Unit-

MONEY
 Learning Objectives

After comprehensive studying of this chapter, learners will be

able to:
 define and explain the meaning, importance, functions and forms of money.
 define value of money.
 explain quantity theory of money (Fisher's equation).
 define and explain the meaning, causes and consequences of inflation and deflation.

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 Introduction

 In the beginning of human civilization, people had very few wants. They could
meet their needs themselves. As such, there was no need of money. With the
development of civilization, human wants multiplied rapidly. So they could not
meet their needs which led to interdependence between them. Hence, the
barter system came into existence to fulfil the initial needs of exchange.
 But a number of difficulties were observed in this system. A need was felt that
there should be such a system that could save all from these difficulties. Money
came into existence in these circumstances.
 According to D.H. Robertson,“Anything which is widely accepted in payment
for goods or in discharge of other kinds of business obligations is called money.”
 According to Crowther, money is “Anything that is generally acceptable as a
means of exchange (i.e., as a means of setting debts) and, at the same time,
acts as a measure and as a store of value.”
 Barter System

 Before the introduction of money, goods and services were exchanged for
goods and services. This practice is known as barter system. It is the exchange
system without the use of money. The economy with barter system is known
as barter economy. Barter system became rare in practice because it had
following difficulties:
1. Lack of double coincidence of wants
2. Lack of common measure of value
3. Lack of divisibility
4. Lack of store of value
5. Difficult to use as a deferred payment
6. Difficulty in Transfer of value
 Characteristics of Good Money

2. Divisibility:
Money must be 3. General 4. Stability in
5. Scarcity:
divisible into Acceptability: Value: Money
1. Portability: Money must be
smaller Money must be must have a
Money must be limited in supply
denomination to generally stable value in
portable. It to have a
facilitate small acceptable. It terms of the
should be light reasonable
transactions. avoids things it can buy.
in weight to be value. Moreover,
Paper money inconvenience If the value of
easily carried there should not
and coins do this and facilitates money changes
out. This be undue
job very well. For easy and wide by large
characteristic increase in the
instance, paper circulation of magnitude,
makes paper supply of money
notes of Rs.1, 2, money. It also money may fail
money as the so that its value
5, 10 and 20 reduces chances to perform its
ideal money. is maintained
enable us to of counterfeit functions
relatively stable.
make small money. properly.
purchases.
 Importance of Money
 Money is one of the greatest invention of mankind. It is the guiding star of all economic activities in the
modern economy. It plays a dominant role in all the fields of economics viz., consumption, production,
exchange, distribution and public finance.
Alfred Marshall rightly says that, “Money is the pivot around which economic science clusters.” The
following are the roles of money in the modern economy:
1.Consumption: In the field of consumption, money measures the marginal utility obtained from the
consumption of a commodity. It helps the consumer to equalize the marginal utility derived from different
commodities and to maximize his satisfaction.
2.Production: Before the advent of money, producers were always hesitant to produce more. They used to
produce only that much which could be bartered in the local market. But the introduction of money assured
the producers or entrepreneurs about the sale of their product; as such, the volume and variety of
production went on increasing.
3.Exchange: Money has removed all the difficulties of barter system. Money serves as medium of exchange
and measure of value. It has general purchasing power. Anything can be bought directly with the help of
money.
4.Distribution: Production is the result of joint efforts of different factors of production. These factors of
productions are land, labour, capital and organization. Money enables the producer to distribute the shares
of the factors of production in the form of rent, wage, interest and profit.
5.Public Finance: Public finance means funding function of the state. The government collects taxes, fees,
penalty, interest and prices, etc. in terms of money. The money so collected is utilized for administrative and
developmental purposes. Without money, the functions of a modern state would become almost impossible.
 Functions of Money

The functions of money can be explained under the following three headings:
1. Primary Functions: The primary functions of Money are two fold:
i. Medium of Exchange ii. Measure of Value

2. Secondary Functions: Money performs the following secondary functions

i. Standard of Deferred Payment ii. Store of Value iii. Transfer of Value

3. Contingent Functions: Prof. Kinley has mentioned the following

contingent functions of money.
i. Distribution of National Income ii. Maximum Satisfaction

iii. Basis of Credit iv. Increase in the Productivity

of Capital
 Types of Money
 There are different forms or kinds of money. These forms or kinds are
explained below:
a. Commodity Money: The commodity used as money is called
commodity money or commodity standard. People had used different
types of commodities as money. For example, people used animal
leathers, bones and teethes during hunting age; good grains and cattle
during pastoral age, and different other commodities at different times as
money.
b. Metallic Money: If the metals like gold and silver are used as money, it
is known as metallic money or metallic standard. Those money possessed
quality of good money. So they were used for a long time. But nowadays,
the metallic money is used less commonly then the paper money. There
are two types of metallic money:
i. Standard or Full-Bodied Coin ii. Token Coin
 Contd…

c. Paper Money: Paper money is made up of paper. It is issued

through central bank by the government. Paper money possesses
higher face value than intrinsic value. Paper money is unlimited legal
tender. All are bound to accept it by law. Paper money can be classified
under four heads.
i. Representative Paper Money ii. Convertible Paper
Money
iii. Inconvertible Paper Money iv. Fiat Money
d. Credit Money: Credit money or bank money is the credit issued by
banks. It is also known as optional money as there is no legal provision
to enforce the acceptance of credit money. No one can be forced to
accept this type of money against his wish.
 Value of Money

