Definition of money

Money is anything that is generally accepted in payments of goods or services or in the repayment
of debts.

Functions of Money
Money serves three major primary functions:-
a. Medium of exchange
b. Unit of Account
c. Store of value (wealth)
Secondary function of money:-
d. Standard of deferred payment

PRIMARY FUNCTIONS OF MONEY

A. Medium of Exchange
In a decentralized economy with many different kinds of goods, money serves the purpose of
allowing transactions to occur without requiring the “double coincidence of wants.”
In almost all market transactions in our economy, money in the form of currency or checks is a
medium of exchange. It is used to pay for goods and services.
The use of money as a medium of exchange promotes economic efficiency by minimizing the
time spent in exchanging goods and services.

The time spent trying to exchange goods or services is called transaction cost. In a barter
economy, transaction costs are high because people have to satisfy a “double coincident of
wants”: they have to find someone who has a good or service they want and who also wants a
good or service they have to offer.

Attributes for a commodity used as a medium of exchange:-

a. General acceptability: an economic agent accepts money only if he is convinced the next
person will also accept the same. Some units e.g. U.S dollars are more acceptable than
others.
b. Recognizability: economic agents should be able to distinguish various units of money.
c. Portability: must be lighter than the commodities it exchanges for.
d. Durability: should last longer since minting of money is also expensive.
e. Homogeneity: units of money with similar value should have same characteristics
f. Divisibility: can be broken into smaller units
g. Convertibility: among different currencies
h. Generally scarce: money should reasonably scarce to contain inflation levels

Forms of money that have satisfied these criteria have taken many unusual forms throughout
human history, ranging from wampum (small polished strings of beads made from shells and
threaded on string) to tobacco and cigarettes used in prisoner-of-war camps during World War II.

B. Unit of Account
The second role of money is to provide, unit of account, that is, it is used to measure value in the
economy. We measure the value of goods and services in terms of money, just as we measure
weight in terms of kilograms.
Using money as a unit of account reduces transaction costs in an economy by reducing the number
of prices that need to be considered. The benefits of this function of money grow as the economy
becomes more complex

C. Store of Value
Money also functions as a store of value: it is a repository of purchasing power over time. A store
of value is used to save purchasing power from the time income is received until the time it is spent.
This function of money is useful, because most of us do not want to spend our income immediately
upon receiving it, but rather prefer to wait until we have the time or the desire to shop.

Money is not unique as a store of value: any asset-whether money, stocks, bonds, land, houses,
art, or jewelry can be used to store wealth. Many such assets have advantages over money as store
of value. They often pay the owner a higher interest rate than money, experience price
appreciation, and deliver services such as providing a roof over one’s head. If these assets are a
more desirable store of value than money, why do people hold money at all?

How good a store of value money is depends on the price level, because its value is fixed in terms
of the price level. A doubling of all prices, for example, means that the value of money has dropped
by half, conversely, a halving of all prices means that the value of money has doubled. During
inflation, when the price level is increasing rapidly, money looses value rapidly, and people will
be more reluctant to hold their wealth in this form. This is especially true during periods of extreme
inflation, know as hyperinflation. In which the inflation rate exceeds 50% per month.

SECONDARY FUNCTION
D. Standard of Deferred payment
Borrow today and repay later or buy today and pay later has been an old practice. One necessary
condition of deferred payment has been that the value returned must be the same. During the
barter days, it might be a difficult problem to judge whether the value returned after a lapse of
time was the same.

With the expansion of economic activities, the volume of borrowing and lending and lending and
sale and purchase on credit expanded enormously. Personal borrowing and lending expanded to
professional activity by a class of people including moneylenders to modern banking systems and
growth of credit market, involving payment of interest and principal at a later date. The deferred
payment system expanded to purchase of raw materials, payment of wages, salaries and pensions,
payment by wholesalers to producers and by retailers to wholesalers and consumers to retailers. In
the absence of money, the economic system would have either not grown to today’s level or
would have been extremely chaotic.

The advent of money has solved the problem of deferred payment by its unique merits as:
a. It is generally acceptable.
b. It is legally enforceable and
c. It has a relatively more stable value than other commodities.

