BANKING PRACTICE

UNIT 2
WHAT IS MONEY?
Money is really anything that people use to pay for goods and services and to pay people for
their work. Historically, money has taken different forms in different cultures—everything from
salt, stones, and beads to gold, silver, and copper coins and, more recently, virtual currency has
been used. Regardless of the form it takes, money needs to be widely accepted by both buyers
and sellers in order to be useful.
THE FOUR DIFFERENT TYPES OF MONEY
Money can be described as a generally accepted medium of exchange for goods and services.
Virtually anything can be considered money, as long as it performs the three major functions of
money (i.e. medium of exchange, store of value, unit of account). With this in mind, it is not
surprising that there were different types of money throughout history. To give you a brief
overview, we are going to take a look at the four most relevant ones below: commodity money,
fiat money, fiduciary money, and commercial bank money.
Commodity Money
Commodity money is the simplest and most likely also the oldest type of money. It builds
on scarce natural resources that act as a medium of exchange, store of value, and unit of account.
Commodity money is closely related to (and originates from) a barter system, where goods and
services are directly exchanged for other goods and services. Commodity money facilitates
this process, because it acts as a generally accepted medium of exchange. The important thing to
note about commodity money is that its value is defined by the intrinsic value of the commodity
itself. In other words, the commodity itself becomes the money. Examples of commodity
money include gold coins, beads, shells, spices, etc.
Fiat Money
Fiat money gets its value from a government order (i.e. fiat). That means, the government
declares fiat money to be legal tender, which requires all people and firms within the country to
accept it as a means of payment. If they fail to do so, they may be fined or even put in
prison. Unlike commodity money, fiat money is not backed by any physical commodity. By
definition, its intrinsic value is significantly lower than its face value. Hence, the value of fiat
money is derived from the relationship between supply and demand. In fact, most modern
economies are based on a fiat money system. Examples of fiat money include coins and bills.
Fiduciary Money
Fiduciary money depends for its value on the confidence that it will be generally accepted as a
medium of exchange. Unlike fiat money, it is not declared legal tender by the government,
which means people are not required by law to accept it as a means of payment. Instead,
the issuer of fiduciary money promises to exchange it back for a commodity or fiat money if
requested by the bearer. As long as people are confident that this promise will not be broken,
they can use fiduciary money just like regular fiat or commodity money. Examples of fiduciary
money include cheques, bank notes, or drafts.
Commercial Bank Money
Commercial bank money can be described as claims against financial institutions that can be
used to purchase goods or services. It represents the portion of a currency that is made of debt
generated by commercial banks. More specifically, commercial bank money is created through
what we call fractional reserve banking. Fractional reserve banking describes a process where
commercial banks give out loans worth more than the value of the actual currency they hold. At
this point just note that in essence, commercial bank money is debt generated by commercial
banks that can be exchanged for “real” money or to buy goods and services.
In a Nutshell- conclusion
The four most relevant types of money are commodity money, fiat money, fiduciary money, and
commercial bank money. Commodity money relies on intrinsically valuable commodities that
act as a medium of exchange. Fiat money on the other hand gets its value from a government
order. Meanwhile fiduciary money depends for its value on the confidence that it will be
generally accepted as a medium of exchange. And commercial bank money can be described
as claims against financial institutions that can be used to purchase goods or services.

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FUNCTIONS OF MONEY
Money is often defined in terms of the three functions or servicesthat it provides. Money serves
as a medium of exchange, as a store of value, and as a unit of account.

Medium of exchange.Money's most important function is as a medium of exchange to facilitate

transactions. Without money, all transactions would have to be conducted by barter, which
involves direct exchange of one good or service for another. The difficulty with a barter
system is that in order to obtain a particular good or service from a supplier, one has to possess a
good or service of equal value, which the supplier also desires. In other words, in a barter
system, exchange can take place only if there is a double coincidence of wants between two
transacting parties. The likelihood of a double coincidence of wants, however, is small and
makes the exchange of goods and services rather difficult. Money effectively eliminates the
double coincidence of wants problem by serving as a medium of exchange that is accepted in all
transactions, by all parties, regardless of whether they desire each others' goods and services.

