11. Money- Meaning, Functions, Classification and Gresham’s Law Objectives: After studying this lesson, you will be able to understand, The meaning of money. The different functions of money The classification of money. Meaning of Grasham’s law 11.1 Definition of money 11.2 Functions of Money 11.2.1 Main Functions 11.2.2 Secondary Functions 11.2.3 Contingent Functions 11.2.4 Other functions of money 11.3 Classification of money: 11.3.1 Legal Tender Money; 11.3.2 Optional money:
Transcript
11. Money- Meaning, Functions, Classification and
Gresham’s Law
Objectives:
After studying this lesson, you will be able to understand,
Money has been defined differently by different economists, as there is no unanimity
over its definition. Some definitions are too extensive while others are too narrow. For
example, Walker’s definition is too wide. In Walker’s words” Money is what money
does”. According to this definition, we can include all those things in money, which
perform the functions of money. Thus money does not comprise metallic coins and
currency notes only. It also includes cheques, hundies, bills of exchange, etc., because
they also perform the functions of money. On the other hand, Robertson’s definition of
money is rather narrow.
According to him, Money is a “commodity, which is used to denote anything which is
widely accepted in a payment for goods or in discharge of other business obligations”.
According to this definition, metallic money alone deserves to be called money in the
strict sense of the term because it alone is generally acceptable by the people, left to
them. This definition unnecessarily narrows down the field of money.
Some economists define money in legal terms saying that ‘anything which the state
declares as money is money”. Thus, money possesses legal sanction to discharge debts
and perform other functions of money. But legal sanction alone is not a significant factor
in making money generally acceptable. The bank deposits or credit money are not legal
tender money but these are generally acceptable in payment and actually constitute a
major part of the circulating medium.
None of above definitions is satisfactory since they are either two wide or too narrow. A
suitable definition of money should emphasize not only the important functions of
money, but also its basic characteristic, namely, general acceptability. From this point of
view, Crowther; s definition appears to be ideal definition. He defines money as
‘anything that is generally acceptable as a means of exchange and that at the same time
acts as a measure and as a store of value”. This definition points out that money should
perform all the three important functions of being a medium of exchange, a standard of
value, and a store of value. Besides, money should be a commodity, which is generally
acceptable by the community in payment for anything. In other words, the commodity
chosen as money must be universally acceptable within community in exchange for
goods and services or in payment of debts.
11.2 Functions of Money:
The most general way to define money is to lay down its main functions. The various
functions of money can be classified into four groups.
1) Main Functions
2) Secondary Functions
3) Contingent Functions
4) Other Functions.
Let us now try to understand initially about the main functions of money.
11.2.1 Main Functions:
These are also referred to as original functions of money. Following are the two main
functions of money:
a) Money is a Medium of exchange:
b) Money is a measure of value
Money is a Medium of Exchange:
This may be considered as the most basic function of money. Money has the quality of
general acceptability. As such, all exchanges take place in terms of money. In ancient
times, commodities used to be exchanged for commodities. That was known as Barter
system. But, with the lapse of time, the barter system proved difficult and inconvenient
for the people. The main difficulty of the barter system was the lack of double
coincidence of wants. It was on account of the difficulties and inconveniencies of barter
that money came into existence. In the modern money exchange system, the prices of
goods and services are expressed in terms of money. On account of the use of money, the
exchange transactions have now come to be divided into two parts. One is purchases and
another one sale. Thus, in the modern society money acts as intermediary are sales and
purchases. It is on this account that money is referred to as the medium of exchange. The
difficulty of the lack double coincidence of wants no longer exists now on account of the
invention of money. Since money is generally acceptable, everyone accepts it in
exchange for goods and services and utilizes it for purchasing goods and services of his
choice. Money thus, promotes specialization among individuals, firms and regions.
Since money is a medium of exchange, it bestows upon the holder the power to command
marketable goods and services at his own option whenever he needs them. If the
individual concerned has no money, he may have to borrow it to acquire the necessary
command over marketable goods and services for his own benefit.
Money is a Measure of Value:
The second important function of money is that it measures the value of goods and
services. In other words, the prices of all goods and services are expressed in terms of
money. Since all values are expressed in terms of money, it is easier to determine the rate
of exchange between various types of goods and services in the community. But the
people enjoyed no such facility under the barter system. In view of its function as a
measure of value, money also serves as a unit of account. It means that all records are
kept and maintained in terms of the monetary unit, for instance in India Rupee.