BARTER SYSTEM:
When money was not invented then barter system was prevailing. Barter system may be defined
as the exchange of goods for goods. In the barter system, certain difficulties were faced by the
individuals to make transactions. These difficulties were faced by the individuals to make
transactions. These difficulties were the following:-
1. Lack of Double Coincidence of wants:
Under barter system, the double coincidence of wants must be fulfilled for making transactions. If
there is a farmer who has wheat and wants cloth in exchange of wheat then he should find out a
person who has cloth and is willing to get wheat against cloth. If the first person succeeds to find
out a person who has cloth but he wants sugar against cloth then double coincidence of wants will
not be fulfilled. It was difficult to make transactions under barter system due to lack of double
coincidence of wants.
2. Lack of Measure of Value.
If two persons were willing to get each other’s goods then second difficulty was to decide how
much quantity of one commodity must be exchanged for a specific quantity of other commodity.
For example, it was difficult to decide how much quantity of wheat must be exchanged for a
specific quantity of cloth. In this case, one person could be in loss due to greater necessity of other
person’s product.
3. Lack of Store of Value:
Under barter system, it was not possible to store the value of perishable goods like milk, vegetable,
fruit, fish etc. for a long period.
4. Indivisibility of Commodities:
It was not possible to divide commodities into smaller quantity. For example, if a person wanted
cloth equal to half value of a sheep then he could not divide sheep into two parts.
5. Lack of Standard of Deferred Payments.
Under barter system, the borrowing and lending was made in terms of goods. It was difficult to
decide whether the same value was returned latter or not.
In view of the difficulties of the barter system, different commodities were used as money in
different periods. The commodities which were used as money from time to time are the
following:-
1. Hides and skins, stones, arrows, agricultural commodities like wheat, rice etc.
2. Different metals like silver, copper, gold etc.
3. Paper.

The Evolution of money

1. From barter economy to commodity economy
2. From commodity economy to metallic economy
3. From metallic economy to coinage economy
4. From coinage economy to paper money
5. From paper money to credit money.

EVOLUTION OF MONEY
We can obtain a better picture of the functions of money and the forms it has taken over time by
looking at the evolution of the payment systems, the method of conducting transactions in the
economy. The payment system has been evolving over centuries and with it the form of money.
At one point, precious metals such as gold were used as the principle means of payment and were
the main form of money. Later, paper assets such as checks, and currency began to be used in the
payments systems and viewed as money. Where the payment system is heading has an important
bearing on how money will be defined in the future.

Commodity Money
To obtain perspective on where the payment systems is heading, it is worth exploring how it has
evolved. For any object to function as money it must be universally acceptable, everyone must be
willing to take it in payment for goods and services. An object that clearly has value to everyone
is a likely candidate to serve as money, and natural choice is a precious metal such as gold and
silver. Money made up of precious metals or another valuable commodity is called commodity
money, and from ancient times until several hundred years ago, commodity money functioned as
the medium of exchange in all but the most primitive societies. The problem with a payment
systems based exclusively on precious metals is that such a form of money is very heavy and is hard
to transport from one place to another. Specifically, commodity money had the following
problems by today’s standard. It lacked (i) uniformity; (ii) homogeneity; (iii) standard size and
weight; (iv) durability and storability; (v) portability; (vi) stable value; and (vii) divisibility. Owing
to these problems, other forms of money were evolved over a long period of time, viz.., (a)
metallic coins, (b) paper currency and (c) demand deposit (operated through cheque system). These
forms of money perform the basic functions of money and constitute, according to the
conventional approach, the total supply of money.

The first two forms of money (metallic coins and paper currency) possess two distinctive features
against the third form of money (demand deposits). The metallic coins and paper currency are
created and issued by the government and are legal tenders in the sense that they enjoy a legal
status. As legal tenders, coins and paper currency are not only accepted as a medium of exchange
by all the citizens of a country but are also legally enforceable in the settlement of payment
obligation. These forms of money have perfect liquidity. Demand deposits, on the other hand are
the product of the banking system and making and accepting payments by cheques is optional, i.e.,
one has the option to make and accept payments through cheques.

Fiat Money
The next development in the payment system was paper currency (pieces of paper that function
as a medium of exchange). Initially, paper currency carried a guarantee that it was convertible into
coins or into a fixed quantity of precious metals. However, currency has evolved into fiat money,
paper currency decreed by governments as legal tender (meaning that legally it must be accepted
as payments for debts) but not convertible into coins or precious metals. Paper currency has the
advantage of being much lighter than coins and precious metals, but it can be accepted as a medium
of exchange only if there is some trust in the authorities who issue it and if printing has reached a
sufficiently advanced stage that counterfeiting is extremely difficult. Because paper currency has
evolved into a legal arrangement, countries can change the currency that they use at will. Indeed,
this is what many European countries did when they abandoned their currencies for the Euro in
2002.

