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 Meaning

Money is a anything which is widely accepted in payments

for goods, or in discharge of other kind of business

The term medium of exchange is used to describe money’s

ability to settle debts and to increase the purchasing
power of individuals. Money derives its power and value
from being the legal tender that is accepted as a universal
method of payment within the boundaries of each country
or an economic bloc.
• Functions of Money

Measurement &
Distribution of
National Income
Functions of Money

I – Primary Functions

•Measure of value : Money use as a tool to measure the value of

goods and services. Any commodity can be measured in monetary

•Medium of exchange: Medium of exchange is simply refers,

using of money for buying and selling.
Functions of Money

II – Secondary Functions
Store of value: In this function people hold money for aiming
future. Since, money has high liquidity people like to store value in
terms of money.

Standard of deferred payments: Here the current credit

transactions are measured in money with a future value. This
function of money may not true in economic instability conditions like
inflation, deflation etc.

Money as a Transfer of Value: It keeps on transferring values

from person to person and place to place. A person who holds money
in cash or assets can transfer that to any other person.
Functions of Money
III – Contingent Functions
• Money as the Most Liquid of all Liquid Assets

• Basis of the Credit System: Money is at the back of all credit. A

commercial bank cannot create credit without having sufficient
money in reserve. The credit instruments drawn by businessmen
have always cash guarantee supported by their bankers.

• Equalizer of Marginal Utilities and Productivities: Since

prices of goods indicate their marginal utilities and are expressed
in money, money helps in equalizing the marginal utilities of
various goods.

• Measurement of National Income

• Distribution of National Income: Rewards of factors of

production in the form of wages, rent, interest and profit are
determined and paid in terms of money.
Functions of Money

IV- Other Functions:

• Helpful in making decisions: Money is a means of store of

value and the consumer meets his daily requirements on the
basis of money held by him.

• Money as a Basis of Adjustment: To carry on trade in a

proper manner, the adjustment between money market and
capital market is done through money. Similarly, adjustments in
foreign exchange are also made through money. Further,
international payments of various types are also adjusted and
made through money.
(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. 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: Metals like gold, silver, copper, etc. were
used as they could be easily handled and their quantity can be
easily ascertained. It is divided into two parts:

a) Standard Money or Full Bodied Money: In this kind of

money, face value of the money is not greater than the value of
the stuff, which it is composed. Here the coins were generally
made of precious metal like gold and silver.

b) Token Money: The face value of the token coin is higher

than their metallic worth. Eg: One Rupee coin is the example of
Token money.
(iii) Paper Money: Paper money is regulated and controlled by
Central bank of the country (RBI in India). It is divided into two

a) Representative Paper Money: It has negligible or no

intrinsic value. But it is accepted as money since it represents
money. It is of two kinds:

• Convertible Paper Money: It refers to currency notes which

are freely convertible into full bodied money (i.e it can be
converted to gold or silver coins). But now such notes are not
in circulation because RBI has given up the concept of such

• Inconvertible Paper Money: It cannot be converted to full

bodied money, still circulates and commands value as their
issues is regulated by the responsible government. It is not
backed up by standard coins of gold and silver.

b) Fiat Money: It is that inconvertible paper money , which

circulates in the country under extraordinary conditions on the
command of the State.

(iv) Credit Money or Bank Money: 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. It includes
Demand drafts and credit instruments too.

(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.

On the basis of development the money has been categorized

into following forms:

A) On the Basis of Accountability: Keynes has divided into

following types:

 Money of Account: Money of account is the monetary unit in

terms of which the accounts of country are kept and
transactions settled, i.e., in which general purchasing power,
debts and prices are expressed. The rupee is a money of
account as our account is maintained in Rupee.

 Actual Money: Money that actually circulates in the economy is

called as Actual or Proper Money. It acts as a medium of
exchange of goods and services in the country.

B) On the Basis of Legality: It is divided into two parts:

 Legal Tender Money: Money which can be legally used to

make payment of debts or other obligations is termed as legal
tender money. Legal tender money is of two kinds:

 Limited Legal Tender: It refers to that form of legal tender

money, which can be paid in discharge of a debt up to a certain
limit. In India, coins are limited legal tender. Eg: 5,10,20,25
paisa coins

 Unlimited Legal Tender: It refers to that form of legal tender

money, which can be paid in discharge of a debt of any amount.
In India, paper notes are unlimited legal tender. Eg: all the
currency notes and Rs 2,5,10 coins

 Non-Legal Tender Money or Optional Money: It refers to

that form of money, which is generally accepted, but legally,
one is not bound to accept it. For example, cheques, bank
drafts, bills of exchange, etc.