It may however, be pointed out that money still presents a difficulty in its role as a
collective measure of values. The difficulty is that the value of money itself is subject to
changes from time to time.
11.2.2 Secondary Functions:
Money as a standard of Deferred Payments;
In the absence of money, borrowing and lending were difficult or borrowed and lending
amount could be returned only in terms of goods and services, but the modern money
economy has greatly facilitated the borrowing and lending process in terms of money. In
other words, money now acts as the standard of deferred payments for the following
reasons: the value of money is stable compared to the values of other commodities,
Money is more durable compared to other commodities: Money has the quality of general
acceptability. Hence it continues to be always desirable. But in its role as a standard of
deferred payments, money also suffers from certain drawbacks. They are; its own value is
not wholly stable. On the contrary, its value keeps on fluctuating from time to time. As a
consequence, debtors and creditors are differently affected at different times. For
instance, if the value of money depreciates on account of a price rise, the creditors lose
while debtors gain.
Money is a Store of Purchasing Power:
Money should have store of value character. Otherwise it is of no use in saving under
barter system. Because savings in terms of goods and services are not permanent and
some of which happened to be perishable. Thus savings done in terms of money under
modern money economy are more permanent and money made possible capital
accumulation, which is an essential, prerequisite of economic growth. Money also serves
as an excellent store of wealth, as it can be easily converted into other marketable assets,
such as, land machinery, plant etc., but money can perform this function satisfactorily
only if its own value is fairly stable.
As a store of value, people’s preference of money over other assets flows essentially from
the characteristic liquidity of money and the uncertainty about the future value of non-
money assets. By acting as a store of value, money provides a link between the present
and the future.
As mentioned earlier, though there are contingent and other functions of money, but as a
student of UG, it is sufficient to learn above stated important functions of money.
However, list out the contingent and other functions in brief in the following.
11.2.3 Contingent functions: money will act as the basis of credit to be created by
commercial banks, money also facilitates the distribution of social income among the
population in an economy, money helps to equalize marginal utilities and marginal
productivities and money increases productivity of capital.
11.2.4 Other functions of money: Money helps to maintain repayment capacity, money
represents generalized purchasing power and money gives liquidity to capital.
11.3 Classification of money:
Different economists on the basis of different criteria have classified money. On the
basis of legality, money can be classified under two heads:
11.3.1 Legal Tender Money;
It is that money which is accepted as a means of payment both by the Govt as well as the
people. This type of money has legal sanction behind it. No one refuse to accept it as a
means of payment.
Legal tender money can be further subdivided under two heads: a) limited legal tender, b)
unlimited legal tender.
Limited Legal Tender is that money which no person can be forced to accept beyond a
certain maximum limit. The Govt under statute fixes the maximum limit. For example
1,2,5,10,20 and 25 paise coins are legal tender only up to a sum of rupees twenty-five. If
some one is called upon to accept the small coins beyond the maximum limit of Rs 25/- is
perfectly free to refuse them. But up to the limit of Rs. 25/-, he cannot refuse the small
coins under the provisions of the law.
Un-Limited Legal Tender is that money which a person has to accept up to any limit,
because it is an unlimited legal tender. This type of money accepted by the people to an
unlimited extent. For example, one rupee coin’s, fifty paise coins and paper notes of all
denominations are unlimited legal tender in India.
11.3.2 Optional money:
It is that money, which ordinarily accepted by the people, but has no legal sanction
behind it. No one can be forced to accept this type of money against his wishes. It is
optioned money. If the persons is paying this money enjoys high credit in the market,
everyone will readily accept it. But as pointed out above, no one can be forced to accept
it. Different types of credit instruments like cheques, hundies and bills of exchange are
examples of optional money.
Money can be classified under two sub-heads on the basis of the commodity used in
making it.
1) Metallic money
2) Paper money
11.3.3 Metallic Money:
This money is made of a particular metal (i.e., Gold, Silver, Copper, Nickel, etc.,).