Major drawbacks of paper currency and coins are that they are easily stolen and can be expensive
to transport in large amounts because of their bulk. To combat this problem, another step in the
evolution of the payments system occurred with the development of modern banking: the
invention of cheques

Cheques
A cheque is an instruction from you to your banker to transfer money from your account to
someone else’s account when she deposits the cheques. Cheques allow transactions to take place
without the need to carry around large amounts of currency. The introduction of cheques was a
major innovation that improved the efficiency of the payments systems. Frequently payments
made back and forth cancel each other, without checks, this would involve the movement of a lot
of currency. With cheques, payments that cancel each other can be settled by cancelling the
cheques, and no currency need no moved. The use of checks thus reduces the transportation costs
associated with the payment system and improves economic efficiency. Another advantage of
checks is that they can be written for any amount up to the balance in the account, making
transaction for large amounts such easier. Cheques are also advantageous in that loss from theft is
greatly reduced, and because they provide convenient receipts for purchases
There are, however, two problems with a payment systems based on cheques. First, it takes time
to get cheques from one place to another, a particularly serious problem if you are paying someone
in a different location who needs to be paid quickly. In addition, if you have a checking account,
you know it usually takes several business days before a bank will allow you to make use of the
funds from a cheque you have deposited. If your need for cash is urgent, this feature of paying by
check can be frustrating. Second, all the paper shuffling required to process checks is costly; it is
estimated that it currently costs over $10 billion per year to process all the cheque written in the
United States

Electronic Payments
The development of the inexpensive computers and the spread of the internet now make it cheap
to pay bills electronically. In the past, you had to pay your bills by mailing a check, but now banks
provide Web sites at which you just log on, make a few clicks, and thereby transmit your payment
electronically. Not only do you save the cost of the stamp, but paying bills become (almost) a
pleasure, requiring little effort. Electronic payment systems provided by banks now even spare you
the step of logging on to pay the bill. Instead, recurring bills can be automatically deducted from
your bank account. Estimated cost savings when a bill is paid electronically rather than by a check
exceed one dollar per transaction. Electronic payment is thus becoming far more common in the
Kenya.

E-Money
Electronic payments technology can substitute not only for checks, but also for cash, in the form of
electronic money (or e-money) - money that exists only in the electronic form. The first form of e-
money was the debit card. Debit cards, which look like the credit cards, enable consumers to
purchase goods and services by electronically transferring funds directly from their bank accounts
to a merchant account. Debits cards are used in many of the same places that accept credit cards
and are now often becoming faster to use than cash. At most supermarkets, for example, you can
swipe your debit card through the card reader at the checkout station, press a button, and the
amount of the purchases is deducted from your bank account. Most banks and companies such as
Visa and MasterCard issue debit cards, and your ATM card typically can function as a debit card.

A more advanced form of e-money is the stored –value card. The simplest form of stored-value
card is purchased for a preset dollar amount that the consumer pays up front, like a prepaid phone
card. The more sophisticated store-value card is known as a
Smart-card. It contains a computer chip that allows it to be loaded with digital cash from the
owner’s bank account whenever needed. In Asian countries, such as Japan and Korea, cell phones
now have a smart card feature that raises the expression, “pay by phone” to a new level. Smart
cards can be loaded from ATM machines, personal computers with a smart card reader, or
especially equipped telephones.

A third form of electronic money is often referred to as e-cash, which is used on the internet to
purchase goods and services. A consumer pays e-cash by setting up an account with the bank that
has links to the internet and then has the e-cash transferred to her PC. When she wants to buy
something with e-cash, she surfs to a store on the Web and clicks the “buy” option for a particular
item, whereupon the e-cash is automatically transferred from her computer to the merchant’s
computer. The merchant can then have the funds transferred from the consumer’s bank account to
his before the goods are shipped.
INFLATION
This is the general rise in price of goods and services in the economy

TYPES OF INFLATION
Various types of inflation are related to the rate of rise in prices of commodities. The types of
inflation are:-
1. Creeping Inflation
when prices rise at a rate of 2 to 3% per annum, it is called creeping inflation. This type of
inflation is not harmful. It is considered helpful to induce more investment.
2. Moderate Inflation
When prices rise from 4 to 5% per annum, it is considered as moderate inflation. This inflation
may be harmful in some cases.
3. Rapid Inflation.
In this case, prices rise at a rate of 6% or over per annum. This inflation is definitely harmful and
it must be controlled.
4. Hyper Inflation
The most serious type of inflation is known as runaway or galloping inflation” or hyper inflation.
This type of inflation has taken place in Germany, Austria, Hungary, China, Uganda and some
countries of South America. In this type of inflation, currency in circulation becomes unacceptable
and in the end, a new currency is to be issued.