C) On the Basis of Liquidity: It is divided into two parts:

 Money Proper: Money which has the quality of general

acceptability which makes it the most liquid asset. By liquidity,
we mean the speed and certainty with which an asset can be
converted back into money. Coins, currency notes and bank
money are the most liquid form of money.

 Near Money: It includes those financial assets, which are not

as liquid as coins and currency notes, but can be easily
converted into money for paying debts. For example, National
saving deposits, fixed deposit receipts, bonds, etc.
I) CLASSICAL APPROACH: The classical theory of demand for money is
presented in the classical quantity theory of money and has two
approaches: Fisherman approach and Cambridge approach.

A) Fisherian Approach: Money is demanded by the people

not for its own sake, but as a medium of exchange.

Thus, the demand for money is essentially to spend or for carrying on

transactions and thus is determined by the total quantity of goods and
services to be transacted during a given period.

Further, the demand for money also depends upon velocity of circulation of

Fisher's equation (Equation of Exchange)

M is the total quantity of money
V is its velocity of circulation
P is the price level
T is the total amount of goods and services exchanged for money.


A) Fisherian Approach: MV represents the supply of money

which is given and in equilibrium equals the demand for money. Thus the
equation becomes

Md = PT
(Md) = The demand for money
(P)= Price level
(T) = volume of transactions over a period of time

But it does not explain fully why people hold money. It does not clarify
whether to include as money such items as time deposits or savings
deposits that are not immediately available to pay debts without first
being converted into currency.


B) Cambridge Approach :
Fisher's transactions approach emphasized the medium of
exchange function of money, the Cambridge cash-balance
approach is based on the store of value function of

According to the Cambridge economists, the demand for

money comes from those who want to hold it for various
motives and not from those who want to exchange it for goods
and services.

Thus, in the Cambridge approach, the demand for money

implies demand for cash balances.

B) Cambridge Approach :
The Cambridge economists considered a number of factors
which tend to influence the demand for holding money. They
are as follows:
 People tend to hold money for transactions motive.

 Money is also demanded for precautionary motive since

money holding provides a degree of security against future

 For Cambridge School, the opportunity cost of holding

money consists of rate of interest, the yield on real
capital and the expected rate of inflation.

 Other factors influencing money demand according to the

Cambridge School are habits of the individual, the system of
payments in the community, the availability of money
substitutes, the density of population, etc.

B) Cambridge Approach :
The portion of cash is commonly represented as K, a
portion of nominal income the product of the price level and
real income (PY)

Md = KPY
The value of K has been assumed to be stable in the sense
that the determinants of K don't change significantly in the
long run.

The purpose of this simplification of the demand for money

function by the Cambridge economists was to show that K in
the Cambridge equation was just the reciprocal of V in Fisher's
equation (i.e., K = 1/V).

B) Cambridge Approach :

In the end, the classical theory of demand for money may be

summarized as under:

1. Money is only a medium of exchange.

2. The ratio of desired money balances to nominal income is assumed to be

constant at its minimum, or, in other words, velocity of money is constant
at its maximum (because K = 1/V).

3. The public holds a constant fraction of its nominal income in non-interest-

earning cash balances for transactions and precautionary motives.

4. Hoarding, i.e., holding money above the minimum desired for transaction
purposes, is considered irrational because money in itself has no value.

5. Quantity of money demanded is directly related to the price level.

II) Keynesian Approach of demand for money
Asset Demand for Money
The Keynesian Approach: Liquidity Preference
Keynes in his General Theory used a new term “liquidity
preference” for the demand for money. Keynes suggested three
motives which led to the demand for money in an economy:

(1) Transactions Motive: The transactions demand for money arises

from the medium of exchange function of money in making regular
payments for goods and services. The factors affecting the transaction
motives are as follows:
a) Level of Income: As the level of income rises, the sizes of cash balances for
transaction will also increases and vice-versa.
Lt = KY
Lt = Amount of money demanded for Transaction motive
K= Proportion of income which is kept for transactions purposes,
Y =Level of National income.
II) Keynesian Approach of demand for money

b) Pattern of Income Receipts & Payments: The greater the

synchronization between the timing of receipts and expenditures, the
smaller will be the average money balance one must hold for this

c) Use of Credit: If there is a credit economy then people will require

less money for settling their final transaction. But if there is only cash
transaction then individual and businessman should hold the higher
amount of money.

