Lecture notes on Basics of Money. By Tasew T & Yonas S.

3 Meaning of Money

Money as anything that is generally accepted in payment for goods or services or in

the repayment of debts. Currency, consisting of Birr, bills, and coins, clearly fits this
definition and is one type of money. When most people talk about money, they’re
talking about currency (paper money and coins). If, for example, someone comes up
to you and says, “Your money or your life,” you should quickly hand over all your
currency rather than ask, “What exactly do you mean by ‘money’?”

To define money merely as currency is much too narrow. Because checks are also
accepted as payment for purchases, checking account deposits are considered money
as well. An even broader definition of money is often needed, because other items
such as savings deposits can in effect function as money if they can be quickly and
easily converted into currency or checking account deposits. As you can see, there
is no single, precise definition of money or the money supply, even for economists.

To complicate matters further, the word money is frequently used synonymously

with wealth. When people say, “Joe is rich—he has an awful lot of money,” they
probably mean that Joe has not only a lot of currency and a high balance in his
checking account but has also stocks, bonds, four cars, three houses, and a yacht.
Thus while “currency” is too narrow a definition of money, this other popular usage
is much too broad. Economists make a distinction between money in the form of
currency, demand deposits, and other items that are used to make purchases and
wealth, the total collection of pieces of property that serve to store value. Wealth
includes not only money but also other assets such as bonds, common stock, art,
land, furniture, cars, and houses.

People also use the word money to describe what economists call income, as in the
sentence “Sheila would be a wonderful catch; she has a good job and earns a lot of
money.” Income is a flow of earnings per unit of time. Money, by contrast, is a stock:
It is a certain amount at a given point in time. If someone tells you that he has an
income of $1,000, you cannot tell whether he earned a lot or a little without knowing

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

whether this $1,000 is earned per year, per month, or even per day. But if some- one
tells you that she has $1,000 in her pocket, you know exactly how much this is.

Keep in mind that the money discussed in this book refers to anything that is
generally accepted in payment for goods and services or in the repayment of debts
and is distinct from income and wealth.

3.1 Functions of Money

3.1.1 Money as a unit of Value (Store of Value)

This function of money serves as a unit of measurement in terms of which the value
of all goods and services are measured and expressed. The existence of a common unit
of account is indispensable for the emergence of an ordinary pricing system, which is
essential both for rational economic calculations and choice by the individual and for
transmitting economic information between parties to exchange of goods and
services. By using money different goods and services values of which are not
otherwise comparable are made comparable.

The prices of different goods and services stated in terms of money enable the
individual to decide on what he should specialize in selling and in what proportion he
should buy and combine different goods and services as a buyer.

3.1.2 Money as a medium of Exchange

The introduction of money as a medium of exchange by decomposing the single

transaction of barter into two separate transactions of sales and purchase eliminate
the need for double coincidence of wants. Money will not be required as a means of
payment unless we want to sell at one time and place and buy at another

Each person accepts money as a means of payment because he is confident that others
will accept it in payment from him. A countries legal system also enforces the
acceptance of national currency in discharging of all payments. A social convention
giving general acceptability to money as a means of payment could also be established

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

if some important members of the group say business community unilaterally accepts
in payments a certain form of money of which cheques are good example

3.2 Classification (Structure) of Money

The actual money, which is the money of a country circulates and is current in the
market. It is used as a medium of exchange for goods and services of that country.
All the payments are made and general purchasing power is held with the actual
money. Paper notes issued by central banks and coins minted for monetary uses are
all under different denominations are examples of money.

However, debts, prices, contracts, and general purchasing power are expressed and
accounts are maintained in term of money. Money of account is the description or
tittle and actual money is the thing which the actual money might have changed.
Money is classified differently of which the important classification include the
following:

3.2.1 Commodity money and representative money

Actual money or money proper is further subdivided into commodity money which
also known as full-bodied money and representative money.

Commodity money is that money which is composed of non-metallic or metallic

commodities which possess intrinsic value in addition to their monetary or face value.

On the other hand bank notes which have monetary value, but do not store value
because they cannot be sold as commodity in the market. Such bank notes are known
as representative money.