Store of value. In order to be a medium of exchange, money must hold its value over time; that
is, it must be a store of value. If money could not be stored for some period of time and still
remain valuable in exchange, it would not solve the double coincidence of wants problem and
therefore would not be adopted as a medium of exchange. As a store of value, money is not
unique; many other stores of value exist, such as land, works of art, and even baseball cards and
stamps. Money may not even be the best store of value because it depreciates with inflation.
However, money is more liquid than most other stores of value because as a medium of
exchange, it is readily accepted everywhere. Furthermore, money is an easily transported store of
value that is available in a number of convenient denominations.

Unit of account. Money also functions as a unit of account, providing a common measure of the
value of goods and services being exchanged. Knowing the value or price of a good, in terms of
money, enables both the supplier and the purchaser of the good to make decisions about how
much of the good to supply and how much of the good to purchase.
KEY CHARACTERISTICS OF MONEY
 Durability i.e. it needs to last
 Portable i.e. easy to carry around, convenient, easy to use
  Divisible i.e. it can be broken down into smaller denominations
 Hard to counterfeit - i.e. it can’t easily be faked or copied
 Must be generally accepted by a population
 Valuable – generally holds value over time

DEMAND AND SUPPLY OF MONEY

Demand of Money
The demand for money refers to the total amount of wealth held by the household and
companies. The demand for money is affected by several factors such as income levels, interest
rates, price levels (inflation), and uncertainty.
The impact of these factors on the demand for money is explained in terms of the three primary
reasons to hold money. The three reasons are:
Transactions: This is the money needed for fulfilling transactions. As the total number and size
of transactions increases in an economy, the transaction demand for money also increases.
Precautionary: This is the money needed for uncertain future needs, for example, unexpected
medical expenses. The precautionary demand for money increases as the size of economy
increases.
Speculative: People also hold money for speculative purposes so that they can take advantage of
investment opportunities in the future. If the current returns on financial products are high,
people will rather invest than hold money with a speculative motive. We can say that the demand
for money for speculative motive increases with the increase in perceived risk in other financial
instruments.
There is an inverse relationship between the short-term interest rates and the demand for money
that households and firms want to hold. If the interest rates are low, the demand for money is
high and if the interest rates are high, the demand for money is low. This is because as interest
rates increase, the opportunity cost of holding money increases, and people will be better off by
investing in other financial instruments than holding money.

Supply of Money
The supply of money in an economy is controlled by its central bank, for example, Fed in the
US. The Fed may change the money supply by using open market operations or by changing
reserve requirements.

Demand and Supply Curve

The demand and supply curve for money can be represented as follows:

As you can see, the money supply curve is completely inelastic. The money demand curve is
downward sloping, i.e., the demand for holding money increases with decrease in interest rates.
The short-term interest rate (i) is determined by the equilibrium of the supply and demand for
money. If the interest rates are above the equilibrium, there is excess supply of money. This
means the households and firms are holding more money and they will purchase securities to
lower their money balances. This will lead to an increase in security prices and a drop in interest
rates. Similarly, if interest rates are lower than the equilibrium rate, there is excess demand for
money and people desire to hold money than they actually have. To do so, firms and households
will sell securities, which will decrease the security prices and increase the interest rates.
The central bank can change the money supply, which will influence the interest rates. An
increase in money supply will create excess supply, which will put a downward pressure on
interest rates.

MONETARY STANDARD
The term “monetary standard” refers to the monetary system of a country. Prof. Halm defines
monetary standard as the “principal method of regulating the quantity and the exchange value of
standard money.” When the standard money of a country is chosen in the form of some metal,
then the country is said to have metallic standard. There are three main types of monetary
standards. They are:
1. Monometallism or Single Standard
2. Bimetallism or Double Standard
3. Paper Currency Standard (Managed Currency Standard)

Monometallism or Single Standard

When only on metal is adopted as the standard money and is made legal tender for all payments,
the system is known as monometallism or single standard. For example, now many countries
have the Gold Standard. Suppose a country has adopted silver as the standard money, then it is
said to have Silver Standard. For example, England was on Silver Standard until 1816.