(2) Precautionary Motive: The Precautionary motive relates to “the

desire to provide for contingencies requiring sudden expenditures and
for unforeseen opportunities of advantageous purchases.”

Keynes holds that the transaction and precautionary motives are

relatively interest inelastic, but are highly income elastic.
(3) Speculative Motive/ Asset Demand for Money: The speculative (or
asset or liquidity preference) demand for money is for securing
profit from knowing better than the market what the future will
bring forth”.
Here, the motive of holding the money is depended upon the Level
of Income and Rate of Interest.

The higher the interests rate the lower the amount of asset
demand for money. The total amount of money balances that
people wish to hold for all purposes is called Money Demand and
price level is assumed to be constant in Keynesian model.

Liquidity Trap:
According to Keynes, If the current rate of interest is very low,
people will believe that it is the minimum rate of interest and they
would all hold assets in money rather than bonds. Nobody would
buy bonds at this rate in order to avoid capital loss. Therefore, the
demand curve for money may be perfectly elastic at a certain low
interest rate. The perfectly elastic portion of the demand
curve for money is called the liquidity trap.
Liquidity Trap:
II) Keynesian Approach of demand for money

The Total Demand for Money

According to Keynes, money held for transactions and precautionary purposes

is primarily a function of the level of income, LT=f (Y), and the speculative
demand for money is a function of the rate of interest, Ls = f (r). Thus the
total demand for money is a function of both income and the interest rate:
LD(r)= LT + LS = f (Y) + f (r)
L = f (Y) + f (r)
L=f (Y, r)
LD(r)= represents the total demand for money.
LT = It include demand for money for Transaction & Precautionary
Motive. It is inelastic which don’t change as per the rate of
LS = It include demand for money for Speculative Motive. It is elastic
which change as per the rate of interest.
II) Keynesian Approach of demand for money

Keynes theory of interest has been criticized on the following grounds:

1. It has been pointed out that the rate of interest is not purely a monetary
phenomenon. Real forces like productivity of capital and saving by the
people also play an important role in the determination of the rate of

2. Liquidity preference is not the only factor governing the rate of interest.

3. The liquidity preference theory does not explain the existence of different
rates of interest prevailing in the market at the same time.

5. The Keynesian theory only explains interest in the short-run. It gives no

clue to the rates of interest in the long run.
III) Modern Monetarist Milton Friedman Theory
In his analysis of determinants of money demand, Friedman included not
only level of income and rate of interest on bonds but also rates at return
on other assets such as equity shares, durable goods including real

Thus, Friedman’s theory demand for money can be written as follows:

Md = F(P, Y, rB, rE, rD)
P = price level
Y = level of real income
rB = rate of interest on bonds
rE = rate of return on equity shares
rD = rate of return on durable goods

Any rise in the rates of return on these alternative assets, it will

cause k to fall showing the increased desirability of alternative
non-monetary assets. “In these terms Friedman can be seen to have
restated the quantity theory, providing a systematic explanation of k, an
explanation that takes account of the Keynesian analysis of money’s role as
an asset.”
III) Modern Monetarist Milton Friedman Theory
In terms of Friedman money demand function, the condition for
equilibrium in the money market can be stated as under:

M = Md = k (rB, rE, rD) PY

Where M stands for the supply of money which is determined by the central
bank policies,
k is the proportion of nominal income
(PY) that is held in the form of money
rates of return (rB, rE, rD) on alternative non-monetary assets such as bond,
equity shares, durable goods respectively.

Thus Friedman concludes that quantity of money is an important determinant of

the level of economic activity, that is, output, employment and prices. Here the
short-run and long-run effects of increase in money supply must be

In the short run, the increase in money supply will lead to a change
partly in real income (i.e., real aggregate output or Y) and partly in the
price level (P).

But, in the long run, the increase in money supply will be reflected in
the rise in price level.

Money Supply refers to total volume of money hold by public at a

particular point of time in an economy.

Features of Money Supply:

1. It includes ‘money held by public only’.

2. It is a ‘Stock Concept’, i.e. it is concerned with a particular point of

Measures of Money Supply

From April 1968, the RBI also started publishing another measure of the
money supply which it called Aggregate Monetary Resources (AMR). But
since April 1977, the RBI has been publishing data on four
alternative measures of money supply (M1, M2, M3 and M4) have
been evolved.