Metallic Money is further classified under three sub heads:
a) Standard Money
b) Token Money
c) Subsidiary Money
11.3.3.1 Standard Money:
This is also referred to as the principle money or full-bodied money. Standard coins are
made of gold or silver. These coins are made of a well-defined weight and fineness.
Standard money has the following characteristics:
1) Standard coin is the principal coin of the country. As such, it is the medium of
exchange and also the money of account. When the standard coin is made of one
metal, the monetary system is known as mono-mettalism. If this metal is gold, the
system is referred to as gold mono-metallism. In case, the standard coin is made
of silver only, the system is known as silver mono-metalism.
Some times, the standard coins are made of gold as well as of silver. In other
words, two types of standard coins are in circulation- one made of gold and the
other of silver. Such a monetary system is known as Bi-metalism.
2) The Face value of standard money is equal to its intrinsic value. The face value of
standard money is always equal to its metallic or intrinsic value. In other words,
the standard coin comprises metal whose value is equal to its face value. If some
one melts down a standard coin and sells the bullion in the market, he suffers no
loss because the coin contains metal equivalent to its face value. That is why the
standard money is known as full-bodied money. For example, the Indian rupee
before 1893 was a standard coin. It had in it silver whose metallic value was equal
to its face value.
3) There is free coinage of standard money. A special characteristic of standard
money is that it is minted under free coinage. Under free coinage as is well
known, the mint is open to the public. Under the system, the people have the right
to take their gold or silver to the mint for getting it converted into coins. For this
service rendered to the citizens, the mint some times charges fee, but some times
it does not. The main advantage of this system is that there is no shortage of coins
in the country. Whenever the people experienced shortage of coins they can take
their gold or silver to the mint and get it converted into coins.
4) Standard money is unlimited legal tender money. An important characteristic of
standard money is that its unlimited legal tender, because it’s the principal
monetary unit of the country. All big payments can be made in terms of standard
money to an unlimited extent.
11.3.3.2 Token money:
The token money is used for making smaller payments. It serves as a subsidiary for
standard money. It is generally made of inferior and light metals, such as, copper,
nickel etc, Token money is different from standard money in several respects, I shall
then briefly in the following sentences:
1) There is no free coinage of token money. The government only mines this, the
public enjoys no right to take the metals to the mint and get them converted into token
coins.
2) The face value of token money is higher than its intrinsic value.
3) Token money is limited legal tender money: Token coins can be used for making
payments only to a limited extent. No one can be forced to accept then coins
beyond a certain limit.
4) Token money is a subsidiary of standard money: Token coins are generally used
for making payments in smaller transactions. As such, they act as subsidiaries of
standard coins.
Let us see the merits and demerits of standard coins in brief:
Merits of Standard Coins:
a) Inspire grater confidence
b) Means of storing purchasing power
c) Easy acceptability in foreign countries
d) No fear of inflation
Demerits of Standard Coins:
a) Not economical
b) Standard money is not elastic
Now let us also study the merits and demerits of Token coins:
Merits of Token Coins:
a) Economical use of metals
b) Token currency is much more elastic
Demerits of Token Coins:
a) Inspire less confidence
b) Consistability
c) Fear or over-issue
d) Acceptability within the country
e) Limited legal tender
11.3.3.3 Subsidiary money:
Subsidiary coins are issued to facilitate smaller payments. The main characteristics of
subsidiary coins are:
a) The subsidiary coins are low-value coins and are made of lighter metals.
b) They facilitate the exchange of low-priced goods and services
c) There coins are not subject to free coinage, they are issued by the government
itself
d) All subsidiary coins are token coins
e) The relationship of subsidiary coins with the standard coins is defined and
determined under statute.
11.4 Paper Money:
Paper money has a long history to its credit. China was the first in the world to make use
of this in the 9th century and it began in India in the 19th century.
Paper money can be classified under three heads:
1) Representative Paper Money
2) Convertible Paper Money
3) In-Convertible Paper Money
11.4.1 Representative Paper Money:
This type of paper money is fully backed up by Gold and Silver reserves. In the
beginning to avoid wastage of metals the paper currency was issued. Hence, the monetary
authority maintained metallic reserves equivalent to the value of paper notes issued. The
demand for converting paper notes into cash was met by making use of gold and silver
kept in reserves. Thus, under the system of representative paper money, gold and silver
equivalent to the value of paper notes issued were kept in reserves by the monetary
authority.