3.2.2 Legal Tender Money and Option Money

Legal tender money is that money means of which any payment can be made and
the payees are legally bound to accept unconditionally while:

i. Executing exchange of various goods and services

ii. Setting debts resulting from previous contractual obligations

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

Optional money consists of vast amounts of monetary circulations, which while not
legal tender is generally accepted, in discharging of debt and all other payments.

The acceptability and refusal to accept optional money such as cheques, promissory
notes, bills of exchange etc has no baking legal obligation. Therefore the acceptance
of these instruments of payments of payment receive them on the account of
confidence and credibility of the parties which offer them.

3.3 Characteristics/Qualities of money

3.3.1 General acceptability

For anything to be money, it should be accepted by everybody as a means of

payment in exchange of goods and services rendered.

3.3.2 Durability

Anything to be a good money, it should be storable and last without losing its value
over a period of time.

3.3.3 Portability

The material used as money should be easily carried and transferred from one place
to another. It should contain large value with a small bulk.

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

3.3.4 Cognoscibility

The material with which money is made should be easily recognized by sight or touch.
It should be distinguishable or touch from other types of money. Coins and currency
notes of different denominations in different designs and sizes meet this quality of
good money.

3.3.5 Homogeneity

The material with which money is made should be of the same quality. All forms of
money should be same material, Weight, size, and coins. For instance, all coins of one
denomination must be of same metal, weight, shape and size. Similarly all paper
notes of one denomination must have the same quality of paper design and size.

3.3.6 Divisibility

The money material should be capable of being divided in to smaller parts without
losing value. This will facilitate transaction and exchange to the smallest unit. The
larger denomination can be divided in to smaller units is noted

3.3.7 Stability of value

Money serve as a store of value and as a common denominator of value, it should be

stable in its own value. If its value fluctuates its function as a store of value and
measures of value will be jeopardized. This can be done by proper control on the
issuance of paper money

3.4 Measures of Money

There is no universally accepted definition for money. This is mainly because

a. Money serves more than one purpose

b. The other assets though in different degrees also serves as money

The definition of money as anything that is generally accepted in payment for goods
and services tells us that money is defined by people’s behavior. What makes asset
money is that people belief that it will be accepted by others when making payment.

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

The difficulties in definition made economists prefer to define money by what it

constitutes than by what it is. To measure money, we need a precise definition that
tells us exactly what assets should be included. There are two ways of obtaining a
precise definition of money.

1. The theoretical approach

2. The empirical approach

The theoretical approach defines money by using economic theory to decide which
assets should be included in its measure. As we have seen, the key feature of money
is that it is used as a medium of exchange. Therefore, the theoretical approach focuses
on this aspect and suggests that only assets that clearly serve as a medium of
exchange belong in a measure of the money supply. Currency and checking account
deposits can be used to pay for goods and services and clearly function as a medium
of exchange. The theoretical approach suggests that a measure of the money supply
should include only these assets.

Unfortunately, the theoretical approach is not as clear – cut as we would like. Other
assets function like a medium of exchange but are not quite as liquid as currency and
checking account deposits.

The ambiguities inherent in the theoretical approach in determining which assets

should be included in a measure of money have led many economists to suggest that
money should be defined with a more empirical approach; that is, the decision about
what to call money should. Be based on which measure of money works best in
predicting movements of variables that money is supposed to explain.

Money is something which is very difficult to define since it belongs to the category
of things which are not amenable to any single definition. It is so partly because it
performs more than three functions in the economy. It is, therefore, easier to
understand what money consists of than to give any universally accepted definition
of money. Broadly there are four important approaches to the definition (or
measurement) of money.

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

1. Conventional approach

2. Chicago approach

3. Gurley and Shaw approach

4. Central bank approach

3.4.1 The Conventional Approach

This is the oldest approach. According to this the most important function of money
in society is to act as a medium of exchange. Money is what it uniquely does. Keynes
defined money as “that by delivery of which debt contracts and price contracts are
discharged and in the shape of which general purchasing power is held”. The types of
assets that satisfy these criteria are

a) Currency (c)

b) Demand deposits in commercial banks (DD)

Thus according to the conventional definition

M = C + DD, this is the narrow (M1) definition of money. It excludes time deposits in
the commercial banks because such deposits must first be converted in to either
currency or demand deposits before they can be spent.