 By the term "value of money", we mean the purchasing power of

money. It refers to the amount of goods and services that can be
purchased with a given unit of money.
 In other words, the value of money means the buying capacity of
money. Thus, the value of money depends upon the price level.
 The lower the price level, the higher will be the value of money and
vice-versa.
 Hence, there is inverse relationship between the value of money and
the price level.
 Unit-5 Inflation

According to Keynes, "Inflation is the result of the excess of aggregate demand over the
available aggregate supply and true inflation starts only after full employment".
Inflation is the rise in general price level. But every rise in general price level is not
inflation. It is the persistent and appreciable rise in general price level. Inflation causes the
decrease in value of money or the purchasing power of money. Hence, the cost of l
Features of Inflation: The following are the main features of inflation:
1. Inflation is the rise in general price level, not a state of high price.
2. Inflation is not a small or temporary fluctuation but is a sustained and appreciable
rise in general price level.
3. Inflation is not the increase in relative/individual prices but is the increase in general
price level.
4. Pure inflation starts after full employment.
5. Inflation may be demand-pull or cost-push.
 Demand-pull Inflation

 Inflation resulting from increase in aggregate demand is called demand-

pull inflation. It occurs when there is increase in aggregate demand for
goods and services keeping the aggregate supply constant. When
aggregate demand increases, the available aggregate supply cannot
meet the increased demand so the price of goods and services will rise
and demand-pull inflation occurs. Y

AS
 For explanation, juts go
through the book in details.

Price Level
P2 E2

P1 E1 AD2

P E AD1
AD

O X
YF
Aggregate Demand and Aggregate Supply
 Causes of Demand-pull Inflation

1. Increase in Money Supply and Bank Credit: Due to the increase in money supply and
bank credit, investment, income and consumption also increases.
2. Decrease in Interest Rate: Decrease in interest rates causes a rise in consumer spending
and higher investment. This will lead a rise in aggregate demand and inflationary pressures.
3. Increase in Government Expenditure: When there is increase in government
expenditures in the form of regular and development expenditure, there will be directly increase in
demand for goods and services.
4. Decrease in Tax Rate: The low rate of taxes increases disposable income and hence the
purchasing power of people which makes the aggregate demand high. This leads to demand-pull
inflation.
5. Increase in Export: Due to increase in export, there will be increase in aggregate demand.
If supply of goods cannot be increased accordingly then demand-pull inflation arises.
6. Currency Devaluation: The main aim to devaluate a currency is to increase exports
relative to import. Increase in exports leads to increase in the demand for domestic goods relative
to its supply. This causes the price level to rise.
 Cost-push Inflation
 Inflation resulting from the decrease in aggregate supply due to the
increase in cost of production is called cost-push inflation. When there is
rise in prices of factors of production there will be increase in cost of
production. This will lead to a decrease in aggregate supply and hence
the rise in price level called cost-push inflation.
In the figure 9.3, aggregate demand and aggregate Y
supply are measured along the X-axis and price level
along the Y-axis. AD is the aggregate demand curve
Price
and AS is the aggregate supply curve. The AS curve is Level
upward sloping in the beginning and becomes parallel P2
P1
to the Y-axis when full employment is reached. AD and E
P
AS curves intersect with each other at point E where AS2
AS1 AD
general price level is OP. When prices of factors
AS
production rises, the cost of production increases and
the AS curve shifts to AS1 resulting price level to rise O
M N YF
X

from OP to OP1. Further shift in AS to AS2, the price Aggregate Demand and Aggregate Supply

level rises to OP2. This shows that the increase in cost

of production causes the cost-push inflation.
 Causes of Cost-push Inflation

1. Increase in Wage: Existence of strong trade union exercises its union power to
increase the real wage rate of the labour. The cost-push inflation originating from the increased
wage rage is called wage-push inflation.

2. Increase in Profit Margin: When the producers increase their profit margin, price will
definitely rise. The inflation originating from the increased profit-margin is called profit-push
inflation.

3. International Reason: The economy of a country is linked with other countries. If the
price of consumer goods raw materials and capital goods increase in foreign countries the price
of goods and services also increases in the country.

4. Natural Disasters: The occurrence of natural disasters like, earthquake, flood,

droughts has adverse effect on the productivity. This reduces the output and thus reduces the
supply relative to demand. Thus, price level rises.