Main advantages and disadvantages of Representative money are as follows:
Advantages of Representative money :
a) No fear of inflation
b) Economy in use of valuable metals
c) Public confidence
Disadvantages of Representative money:
a) No saving in gold and silver
b) Lack of elasticity
c) Unsuitable for poorer countries
11.4.2 Convertible Paper Money:
It refers to that type of paper money, which is convertible into standard coins at the
option of the holder. The characteristics of convertible paper money give us a better
understanding of this.
a) The basic principle underlying this system is that the public for encashment does
not simultaneously present all the notes. Therefore, the value of gold, silver kept
in reserves is less that the value of notes issued by monetary authority.
b) The monetary authority assures the public that they can get their paper notes
converted into cash at their option.
c) The approved securities such as gold, and silver can be encashed at anytime.
d) Thus, gold and silver in the reserves are not kept equivalent to the value of the
paper currency issued, but they are some what less than that of currency under
this system the reserves comprise two portions:
i) Metallic portion- this portion contains gold, silver and standard coins and,
ii) Fiduciary potion – this portion contains only approved securities
e) Under this system, the people are given gold and silver in exchange for paper
currency for making payments abroad.
f) The government is ever ready to buy gold and silver at predetermined rates.
Merits and demerits of the type of money are as follows;
Merits of convertible paper money:
a) Economy in use of valuable metals
b) Flexibility
c) Inspire greater public confidence
d) Facility in foreign trade
Demerits of convertible paper money:
a) Fear of over –issue of paper currency
b) It does not inspire as much confidence as representative money
Though this system spread to many countries and is widely adopted, it’s the system of
inconvertible money, which is in force.
11.4.3 Inconvertible paper money;
This system prevails in a country when the monetary authority gives no guarantee to
convert the paper notes into coin or other valuable metals. Such a type of paper currency
circulation account of the high credit enjoyed by the monetary authority. The following
are its characteristics.
a) Under this system. The issuing authority keeps no metallic reserves behind paper
currency nor does it guarantee the convertibility of paper note into coins and
metals. It’s possible that the issuing authority backs up the note-issue with
government securities, treasury bills and even bonds.
b) Such type of paper currency can be issued at best only in limited quantity but if
need arises, the issuing authority may issue more paper notes without metallic
cover.
11.4.4 Fiat Money:
Lastly, this is only a variety of in convertible fiat money and is issued generally at a time
of crisis. That is why it’s sometimes referred to as emergency currency. No reserves of
any type are kept behind and are neither backed up by the metallic and fiduciary cover.
The monetary authority gives no guarantee to convert fiat money into metallic coins. The
main characteristics of fiat money may be summed up as follows:
a) Fiat money is issued in limited quantities
b) Fiat money is issued at a time of crisis
c) There is no-cover (metallic or fiduciary) behind it
The fact of the matter is that fiat money is an extra-ordinary type of money and is issued
under special circumstances. Fiat money is however, is an unlimited legal tender.
At the outset, the above mentioned are the different types of money which have been and
are being used in the countries to carry on their daily transactions. The divisions and sub-
divisions made it easier, though money has undergone many changes from barter system
to the present day paper currency, however we may call it, it is highly essential.
11.5 Gresham’s Law:
Queen Elizabeth of England wanted to reform the currency system which was existed
during the time of her grandfather to have a single unified currency in order to strengthen
the trade and commerce in the country. She was introduced reform of the currency
system by issuing new coins of better weights and shape with the hope that public will
deposit the old dishonored coins in treasury and very soon the work of currency reforms
would be successfully accomplished. But to her absolute disappointment she found that
the new coins disappeared from the circulation no sooner these were issued from the
mint. Upset by this situation the queen on the advice of her minister consulted Sir
Thomas Gresham who was the master of the mint under queen Elizabeth. Gresham
enquired about the phenomenon in 1558 and came to the conclusion that bad money
drives out good money. This has to be come to known as Gresham’s law.
When two kinds of money in circulation the problem before the government is to keep
them concurrently in circulation. When the two currencies having the legal value have
different intrinsic or real value in the domestic or foreign market then the money having
higher market value is set to be under valued currency while other set to be over valued
currency. A money over valued by the government is that which has less purchasing
power in the market. In such a situation the over valued currency will tend to drive out
the under valued currency from circulation. The under valued currency is withdrawn
from monetary use melted and diverted to non monetary uses. Gresham’s law is based on
this observation.