Note that demand deposits are deposits payable on demand through cheque or
otherwise. It is important to note that among deposits it is only demand deposits
which serve as a medium of exchange,

This definition of money is superior to other definitions because:

a. it incorporates only perfectly liquid assets

b. The central bank has a better control over it since it is easily measureable.

3.4.2 The Chicago approach

The Chicago economists led by Professor Milton Friedman adopted a broader

definition of money by defining it more broadly as “a temporary abode of purchasing
power”. Their argument is that since in the economy money income and spending flow

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

streams are not perfectly synchronized in time in order to function as a medium of

exchange, money should be temporarily stored as a general purchasing power. This
could be in the form of currency, demand deposits or time deposits (including saving
deposits).

M2 = C + DD + SD + TD,

Where C – Currency, SD – Saving deposits

DD – Demand deposits (Checkable deposits :), TD – Time deposits

The Chicago economist advanced two reasons for including time and saving deposits
in the definition of money.

1. National income is more highly correlated with money that includes saving and
time deposits than money narrowly defined i.e. the change in money supply can better
explain the change in macroeconomic variables when defined broadly,

2. According to economic theory, perfect or near perfect substitutes of a commodity

should be included in the definition of a single commodity. According to Chicago
economist time deposits (deposits which are not payable on demand and on which
cheques can’t be drawn) are very close substitutes for currency and demand deposits,
and have good liquidity.

3.4.3 Gurley and Shaw approach

This approach is associated with the names of Professor John G. Gurley and Edwards

Shaw. According to these economists there exists a fairly large spectrum of financial
assets which are close substitutes for money. They emphasized the close substitution
relationship between currency, demand deposits, time deposits, saving deposits;
credit issued by credit institution, shares, and government bonds etc all of which are
regarded as alternative liquid stores of value by the public.

A rapid growth of deposits held by non – bank financial institutions (n.b.f.is) has
increased their practical importance as a source of credit.

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

M3= C + DD + SD + TD +…+ n.b.f.i deposits.

The definition includes all deposits of and the claims of all types of financial
intermediaries. It assigns weights to each asset in the definition of money to come up
with the total supply of money. That is assignment of weights according to the degree
of substitution (or degree of liquidity). For instance it gives a weight of one to currency
and demand deposits as they are perfect substitutes and zero to houses which are
imperfect substitute, weights such as 0.25, 0.5, 0.75, 0.8, etc would be assigned to
different assets according to the degree of substitution.

Theoretically this approach is superior to the Chicago which assigns equal weights to
all items in the definition of money ranging from currency to time deposits. However
practically it is difficult to implement it.

3.4.4 The central bank approach (Radcliff committee)

This approach, which has been favored by the central bank authorities, takes the
widest possible view of money. It defines money as

M = C + DD + SD + TD + non – clearing bank deposits + n.b.f.i deposits + credit lines.

Money is identified with the credit extended by various sources. The reason for
identifying money with credit used in the broadest possible sense of the term lies in
the central banks historic position that “total credit availability constitutes the key
variable for regulating the economy.

The problem with this definition is that it is difficult to measure it due to vast degree
of liquidity, and since some financial institution may operate beyond the knowledge
of central bank, it is too difficult to use it for policy purpose.

In general two pragmatic means could be used to define the money supply of a
particular country.

1. The definition utilized should depend on the particular problem (the problem at
hand) being studied.

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Lecture notes on Basics of Money. By Tasew T & Yonas S.

Example: if an analysis of the effect of the money supply on economic activity is being
undertaken, the appropriate definition of money supply is the one that provides the
best statistical results. If M1 is statistically predictable than M2, monetary policy
should be designed in terms of that narrow definition.

2. A method of identifying a break in the spectrum of assets to separate money. If the

substitutability b/n DD and TD is lower than that between TD and other liquid assets,
then the definition of money should be limited to currency and demand deposits.

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