Page 1 : Defining Money by Its Functions, Learning Objectives, By the end of this section, you will be able to:, Explain the various functions of money, Contrast commodity money and fiat money, Money for the sake of money is not an end in itself. You cannot eat dollar bills or wear your bank account. Ultimately, the usefulness of money rests in exchanging it for goods or services. As the American writer and humorist Ambrose Bierce (1842–1914) wrote in 1911, money is a “blessing that is of no advantage to us excepting when we part with it.” Money is what people regularly use when purchasing or selling goods and services, and thus money must be widely accepted by both buyers and sellers. This concept of money is intentionally flexible, because money has taken a wide variety of forms in different cultures., Barter and the Double Coincidence of Wants, To understand the usefulness of money, we must consider what the world would be like without money. How would people exchange goods and services? Economies without money typically engage in the barter system. Barter—literally trading one good or service for another—is highly inefficient for trying to coordinate the trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide. For example, if an accountant wants a pair of shoes, this accountant must find someone who has a pair of shoes in the correct size and who is willing to exchange the shoes for some hours of accounting services. Such a trade is likely to be difficult to arrange. Think about the complexity of such trades in a modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and goods., Another problem with the barter system is that it does not allow us to easily enter into future contracts for the purchase of many goods and services. For example, if the goods are perishable it may be difficult to exchange them for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries. Additionally, while the barter system might work adequately in small economies, it will keep these economies from growing. The time that individuals would otherwise spend producing goods and services and enjoying leisure time is spent bartering., Functions for Money, Money solves the problems created by the barter system. (We will get to its definition soon.) First, money serves as a medium of exchange, which means that money acts as an intermediary between the buyer and the seller. Instead of exchanging accounting services for shoes, the accountant now exchanges accounting services for money. This money is then used to buy shoes. To serve as a medium of exchange, money must be very widely accepted as a method of payment in the markets for goods, labor, and financial capital., Second, money must serve as a store of value. In a barter system, we saw the example of the shoemaker trading shoes for accounting services. But she risks having her shoes go out of style, especially if she keeps them in a warehouse for future use—their value will decrease with each season. Shoes are not a good store of value. Holding money is a much easier way of storing value. You know that you do not need to spend it immediately because it will still hold its value the next day, or the next year. This function of money does not require that money is a perfect store of value. In an economy with inflation, money loses some buying power each year, but it remains money., Third, money serves as a unit of account, which means that it is the ruler by which other values are measured. For example, an accountant may charge $100 to file your tax return. That $100 can purchase two pair of shoes at $50 a pair. Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs., Finally, another function of money is that money must serve as a standard of deferred payment. This means that if money is usable today to make purchases, it must also be acceptable to make purchases today that will be paid in the future. Loans and future agreements are stated in monetary terms and the standard of deferred payment is what allows us to buy goods and services today and pay in the future. So money serves all of these functions— it is a medium of exchange, store of value, unit of account, and standard of deferred payment., Commodity versus Fiat Money, Money has taken a wide variety of forms in different cultures. Gold, silver, cowrie shells, cigarettes, and even cocoa beans have been used as money. Although these items are used as commodity money, they also have a value from use as something other than money. Gold, for example, has been used throughout the ages as money although today it is not used as money but rather is valued for its other attributes. Gold is a good conductor of electricity and is used in the electronics and aerospace industry. Gold is also used in the manufacturing of energy efficient reflective glass for skyscrapers and is used in the medical industry as well. Of course, gold also has value because of its beauty and malleability in the creation of jewelry., As commodity money, gold has historically served its purpose as a medium of exchange, a store of value, and as a unit of account. Commodity-backed currencies are dollar bills or other currencies with values backed up by gold or other commodity held at a bank. During much of its history, the money supply in the United States was backed by gold and silver. Interestingly, antique dollars dated as late as 1957, have “Silver Certificate” printed over the portrait of George Washington, as shown in . This meant that the holder could take the bill to the appropriate bank and exchange it for a dollar’s worth of silver., Figure 1. A Silver Certificate and a Modern U.S. Bill. Until 1958, silver certificates were commodity-backed money—backed by silver, as indicated by the words “Silver Certificate” printed on the bill. Today, U.S. bills are backed by the Federal Reserve, but as fiat money. (Credit: “The.Comedian”/Flickr Creative Commons), As economies grew and became more global in nature, the use of commodity monies became more cumbersome. Countries moved towards the use of fiat money. Fiat money has no intrinsic value, but is declared by a government to be the legal tender of a country. The United States’ paper money, for example, carries the statement: “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.” In other words, by government decree, if you owe a debt, then legally speaking, you can pay that debt with the U.S. currency, even though it is not backed by a commodity. The only backing of our money is universal faith and trust that the currency has value, and nothing more., Watch this  on the “History of Money.”, Key Concepts and Summary, Money is what people in a society regularly use when purchasing or selling goods and services. If money were not available, people would need to barter with each other, meaning that each person would need to identify others with whom they have a double coincidence of wants—that is, each party has a specific good or service that the other desires. Money serves several functions: a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. There are two types of money: commodity money, which is an item used as money, but which also has value from its use as something other than money; and fiat money, which has no intrinsic value, but is declared by a government to be the legal tender of a country., EVOLUTION OF MONEY, Some of the major stages through which money has evolved are as follows: (i) Commodity Money (ii) Metallic Money (iii) Paper Money (iv) Credit Money (v) Plastic Money., Money has evolved through different stages according to the time, place and circumstances., (i) Commodity Money:, In the earliest period of human civilization, any commodity that was generally demanded and chosen by common consent was used as money., ADVERTISEMENTS:, Goods like furs, skins, salt, rice, wheat, utensils, weapons etc. were commonly used as money. Such exchange of goods for goods was known as ‘Barter Exchange’., (ii) Metallic Money:, With progress of human civilization, commodity money changed into metallic money. Metals like gold, silver, copper, etc. were used as they could be easily handled and their quantity can be easily ascertained. It was the main form of money throughout the major portion of recorded history., (iii) Paper Money:, It was found inconvenient as well as dangerous to carry gold and silver coins from place to place. So, invention of paper money marked a very important stage in the development of money. Paper money is regulated and controlled by Central bank of the country (RBI in India). At present, a very large part of money consists mainly of currency notes or paper money issued by the central bank., (iv) Credit Money:, ADVERTISEMENTS:, Emergence of credit money took place almost side by side with that of paper money. People keep a part of their cash as deposits with banks, which they can withdraw at their convenience through cheques. The cheque (known as credit money or bank money), itself, is not money, but it performs the same functions as money., (v) Plastic Money:, The latest type of money is plastic money in the form of Credit cards and Debit cards. They aim at removing the need for carrying cash to make transactions., Top 12 Criticisms Against the Quantity Theory of Money, Article Shared by, ADVERTISEMENTS:, Here we detail about the twelve important criticisms against the quantity theory of money., 1. Simple Truism:, The quantity MV = PT is more truism, an obvious fact. It indicates that the total quantity of money given in exchange for goods and services (MV) is equal to the money value of goods and services given in exchange for money (PT)., In other words, the total amount of money expenditures of buyers is equal to the total amount of money receipts of sellers. The equation does not tell us anything new or precise about money and prices; it merely restates in a simple form that is evidently true. It does not show which the cause; which is the effect is, it simply shows what has happened., 2. Unreal Assumptions:, ADVERTISEMENTS:, The quantity theory of money as stated by Prof. Fisher is based on unreal assumptions like the existence of full employment of resources and stability of expenditure. The theory assumes that other things like V, V’, M’ and T remain constant. But in actual practice a change in M is bound to affect V, M’, V’ and T. In a dynamic world, change in one factor induces changes in other factors. Experience has shown that the velocity of money instead of remaining constant varies in direct proportion to the volume of production (T)., 3. It Fails to Explain Trade Cycle:, The transactions approach to the quantity theory of money does not help in explaining the trade cycle though it may be taken as a satisfactory- explanation of the long-term trends of prices. It is true that shortage of money (M) and credit (M’) has brought a boom to a sudden end but sometimes it collapses due to lack of the supply of money and credit. Moreover, quantity theory of money is not sufficient to explain the reversal of trend at the bottom of the slump., If it is a decline in the quantity of money that causes a depression, an increase in it should be sufficient to cause an upturn but there are many examples, which go to prove its fallacy, as an increase in the supply of money at the bottom of a slump ‘did not raise the prices., Prof. Crowther remarks:, ADVERTISEMENTS:, “The quantity theory is, at best imperfect guide to the causes of the trade cycle.”, 4. The Theory is Useful in the Long Period:, The quantity theory of money is also criticized on the ground that it explains only long-run phenomenon; it does not help to study the short-run phenomenon. Prof. Coulborn criticized the theory on the ground that “the