5. War: When there is war between the countries or within a country then the productive
resources of a country are diverted towards the production of arms and ammunitions. This
causes the production of necessary goods to fall. Hence the supply decreases and price level
rises.
 Consequences of Inflation

a. Effects on Production: Inflation creates uncertainty which adversely affects

production system. It disrupts price system, reduces saving, encourages hoarding and
speculation activities and ultimately reduces the volume, pattern and quality of production. The
effects of inflation on production activities can be listed below:
i. Reduction in Saving: When price increases, the purchasing power of money falls which
means more money is needed to buy the same quantity of goods. Thus, saving reduces.
ii. Encourages Hoarding: When prices increase, hearing of goods increases in an expectation
to sell it at higher prices.
iii. Reduces Volume of Production: Volume of production decreases because of business
uncertainty that discourages entrepreneurs from taking business risk in production.
iv. Affects Pattern of Production: Because of inflation producers diversifies resources from
producing necessary goods to luxurious goods because the rich, whose incomes increases more
rapidly demand luxury goods.
v. Quality Falls: Since the producer’s interest is higher profits and because there is higher
demand during inflation, producers will not care for the quality of goods sold.
vi. Discourages Foreign Capital: Because inflation reduces the value of money it discourages
foreign capital and even may drive out the foreign capital invested.
 Contd…

b. Effects on Distribution: During inflation, the fixed income groups like pensioners, interest and
rent earners, etc. are always the losers. Similarly, salaried persons like factory workers, teachers, etc.
are also the losers because incomes do not increase as faster as the prices. Inflation is unjust
because it puts the economic burden on those sections of the society who are least able to bear it.
c. Effects on Society: High rate of inflation leads to social unrest situation in the economy.
Dissatisfaction increases among the workers. They demand higher wages to sustain their present
living standard. Moreover, high rate of inflation leads to a general feeling of discomfort for the
household as their purchasing power is consistently falling.
d. Effects on Moral: Inflation adversely affects business morality and ethics. It encourages black
marketing and enables the businessmen to reap wind-fall gains by undesirable men in order to
increase the profit margin, the producers reduce the quality by introduction of adulteration in their
products.
e. Effects on Politics: Inflation also disrupts the political life of a country. It corrupts the politicians
and weakens the political discipline. The increase in inequality and moral degradation from the
inflation can also lead to the loss of faith in the government. Rising prices also encourage agitations
and protests by political parties opposed to the government. This may lead to frequent change in
government.
 Deflation
 Deflation is a sustained decrease in the general price level in an
economy. It is the situation of falling general price level or rising value
of money. According to Crowther, "Deflation is the state of economy
where the value of money is rising or prices are falling."
 Deflation is associated with fall in prices, but each and every fall in
price is not a deflation. Only those falls in price which results in
unemployment, overproduction and fall in the economic activity are
deflationary. Thus deflation is a situation where prices are falling with
the fall in income, output and employment.
 Causes of Deflation:
a. Reduction in money supply b. Increase in rate of interest
c. Increase in tax rate d. Increase in production
e. Other policies of credit control
 Consequences of Deflation

1. Effects on Different Sections of Society

a. Producers: Deflation will adversely affect producers because the fall in the cost of
production is not rapid as the fall in price. When producers buy inputs, he buys it at a
higher price and when he sells output, he sells it at a lower price. As a result, profit
will fall.
b. Traders: Traders suffers the same way as producers. When they make purchases,
they pay higher amount and later sell at lower price due to deflation.
c. Investors: Fixed income investors like bond holders will be benifited because
income remains constant even when price falls. Variable income investors like equity
holders will lose during deflation because their returns or income will fall with falling
prices.
d. Salaried and Labour Classes: Wage earners and salaried persons will gain from
deflation as their income remains fixed even when price falls.
e. Creditors and Debtors: As price falls and the value of money rises creditors will
gain and debtors will lose.
 Contd…

2. Effects on the Economy

a. Cyclical Unemployment: Deflation arises due to a fall in Aggregate Demand in
the economy. This will lead to a decrease in the level of output which will result in
unemployment.
b. Bankruptcies: As the value of money is increasing, it becomes difficult for debtors
to repay the loan. Moreover, during deflation firms will be having lower profits due to
falling prices and will find it difficult to meet their liabilities.
c. Deflationary Spiral: Consistent fall in prices may trigger deflationary spiral. As
firms make less profit, they might not be willing or able to invest which will have
negative implications on the economic growth.
d. Slow Growth Rate: because of falling income, output and employment, the pace
of economic growth slows down or even suffers a set back.
 Assignment

1. Define inflation. What are its features?

2. Define inflation. What are its effects?
3. Define demand-pull inflation. Explain its causes.
4. Define cost-pull inflation. Explain its causes.
5. Explain deflation. What are its consequences?
6. Define money. Explain the functions of money.
7. What are the causes and consequences of inflation?
8. Explain the various forms of money.
9. Explain the features /characteristics of money.
10. What are the role /importence of money? Explain .

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