A basic aspect of Gresham’s law is that the under valued money can remain in circulation
at home only if it will circulated at a premium. This conclusion follows from the fact that
people will not spend the under valued money at home on the same basis as the over
valued money when they can get relatively more for the under valued money in foreign
countries.
11.6 Summary
Money has been defined differently by different economists, as there is no unanimity
over its definition. Some definitions are too extensive while others are too narrow. And as
par as concerned with the classification of money, different forms of money and its
advantages as well as disadvantages also discussed in this lesson. We also covered what
is Gresham’s law and its importance. It is in this view money has been playing key role in
an economy. However, money no doubt, is a significant and important factor in the
operations of a modern economy, yet its limitations cannot be overlooked or ignored in
any fair evaluation of the role played by it.
11.7 Check your progress
Whether the following statements are true or false
1. “ Money is what money does” said by walker
2. Money is in the normal sense, means currency
3. Measure of value is an essential function of money
11.8 Key concepts
Medium of exchange
Measure of value
Store of value
Differed Payments
Representative Money
Fiat money
11.9 Self Assessment questions
1 Define money and explain its main functions
2. Explain the various types of money and briefly mention their characteristics
4. Distinguish between Convertible and inconvertible paper money
5. What is Gresham’s law
11.10 Answers to check your progress
1. false 2. False 3 True
11.11 Suggested Readings
Ackley Gardner : Macro economic theory
Ward R A: Monetary theory and policy
Rana & Verma : Macro economic analysis
Hajela TN: Monetary economics
Ghatak : Monetary economics in developing economies
Various functions of money can be classified into three broad groups:
(a) Primary functions, which include the medium of exchange and the measure of value;
(b) Secondary junctions which include standard of deferred payments, store of value and transfer of value; and
(c) Contingent functions which include distribution of national income, maximization of satisfaction, basis of credit system, etc. These functions have been explained below:
1. Medium of Exchange:The most important function of money is to serve as a medium of exchange or as a means of payment. To be a successful medium of exchange, money must be commonly accepted by people in exchange for goods and services. While functioning as a medium of exchange, money benefits the society in a number of ways:
(a) It overcomes the inconvenience of baiter system (i.e., the need for double coincidence of wants) by splitting the act of barter into two acts of exchange, i.e., sales and purchases through money.
(b) It promotes transactional efficiency in exchange by facilitating the multiple exchange of goods and services with minimum effort and time,
(c) It promotes allocation efficiency by facilitating specialization in production and trade,
(d) It allows freedom of choice in the sense that a person can use his money to buy the things he wants most, from the people who offer the best bargain and at a time he considers the most advantageous.
2. Measure of Value:Money serves as a common measure of value in terms of which the value of all goods and services is measured and expressed. By acting as a common denominator or numeraire, money has provided a language of economic communication. It has made transactions easy and simplified the problem of measuring and comparing the prices of goods and services in the market. Prices are but values expressed in terms of money.
Money also acts as a unit of account. As a unit of account, it helps in developing an efficient accounting system because the values of a variety of goods and services which are physically measured in different units
(e.g, quintals, metres, litres, etc.) can be added up. This makes possible the comparisons of various kinds, both over time and across regions. It provides a basis for keeping accounts, estimating national income, cost of a project, sale proceeds, profit and loss of a firm, etc.
To be satisfactory measure of value, the monetary units must be invariable. In other words, it must maintain a stable value. A fluctuating monetary unit creates a number of socio-economic problems. Normally, the value of money, i.e., its purchasing power, does not remain constant; it rises during periods of falling prices and falls during periods of rising prices.
3. Standard of Deferred Payments:When money is generally accepted as a medium of exchange and a unit of value, it naturally becomes the unit in terms of which deferred or future payments are stated.
Thus, money not only helps current transactions though functions as a medium of exchange, but facilitates credit transaction (i.e., exchanging present goods on credit) through its function as a standard of deferred payments. But, to become a satisfactory standard of deferred payments, money must maintain a constant value through time ; if its value increases through time (i.e., during the period of falling price level), it will benefit the creditors at the cost of debtors; if its value falls (i.e., during the period of rising price level), it will benefit the debtors at the cost of creditors.