Bimetallism or Double Standard

If two metals are adopted as standard money and if a legal ratio is established between the value
of the two metals, then the system known as bimetallism or double standard. In other words,
under this system, gold and silver circulated as legal tender money and there was a legally fixed
ratio of exchange between them. Usually, two metals used under bimetallism are gold and silver.
Bimetallism was adopted in France in 1803. Later on, it was adopted by other countries like
Belgium, Switzerland and Holland. Bimetallism has certain advantages and disadvantages.
Advantages
1. It would secure greater stability of prices. It there is monometallism, the supply of only
one metal could not satisfy the monetary demand satisfactorily. The increasing demand for
money should be accompanied by an increase in the supply of money. Otherwise, there
cannot be a stable price level. Therefore, if there is bimetallism, the supply of two metals
put together will be steadier than that of any one of them. Just as two drunkards might walk
more steadily when they walk hand in hand, the supply of two metals under bimetallism
will make price level more stable.
 2. Bimetallism would promote stable exchange rates between countries using gold and
countries using silver.
3. The supply of gold would not be sufficient for the currency requirements if all countries
adopted gold standard, that is, if they adopted universal monometallism.
4. Bimetallism will keep world prices stable.
Disadvantages
1. There is a great difficulty in maintaining the mint ratio (legal ratio) between the two
metals because market ratio will often fluctuate.
2. Gresham’s law that bad money drives out good money will operate.
3. Bimetallism cannot work if only one country adopted it. All countries in the world should
adopt it.
4. It may result in a lot of confusion, particularly, if there are differences between the legal
ratio and market ratio of the two metals. So bimetallism may not remedy the defects of gold
standard; it may increase the difficulties.

Paper Currency Standard (Managed Currency Standard)