theory is a concept of long- run phenomena”., Fisher agrees that in the short-run of transition V and T do change but over a long- run, as the economy attains equilibrium they become constant. But in a continuously changing world, there is hardly anything like long period equilibrium; “equilibrium is like tomorrow it never comes”., According to Prof. Crowther, “the most we can say for the quantity theory is that the quantity of money in existence seems to be the dominant influence on the price level on the average of long period. But in the short period…….. it may or may not control the movements of prices. And whether it does or does not depend on whether changes in the quantity of money are offset by changes in the velocity of its circulation.”, 5. Interdependence of the Variable:, ADVERTISEMENTS:, The various constituents of the transaction equation like M, V, M’, V’ P and T are not interdependent variables as assumed by the quantity theorists. They are independent. Therefore, it is difficult to know what affects what, and what the consequence of what is. If there is an increase in the physical volume of transactions (T), there is bound to be an increase in the velocity of circulation of money (V). Therefore, T and V are interdependent and rise or fall together., Similarly, M may increase without any rise in P on account of the fact that T may have increased. The prosperity of the 1920s in the USA shows that a rise in T can lead to a rise in M without causing any change in P. The fact of the matter is that these variables are not independent of one another as Fisher has assumed. In, advanced economies, where the bulk of the quantity of money consists of bank credit, it is a consequence rather than a cause of the price level. The quantity theory of money unnecessarily overlooks the mutual interdependence of the factors involved and stresses the quantity of money as the cause and price level as the consequence., 6. It Does not Explain the Causal Relationship:, The theory fails to establish the causal relationship between P and M. The theory does explain why the price level is what it is at any particular time, it does not explain the causes which bring about changes in the price level. In other words, it provides no tools for the correct analysis of the hidden forces which produce variations in the value of money. Prof. Hayek and Prof. Chandler also expressed the view that theory tries to establish an unrealistic direct causal relationship between M and P without realizing the importance of other monetary factors and relative prices., 7. No Integration of Monetary Theory with Price Theory:, In the classical and neo-classical version of the theory, price formation is isolated from monetary phenomena. Money was considered a veil and played passive role, only as a translator of the values of commodities in terms of money. Thus, there could be no integration of monetary theory with the theory of relative prices (value)., There was a false division of economics between theory of value and distribution on the one hand and the theory of money on the other. It is, however, to be realized that under dynamic conditions money has an active role to play, and therefore, the theory of prices must form an integral part of the theory of output, employment and money (monetary theory) and should not remain isolated as in the classical version., 8. It Ignores Money as a Store of Value:, The cash transactions equation upholds money because it is a good medium of exchange. Its great fault is that it completely ignores the significant role of money which it plays as a store of value. Keynes upheld the store of value function of money and laid great stress on the speculative motive for holding money as against the classical emphasis on the transaction and precautionary motives for holding money., 9. Mutually Inconsistent:, The theory is criticized on the ground that some of the elements used in the equation are mutually inconsistent for, example, P includes all sorts of prices, wholesale as well as retail, wages and profits. Some prices move fast, while others are rigid. It is very difficult to say whether P represents highly fluctuating wholesale prices of rigid retail prices., Similarly, T includes goods as well as services. Further, whereas M refers to a point of time, V refers to the velocity of money over period, MV involves the error of multiplying mutually inconsistent and non-comparable factors. Thus, the quantity theory of money is said to consist of mutually inconsistent elements., 10. Undue Emphasis on Quantity of Money:, Quantity theorists wrongly stress the role of the quantity of money as the main determinant of price level. Keynes, however, points out that the change in economic activity or the price level is caused not a change in the quantity of money alone but also by other fundamental factors like income, expenditure, saving and investment. Thus, price level is not the function of money supply alone in turn, it is influenced by a large number of monetary and nonmonetary factors., 11. Static:, ADVERTISEMENTS:, Quantity theory of money has been criticized on the ground that it is highly static. It applies under conditions where things remain constant but ours is a dynamic world, where things are fast changing. The validity of the theory depends upon the existence of full employment, which is very difficult to attain in actual practice. For analyzing the problems of dynamic economy and fluctuations therein, the quantity theory proves to be utterly inadequate., 12. Inconsistent with Actual Facts:, The theory has been found to be inconsistent with actual facts. For example, a small increase in M may lead to a considerable increase in T. In Germany in 1923, hyper-inflation was caused not on account of an increase in M but in V, as everybody was spending the depreciating mark