4. Store of Value:Money, being a unit of value and a generally acceptable means of payment, provides a liquid store of value because it is so easy to spend and so easy to store. By acting as a store of value, money provides security to the individuals to meet unpredictable emergencies and to pay debts that are fixed in terms of money. It also provides assurance that attractive future buying opportunities can be exploited.
Money as a liquid store of value facilitates its possessor to purchase any other asset at any time. It was Keynes who first fully realised the liquid store value of money function and regarded money as a link between the present and the future. This, however, does not mean that money is the most satisfactory liquid store of value. To become a satisfactory store of value, money must have a stable value.
5. Transfer of Value:Money also functions as a means of transferring value. Through money, value can be easily and quickly transferred from one place to another
because money is acceptable everywhere and to all. For example, it is much easier to transfer one lakh rupees through bank draft from person A in Amritsar to person B in Bombay than remitting the same value in commodity terms, say wheat.
6. Distribution of National Income:Money facilitates the division of national income between people. Total output of the country is jointly produced by a number of people as workers, land owners, capitalists, and entrepreneurs, and, in turn, will have to be distributed among them. Money helps in the distribution of national product through the system of wage, rent, interest and profit.
7. Maximization of Satisfaction:Money helps consumers and producers to maximize their benefits. A consumer maximizes his satisfaction by equating the prices of each commodity (expressed in terms of money) with its marginal utility. Similarly, a producer maximizes his profit by equating the marginal productivity of a factor unit to its price.
8. Basis of Credit System:Credit plays an important role in the modern economic system and money constitutes the basis of credit. People deposit their money (saving) in the banks and on the basis of these deposits, the banks create credit.
9. Liquidity to Wealth:Money imparts liquidity to various forms of wealth. When a person holds wealth in the form of money, he makes it liquid. In fact, all forms of wealth (e.g., land, machinery, stocks, stores, etc.) can be converted into money.
Economists are not in agreement on the question of definition of money supply. There are four broad approaches of money supply. They are as follows:
1. Traditional Approach:
The traditional approach emphasises the medium of exchange function of money. According to this approach, money supply is defined as currency
with public and demand deposits with commercial banks. Demand deposits are the current accounts of depositors in a commercial bank.
The traditional approach is analytically superior because it provides the most liquid and exact measure of money supply.
The central bank can have better control over the money supply if it includes currency and demand deposits of banks alone. But, this approach limits money supply to a very narrow area.
2. Monetarist Approach:
The Chicago School led by Milton Friedman includes in money supply currency plus demand deposits plus time deposits. Time deposits are fixed deposits of the banks which earn a fixed rate of interest depending upon the period for which the amount is deposited.
According to Friedman money is defined as "anything that serves the function of providing a temporary abode of purchasing power."
Money can act as a temporary abode of purchasing power if it is kept in the form of cash, demand deposits or any other asset which is close to currency, i.e., time deposits. This approach lays emphasis on the store of value function of money and provides a broader measure of money.
3. Gurley and Shaw Approach:
Gurley and Shaw further widened the scope of money supply by including in its constituents currency plus demand and time deposits of banks plus the liabilities of non-banking intermediaries. The liabilities of non-banking intermediaries cover saving bank deposits, shares, bonds, etc. and are close substitutes to money.
4. Radcliffe Committee Approach:
Radcliffe Committee approach or liquidity approach provides much wider view of the concept of money supply. In this approach, the concept of money supply is viewed in terms of general liquidity of the economy.
Money supply covers "the whole liquidity position that is relevant to spending decisions." The spending is not limited to the amount of money in existence. It is related to the amount of money people think they can get hold of whether by receipts of income, by disposal of assets or by borrowing.
Thus, according to this approach, money supply includes cash, all kinds of bank deposits, deposits with other institutions, near-money assets and the borrowing facilities available to the people.
The practical difficulty with this liquidity approach is that the money supply in this wider sense cannot be successfully measured because the degree of liquidity of different constituents of money supply varies considerably.
Moreover, most of the constituents remain outside the control of central bank and thus restrict the effective implementation of monetary policy.