CAUSES OF INFLATION
Inflation take place due to the following causes:-
1. Increase in Demand
A rapid increase in the demand for goods and services may result in a rise in price level. The
demand for commodities may increase due to increase in population or change in taste and
preference. If the population of any country is increasing rapidly and individuals have desire to
buy more and more luxuries and necessities for achieving higher level of satisfaction then this
increase in demand will result in rise in price level. The rise in price level as a result of an increase
in demand is called demand-pull inflation.
2. Increase in Cost of Production.
When cost of production rises, prices also go up. The cost of production may rise due to higher
wage levels, higher cost of raw material or more taxes on the production of commodities. In
recent years, the rapid rises in oil prices have resulted in the rise of cost of production. The rise in
price level due to the increase in cost of product is called “cost Push Inflation.
3. Lack of Supply
The shortage of goods also results in the rise in price level. This shortage may be due to decrease
in production. The agricultural production mainly depends upon climatic situation. If there is
unfavourable climatic situation then agricultural production will be smaller and in this case, price
level will go up.
4. Increase in Investment.
The Government is responsible for the development of the country. The amounts which are
invested by the Government on the development projects like dams, power hoses, irrigation
projects, do not increase national income in the short period. The money spent by the
Government on these projects comes into circulation. This greater supply of money also results in
the rise in price level.
5. Social Evils.
Social evils like hoarding, smuggling etc. create the artificial shortage and prices go up.
EFFECTS OF INFLATION
Inflation is harmful for the economic, social and political stability of any country. It results in
unfair distribution of income. During inflation, rich persons become more and more rich and
poor persons become more and more poor. It can be compared with robbery. Inflation also
stimulates social evils. It disturbs the proper working of any economy.
The presence of inflation can create confusion about the future. It affects the development
activities adversely. The people can loose their confidence in the purchasing power of their
currency and can encourage social evils.

ANTI-INFLATIONARY MEASURES
Anti-inflationary measures are those measures which are adopted to control or remove inflation.
These may be classified as under:-
A. Monetary Measures
B. Fiscal measures
C. Non-Monetary measures.

MONETARY MEASURES
Monetary measures are those measures which are adopted by the central bank of any country.
These are:-
1. Bank Rate Policy
During inflation, bank rate is raised and in view of this, commercial banks also raise their rate of
interest. Due to rise in rate of interest, borrowing is discouraged and supply of money in
circulation decreases.
2. Open Market Operation
During inflation, central bank sells the securities and the supply of money in circulation decreases.
3. Reserve Requirements.
During inflation, reserve requirement is increased by the central bank and due to that money at
the disposal of commercial banks decreases. It helps to control the supply of money in
circulation.
4. Rationing of Credit.
All commercial banks can get loans form the central bank up to a specific limit. During inflation,
this limit is decreased.
5. Margin Requirement
The difference between the value of security and loan advanced against that security is known as
the margin requirement. During inflation, margin requirement is raised.
6. Consumer’s Selective Credit Control
According to this method, central bank discourages the purchase of commodities on installment
basis to check the inflation.

FISCAL MEASURES
The Government of any country can adopt the following measures which are also of monetary
nature. These are known as fiscal measures.
1. Public Expenditure
During inflation, the Government reduces its expenditure. As a result, money supply in circulation
decreases and prices fall.
2. Taxation
The Government imposes more taxes on individual during inflation. Due to higher taxes,
purchasing power of individuals falls and prices start to fall.
3. Public Borrowing
The Government borrows money from individual and spends this mney on more productive
purposes. In this case , product of goods increases and prices tend to fall.
NON-MONETARY MEASURES.
These are:
1. Wage Adjustment
Wages must be raised at regular intervals to enable the individuals to maintain their purchasing
power at the same level.
2. Output Adjustment
Some steps must be taken by the Government to increase the production of goods, so that rise in
price level is checked up.
3. Price Control
Prices of some necessities are fixed by the Government and these cannot be raised without the
permission of the Government.
4. Rationing
According to this method, the purchase of specific commodities is controlled. The individuals can
purchase a specific quantity only during a specific period