as quickly as possible. To overcome this, a decrease in V and not M was needed as this theory would like us to believe. Similarly, there are circumstances when M has increased without an increase in P or the increase in P is not in direct proportion to an increase in M. Thus, the quantity theory has been found, at times, to be inconsistent with actual facts., Besides, quantity theory of money has been criticized by various monetary experts on different grounds. Prof. Crowther says, “The quantity theory can explain the ‘how it works’ fluctuations in the value of money…….. but it cannot explain the ‘why it works’, except in the long period……… it cannot even explain why it is that a certain amount of money will sometimes ‘take’ and start off a rise in prices, while at another time an equal creation may have no effect at all.” Prof. Hayek thinks that the quantity theory has unduly usurped the central place in monetary theory and that the point of view from which it springs is a positive hindrance to further progress., According to Whittakers, “the quantity theory is admirable as an elucidation of the mechanism involved in the price level, but as an explanation of causation it has serious shortcomings.” To Lord Keynes, “the fundamental problem of monetary theory is not merely to establish identities (MV = PT)……. the real task of such a theory is to treat the problem dynamically, analysing the different elements…as to exhibit the causal process by which the price level is determined………. ” Prof. Halm expressed the view that the importance of the equation should by no means be overrated: otherwise, we are bound to get into difficulties., ADVERTISEMENTS:, Despite these criticisms, quantity theory of money has its own merits. A good number of examples are found in economic history which proves the validity of theory when large issues of money have pushed up the prices, like hyper-inflation in Germany in 1923 and in China in 1947-48. Prof. Kemmerer and Prof. Cassel have made attempts to prove the direct and proportional relationship between the supply of money and prices. Moreover, important instruments of credit control like bank rate and open market operations are based on the presumption that a large supply of money leads to higher prices., Paper Money, What Is Paper Money?, Paper money is a country's official, paper currency that is circulated for the transactions involved in acquiring goods and services. The printing of paper money is typically regulated by a country's central bank or treasury in order to keep the flow of funds in line with ., Paper money tends to be updated with new versions that contain security features and attempt to make it more difficult for counterfeiters to create illegal copies., KEY TAKEAWAYS, Paper money is a country's official, paper currency that is circulated for the transactions involved in acquiring goods and services., The printing of paper money is typically regulated by a country's central bank or treasury in order to keep the flow of funds in line with monetary policy., Paper money tends to be updated with new versions that contain security features and attempt to make it more difficult for counterfeiters to create illegal copies., Understanding Paper Money, The first recorded use of paper money was purported to be in the country of China during the 7th century A.D. as a means of reducing the need to carry heavy and cumbersome strings of metallic coins to conduct transactions. Similar to making a deposit at a modern bank, individuals would transfer their coins to a trustworthy party and then receive a note denoting how much money they had deposited. The note could then be redeemed for currency at a later date., Example of Paper Money, In the U.S., paper money is considered . This means that it has no actual value except as an accepted medium of exchange. Before 1971, this was not the case; U.S. banknotes were backed by a certain amount of gold, which was dictated by the ., The U.S. dollar has been the dominant reserve currency since the end of World War II. Prior to World War II, the British pound was the dominant reserve currency., More than 350 million people around the world use the dollar as their main form of currency—and more than $17 trillion of economic activity is accounted for with U.S. paper money. U.S. paper money is the official currency in a number of countries and areas outside of the territorial United States. These countries include Ecuador, El Salvador, Zimbabwe, Timor-Leste, Micronesia, Palau, and The Marshall Islands. The dollar is also used in all U.S. territories, including Puerto Rico and Guam. Turks and Caicos and the British Virgin Islands, both British territories in the Caribbean, also use U.S. paper money as their currency., There are also countries that regularly use the U.S. dollar alongside their own local currency, including Bahamas, Barbados, St. Kitts and Nevis, Belize, Costa Rica, Nicaragua, Panama, Myanmar, Cambodia, and Liberia, as well as several Caribbean territories., The euro is another form of paper money that is used in multiple countries. As of 2020, 19 of the 27 member states in the European Union () use the euro as their official currency., Special Considerations, While paper money is the most accepted medium of exchange, companies often issue shares of their own company to purchase other companies and reward their staff. Shares are units of ownership in a company that entitle the shareholder to an equal distribution in any profits. Of all accepted mediums of exchange, shares are closest to paper money because they can be exchanged on the open market for cash., Top 5 Methods Used for Issuing Notes | India, The following points highlight the top five methods used for issuing notes. The methods are: 1. Simple Deposit System 2. Fixed Fiduciary System 3. Maximum Fiduciary System 4. Proportional