchasing any
goods at that point. Thus, the act of purchase and
sale was separated.

 Lack of double coincidence of wants: A person with a particular good has to find a person who has the
good of his wants and he should also possess the wanted good of the other person. Hence, the
exchange of good is not possible without the double coincidence of wants.
 Lack of store of value: Wealth is stored in terms of goods as there was no money in existence, storage
of goods cost, loss of value and movement of transfer. Hence, it is not practically possible to store the
people’s purchasing power.
 Lack of divisibility: All types of goods cannot be divided and sub-divided. In the absence of a common
medium of exchange, a problem arises when a big indivisible commodity is to be exchanged for a
smaller commodity.
 Lack of deferred payment: Money has made deferred payments easier. When money is borrowed, the
principal and interest amounts have to be returned to the lender. However, these transactions are not
possible in goods and services.
 Problem of storing wealth: In the absence of money, individuals have to store wealth. The value of
stored commodities may change in the due course of time. Storing a particular good for longer period
is more expensive.

Evolution of Money

The evolution of money has passed through various stages with time, place and circumstances.

 Commodity money: Various commodities used as money is known as commodity money. It is the most
primitive form of money. However, certain problems such as improper standardisation, indivisibility and
storage difficulty made this form of money an unsuitable medium of exchange.
 Metallic money: Mono-metalism and bi-metalism, i.e. valuable metals such as gold and silver, were
used as a medium of exchange. As society progressed, different sections of people agreed to consider
some precious metals as a common medium of exchange. The gold coin was introduced in India by
King Kanishka of the Kushan Dynasty during the first century AD.
 Paper money: The paper currency system is a system where coins and currency notes are used as a
medium of exchange. Because of the expansion of trade and commerce and an increased demand for
money as a common medium of exchange, metallic money was replaced by paper money. The
Central Bank of a country assumes supreme authority in issuing paper money of definite
denominations and values. A medium of exchange which is generally acceptable and enforced by law
is called fiat money. For example, rupee notes and coins are legal tender.
 Bank money: At the final stage of evolution of money, demand deposits with commercial banks are
considered bank money. Demand deposits are current account deposits with banks or other financial
institutions which are payable on demand by cheques. Thus, cheques drawn on the demand deposits
of commercial banks can be used as a medium of exchange.

Narrow and Broad Definitions of Money

Currency, demand and time deposits in commercial banks and other types of deposits are the total
amount of money in an economy. Definition of supply of money varies depending on the components
which are included and excluded.

 Narrow definition of money


M1 = Currency with the public + demand deposits with the commercial banks + deposits kept by
commercial banks with the Reserve Bank
M1 = C + DD + OD
 Broad definition of money
M2 = M1 + Savings deposits with post office savings banks
M3 = M2 + Term deposits in commercial banks
M4 = M3 + Savings with the post office other than in the form of National Saving Certificates
 Demand deposits are current account deposits with banks or other financial institutions which are
payable on demand by cheques. Banks do not provide interest payments on deposits.
 Time deposits are fixed term deposits with a fixed maturity period and their term of deposit varying
from 7 days to 10 years. These deposits cannot avail the benefits of issuing cheques against them and
cannot be payable on demand, but time deposits can avail interest towards the deposited amount.

Features of Money
 General acceptability: It should be accepted by people freely in exchange for goods and services.
 Divisibility: It should be easily divisible into smaller parts to facilitate the transaction more easily.
 Durability: Currency notes and coins are used repeatedly and continue for many years.
 Cognisability: It must be easily recognised and have certain distinct marks to avoid confusion by the
receiving person.
 Portability: It can be transferred easily from one place to another at a lot.
 Homogeneity: Various units of money must be homogeneous in quality.
 Stability: It should be stable in value to serve as a measure of value.
Kinds of Money
 Standard money or currency money consisting of currency notes and coins are called fiat money. It
serves as money on the order of the government.
 Bank money refers to bank deposits which can be withdrawn by bank cheques and bank drafts.
 Near money refers to the highly liquid assets which can easily be converted to cash at short notice
such as bank deposits and treasury bills.

Functions of Money

 Primary Functions
o Money acts as a medium of exchange. The major function of money is to facilitate the process of
exchange by removing the defects of the barter system.
o Money is the measure of value. It is the monetary expression of the market value of goods and
services.

 Secondary Functions
o Standard of deferred payments: Deferred payments refer to those payments which are made in the
future. Money has made deferred payments easier. When money is borrowed, the principal and
interest amounts have to be returned to the lender. However, these transactions are not possible in
goods and services. Money performs this function more effectively.
o Store of value: People keep their wealth in the form of money because money is the most liquid
form of wealth. Savings in the form of money is maintained for purchasing commodities with the
savings in the future. In this case, the values of commodities are being stored. Hence, money acts
as a store of value.
o Transfer of value: Money is also a means of transferring a given value from one person to another.
If any person purchases a commodity, then the value of that commodity can easily be transferred
from the buyer to the seller through a payment in terms of money.
 Contingent Functions
o Assisting production decisions: The producers have to decide the amount of factors of production
to make their profit. They have to make factor payments to those factors of production in terms of
money. Thus, the money prices of those factors help the producer to make necessary decisions.
o Assisting consumption decisions: The consumption of the consumer depends on the income level
and money-prices of the commodities in the market. Thus, the income of the consumer and
money-prices of the commodities influence the consumption decision of individuals.
o Assisting distribution of national income: The owners of various factors of production sell their
factors at market prices. They receive money wages, interest, rent and profits as factor incomes.
All these incomes constitute the national income of a country. Hence, the distributions of national
income among the owners of different factors are determined by the money prices of those factors.
o Assisting the operation of a credit system: Money forms the basis of credit operations performed by
the business and financial institutions in a country.

Importance of Money
When there is development of an economy, there is an abnormal increase in economic transactions. As
money is generally acceptable, it is essential as a medium of exchange. Money is considered a dynamic
factor because of the following reasons:

 Money facilitates exchange beyond limits.


 It facilitates accumulation of wealth for the purpose of investment.
 It facilitates the flow of capital from one place to another within and outside countries.
 It helps in economic stability and promotes the growth of the nation.

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