Under the system, as the name indicates, the currency of the country will be in paper. Paper
money consists of bank notes and government notes. Generally, under the system, the currency
system will be managed by the Central Bank of the country. Hence, the system sometimes is
referred to as managed paper currency standard. Almost all countries in the world have managed
currency standard. The paper currency has certain advantages and disadvantages.
Advantages and Disadvantages of Paper Money
Paper money is economical. Its cost of production is negligible. It is convenient to handle and it
is easily portable. It is homogeneous. Its supply can be made elastic. And its value can be kept
stable by proper management. Paper currency can function very effectively as money, provided,
there is proper control of it by the managing authority. It is ideal for internal trade. But for
international trade and payments, gold is still found necessary.
However, paper money has two great disadvantages. There is the danger of over-issue of paper
money by the managing authorities. Over-issue of currency will result in a rise in prices, adverse
foreign exchange rates and many other evils. The over-issue of paper money has ruined many
countries in the past. Another disadvantage of paper money is that it will not have universal
acceptance. It is recognized as money only in the country where it is issued. For others, paper
money is just bits of paper. Gold, on the other hand, has universal acceptance.
THE CLASSICAL GOLD STANDARD
The Gold Standard was a system under which nearly all countries fixed the value of their
currencies in terms of a specified amount of gold, or linked their currency to that of a country
which did so. Domestic currencies were freely convertible into gold at the fixed price and there
was no restriction on the import or export of gold. Gold coins circulated as domestic currency
alongside coins of other metals and notes, with the composition varying by country. As each
currency was fixed in terms of gold, exchange rates between participating currencies were also
fixed.
Central banks had two overriding monetary policy functions under the classical Gold Standard:
1. Maintaining convertibility of fiat currency into gold at the fixed price and defending the
exchange rate.
2. Speeding up the adjustment process to a balance of payments imbalance, although this
was often violated.
The classical Gold Standard existed from the 1870s to the outbreak of the First World War in
1914. In the first part of the 19th century, once the turbulence caused by the Napoleonic Wars
had subsided, money consisted of either specie (gold, silver or copper coins) or of specie-backed
bank issue notes. However, originally only the UK and some of its colonies were on a Gold
Standard, joined by Portugal in 1854. Other countries were usually on a silver or, in some cases,
a bimetallic standard.
In 1871, the newly unified Germany, benefiting from reparations paid by France following the
Franco-Prussian war of 1870, took steps which essentially put it on a Gold Standard. The impact
of Germany’s decision, coupled with the then economic and political dominance of the UK and
the attraction of accessing London’s financial markets, was sufficient to encourage other
countries to turn to gold. However, this transition to a pure Gold Standard, in some opinions, was
more based on changes in the relative supply of silver and gold. Regardless, by 1900 all
countries apart from China, and some Central American countries, were on a Gold Standard.
This lasted until it was disrupted by the First World War. Periodic attempts to return to a pure
classical Gold Standard were made during the inter-war period, but none survived past the 1930s
Great Depression.
How the Gold Standard worked
Under the Gold Standard, a country’s money supply was linked to gold. The necessity of being
able to convert fiat money into gold on demand strictly limited the amount of fiat money in
circulation to a multiple of the central banks’ gold reserves. Most countries had legal minimum
ratios of gold to notes/currency issued or other similar limits. International balance of payments
differences were settled in gold. Countries with a balance of payments surplus would receive
gold inflows, while countries in deficit would experience an outflow of gold.
In theory, international settlement in gold meant that the international monetary system based on
the Gold Standard was self-correcting. Namely, a country running a balance of payments deficit
would experience an outflow of gold, a reduction in money supply, a decline in the domestic
price level, a rise in competitiveness and, therefore, a correction in the balance of payments
deficit. The reverse would be true for countries with a balance of payments surplus. This was the
so called ‘price-specie flow mechanism’ set out by 18th century philosopher and economist
David Hume.
This was the underlying principle of how the Gold Standard operated, although in practice it was
more complex. The adjustment process could be accelerated by central bank operations. The
main tool was the discount rate (the rate at which the central bank would lend money to
commercial banks or financial institutions) which would in turn influence market interest rates.
A rise in interest rates would speed up the adjustment process through two channels. First, it
would make borrowing more expensive, reducing investment spending and domestic demand,
which in turn would put downward pressure on domestic prices, enhancing competitiveness and
stimulating exports. Second, higher interest rates would attract money from abroad, improving
the capital account of the balance of payments. A fall in interest rates would have the opposite
effect. The central bank could also directly affect the amount of money in circulation by buying
or selling domestic assets though this required deep financial markets and so was only done to a
significant extent in the UK and, latterly, in Germany.
The use of such methods meant that any correction of an economic imbalance would be
accelerated and normally it would not be necessary to wait for the point at which substantial
quantities of gold needed to be transported from one country to another.
The ‘rules of the game’
The ‘rules of the game’ is a phrase attributed to Keynes (who in fact first used it in the 1920s).
While the ‘rules’ were not explicitly set out, governments and central banks were implicitly
expected to behave in a certain manner during the period of the classical Gold Standard. In
addition to setting and maintaining a fixed gold price, freely exchanging gold with other
domestic money and permitting free gold imports and exports, central banks were also expected
to take steps to facilitate and accelerate the operation of the standard, as described above. It was
accepted that the Gold Standard could be temporarily suspended in times of crisis, such as war,
but it also was expected that it would be restored again at the same parity as soon as possible
afterwards.
In practice, a number of researchers have subsequently shown that central banks did not always
follow the ‘rules of the game’ and that gold flows were sometimes ‘sterilised’ by offsetting their
impact on domestic money supply by buying or selling domestic assets. Central banks could also
affect gold flows by influencing the ‘gold points’. The gold points were the difference between
the price at which gold could be purchased from a local mint or central bank and the cost of
exporting it. They largely reflected the costs of financing, insuring and transporting the gold
overseas. If the cost of exporting gold was lower than the exchange rate (i.e. the price that gold
could be sold abroad) then it was profitable to export gold and vice versa.
A central bank could manipulate the gold points, using so-called ‘gold devices’ in order to
increase or decrease the profitability of exporting gold and therefore the flow of gold. For
example, a bank wishing to slow an outflow of gold could raise the cost of financing for gold
exporters, increase the price at which it sold gold, refuse to sell gold completely or change the
location where the gold could be picked up in order to increase transportation costs.