Reserve System 5. Minimum Reserve System., Method # 1. Simple Deposit System:, Under this system, the monetary authority is required to keep 100% of the bullion (gold or silver) for every note issued. That is why it is also known as the Full Reserve System. This system has certain merits. It is safe and enjoys public confidence because there is full backing of the bullion for every note issued., The monetary authority cannot take any arbitrary decision in issuing notes. So there is no possibility of over issue of notes. There is also the saving of precious metals through debasement because metal coins are not circulated., ADVERTISEMENTS:, However, this system lacks in elasticity firstly, because the money supply cannot be increased without the full backing of bullion reserves. This may be harmful during war or emergency or for development. It may also adversely affect trade and currency., Second, this system is especially unsuited for poor countries lacking insufficient quantities of gold or silver. Third, it is uneconomical for it does not make a profitable use of bullion reserves lying idle with the monetary authority. Thus this system is highly impracticable in modern times. Perhaps this is the reason for its being not put into practice in any country of the world., Method # 2. Fixed Fiduciary System:, Under this system, a fixed amount of notes is issued by the central bank against reserves of government securities. Such amount is issued on the faith or fiduciary of the central bank and is called the fiduciary limit. The central bank is required to keep 100% gold reserves beyond the fiduciary limit. The fiduciary limit is raised from time to time with the expansion of trade and industry. This system was introduced in England in 1844, in India in 1860, followed by Japan and Norway., This system ensures security, inspires public confidence, and is without any danger of mismanaging the currency through over issue of notes by the central bank. But it has also certain disadvantages., ADVERTISEMENTS:, First, it is a rigid and inelastic system because in times of a financial emergency, notes cannot be issued without keeping cent per cent gold in reserves., Second, the system is inconvenient because in the event of a fall in gold reserves, the central bank has to withdraw notes from circulation with the result that the quantity of money is reduced in the country with its adverse effects on prices, trade and industry., Third, this system is uneconomical because gold reserves are blocked up with the central bank. It was, therefore, abandoned by all countries after World War I when they faced these problems., Method # 3. Maximum Fiduciary System:, Under this system, there is a maximum limit up to which the central bank is authorised to issue notes without any gold reserves. But there has to be full backing of gold reserves beyond this limit. The central bank is, however, authorised to raise or lower the maximum fiduciary limit and to fix the quantity of gold reserves., ADVERTISEMENTS:, Thus this system is not rigid but is elastic. It is also economical because the gold, reserves can be kept to the minimum to meet the requirements of trade and industry., In case the central bank fixes the fiduciary limit very high; there may be excess of notes in circulation thereby leading to inflation. This system was in operation in France, Japan, Russia, Norway, Finland and England. This system has one major defect that there is the possibility of inflation through over issue when the maximum limit may be raised by the government., Method # 4. Proportional Reserve System:, In this system, a certain percentage of the total notes issued by the central bank has to be in gold reserves and the remaining in the form of government securities. This percentage varied between 25 to 40 per cent in countries like Switzerland, Holland, Belgium, USA and India., This system is simple and elastic. The money supply can be changed with changes in the percentage of gold reserves. It provides sufficient security because a certain percentage of note issue is supported by gold., ADVERTISEMENTS:, Still, this system has certain drawbacks. Firstly, It is uneconomical because large quantities of gold reserves have to be kept which cannot be issued for productive purposes. Second, if the gold reserves fall, the reduction in currency in circulation may be more than in proportion to the fall in reserves. This may lead to deflationary tendencies. The opposite may happen when gold reserves increase.’ This system was in vogue in India between 1927 to 1956., Method # 5. Minimum Reserve System:, Under the minimum reserve system, the central bank is authorised to issue notes up to any extent but it must keep a statutory minimum reserve of gold and foreign securities. India adopted this system of note issue in 1956 after discarding the proportional reserve system. Accordingly, the Reserve Bank of India is required to keep a minimum reserve of Rs. 200 crores. Of this, Rs. 115 crores must be in gold and Rs85 crores in foreign securities., This system is highly useful for developing countries because they can meet their financial requirements by printing more notes. They can also reduce the money supply to check inflation. It is, therefore, an elastic system. Further, it is very economical because only a small and fixed amount of gold is required to be kept in reserve., Despite these merits, the minimum reserve system is a dangerous tool in the hands of the monetary authority. It can print any number of notes, thereby creating inflationary pressure within the economy. A corrupt and inefficient government can bring disaster to the economy by excessive printing of notes and thus lose confidence of the people. On the other hand, an efficient and honest administration can transform the economy by a judicious use of this system.