Determinants of Money Supply
1. The Required Reserve Ratio: Under this two important ratio
are considered. They are:

 CRR - Cash Reserve Ratio - Banks in India are required to

hold a certain proportion of their deposits in the form of cash.
However Banks don't hold these as cash with themselves, they
deposit such cash with Reserve Bank of India. This
minimum ratio is stipulated by the RBI and is known as the CRR
or Cash Reserve Ratio. Current ratio: 4 %

 Statutory liquidity ratio (SLR) is the Indian government term

for reserve requirement that the commercial banks in India
require to maintain in the form of gold, government
approved securities before providing credit to the customers.
Higher the ratio lesser the money supply and vice-versa.
Current ratio: 21.5%
Determinants of Money Supply
2. Open market operations refer to the purchase and sale of
government securities and other types of assets like bills,
securities, bonds, etc., both government and private in the open
market. When the central bank buys or sells securities in the open
market, the level of bank reserves expands or contracts.

3. Bank Rate / Discount rate policy: It is the rate charged by

the central bank for lending funds to commercial banks.

Bank rates influence lending rates of commercial banks. Higher

bank rate will translate to higher lending rates by the banks. In
order to control the money supply in the market RBI increase the
bank rate which result in increasing the Lending rates of
Commercial banks which lead to contraction in credit and vice-
Determinants of Money Supply
4. Public’s Desire to Hold Currency and Deposits:
People’s desire to hold currency (or cash) relative to deposits in
commercial banks also determines the money supply. If people are
in the habit of keeping less in cash and more in deposits with the
commercial banks, the money supply will be large and vice-versa.

5. High Powered Money: High-powered money (H) refers to the

money produced by the monetary authority of a country.
In India, high-powered money is produced by the Reserve Bank of
India and the Government of India. High-powered money
(i) currency with the public (C)
(ii) cash reserves of banks (R)
(iii) other deposit's with the Reserve Bank of India (OD).

H = C + R + OD.
Determinants of Money Supply
6. Money Multiplier:
Money multiplier (m) has positive influence upon the money
supply. An increase in the size of m will increase the money supply
and vice versa.

7. Other Factors:
It is also get affected by:
Interest rates.
Income of the Citizen.
Changes in business activity.
The Quantity Theory of Money
Fisher’s Equation of Exchange
This theory explain the causes that determine the exchange value
of or general level of prices.

Fisher defines that “the total volume of money in a country is equal

to the total value of all goods and services.

There are two important factors of the theory:

1. Supply of Money (MV):

M= The supply of Money is taken over a period of time

V= The Velocity / speed of circulation (the number of times unit of

currency is used in a given period of time to buy the goods or
services or changes in hands among spender during a given period
of time.
Fisher’s Equation of Exchange
2. Demand for Money (PT): It depends upon the volume of goods
and services bought. Here, there are two factors:
P= The average price of goods and services.
T= Total Output or Volume of Transaction.

MV = PT

The above equation is showing the relationship between the volume

of money and volume of goods transacted. So, it is also known as
Cash Transaction Version of Quantity Theory.
Fisher’s Equation of Exchange
Price Level in the market can be find out by following formula:

P= MV /T
Due to the criticism, Fisher extended the original equation of
exchange and incorporate the equation with volume of bank
deposits or bank money (M’) and it’s velocity of circulation
So, now equation is

MV + M’V’= PT
P= MV + M’V’/T

So, if the quantity of money in circulation is increases the price

level also increases in direct proportion and vive-versa.
Assumptions of the Theory

 The price level (P) is passive or inactive factor. It get affected

by the value of money (MT).
 Theory assume V & T remain constant and are independent
of the changes in ‘M’.
 Fisher assumes short period of time.
 The assumption of full employment is inherent in the sense
that the volume of goods and services (T) are constant.

 The ratio of credit money (M’) is assumed to be constant.

 There is no Hoarding of Money.
Criticisms of the Theory

 Unrealistic Assumptions
 Price Level may be Active factor.
 Process of Price Level change is not explained properly.
 Theory has limited application.
 Fisher’s ignored Non- Monetary Factors like: economic
 Hoarded Money is not included.
 Time lag between the money supply and affect on price
 P & T are no explained properly. (P=Wholesale price or
retail price and T= Transaction include consumer goods and
capital goods)