Unit : 4

Nature and Functions of Money and Monetary

Standards

Prepared by : Dr. Taral Patel

 Meaning of Money
• A generally accepted medium for the exchange
of goods and services, for measuring value, or
for making payments.
• Many economists consider the amount of
money and growth in the amount of money in
an economy very significant in determining
interest rates, inflation, and the level of
economic activity.
 Functions of money 
Primary
Secondary Contingent Miscellaneous
Function

Bearer of Option
Medium of As a standard Distribution
exchange Deferred Payment National Income Guarantor of
Solvency

As a common Equalization of
As a store Value
Measure of Value Marginal utility

Basic Credit
System

Liquidity and
Uniformity of
wealth
 Concept of Money.

Money Supply Definition of Money Supply:

 It refers to the amount of money which is in
circulation in an economy at any given time.
 Money supply plays a crucial role in the
determination of price level and interest rates.
 Growth of money supply helps in acceleration
of Economic development and price stability.
 There must be a controlled expansion of
money supply i.e No inflation or Deflation in the
Economy.
• It is the total stock of money held by the people
( household, firms and institutions) It the total sum of
money available to the public in the economy at a
point of time
• It includes money held by the public and in circulation
but it does not include money held by Central Bank or
Commercial Bank as they are money creating agencies.
• The separation of producers of money from the users
of money is important from the viewpoint of both
Monetary theory and policy
 Constituents of Money Supply Money Supply
1. Traditional Approach (Narrow Money)
Coins, currency, Demand Deposits
2. Modern Approach (Broad Money) Money
Coins, Currency, Demand Deposits
3. Near Money.
 Modern Approach
 Coins Currency with the Public (High Powered
Money) Demand Deposits with Public (Secondary
Money)
 Time Deposits with banks Financial assets –
deposits non-banking financial intermediaries
 Bills – Treasury and Exchange bills Bonds and
equities Modern view extends the phenomenon
of money to the whole spectrum of liquidity in the
assets portfolio of individuals in modern economy.
 Traditional Approach (M1)
 It includes those items which can be spent immediately
or readily accepted as a medium of Exchange.
 Money that be spent directly, such as cash and current
accounts in banks.
 M1= C +D + OD C= Currency with the Public D =
Demand Deposits with the public in the commercial
and co-operative banks OD = Other deposits held by the
public with
 Time deposits are excluded from it as its not possible
to draw a cheque against them.
 M0,M1,M2 and M3
• Measurement M0 : Currency in circulation and in
bank vaults. Its called as the monetary base- the
base from which other forms of money are created.
• A measure of the money supply which combines any
liquid or cash assets held within a central bank and
the amount of physical currency circulating in the
economy M1 / Narrow Money M1= C +D + OD C=
Currency with the Public D = Demand Deposits with
the public in the commercial and co-operative banks
OD = Other deposits held by the public with RBI
• Measurement Money Supply M2 M2= M1 +
Saving deposit with the post office saving
banks The small saving deposits are not as
liquid as demand deposits but are more liquid
than the time deposits.
• M3 / Broad Money M3 = M1 + Time Deposits
with the banks Time deposits are nit as liquid
however loans from the banks can be
obtained against them and they can also be
withdrawn any time by forgoing interest
earned on them.
 M4
• Measurement Money Supply M4 M4 = M3 +
Total post office deposits (TPOD) TPOD =
Includes saving and time deposits of the public
with the post offices
 Difficulties in Barter
• This is called Lack of coincidence of wants.
• In Barter system goods were exchanged
through goods.
• In this process wants of both buyer and the
seller must coincidence. 
• Lack of coincidence of wants make the
difficulty of Barter system.
• In Barter system the value of every commodity can be
measured in terms of other commodity.  But it is not
possible to measure the commodity value with other
commodity.
• Deferred payments means future payments.
• Under Barter system future payment for present
transaction was not possible. The future exchange
involved some difficulties
• In order to overcome the discussed difficulties in
barter system, money was invented in economy.
• Some Goods are Perishable.
• They perish in a short period. So it was not
possible to store the goods in Barter system
for a long time
•  If we store in Barter system
• In Barter system we cannot divide all the
commodities into small units.
• It is also one of the problem of Barter system.
 Role and importance of Money in modern
economy.
• Money creation and money supply Money creation
and money destruction Money creation in a
monopolistic banking system
• Hundred percent reserve system – result gold standard
• Fractional reserve system under the: gold exchange
standard bank-money standard
• Transaction
• Precautionary
• Speculative  
 Danger Money
• Economics Instability
• Economic Inequality
• Moral Depravity
 Demand for money
• Demand for money arise because of its Demand for money
arise because of its liquidity. He has given three important
reasons for
• He has given three important reasons for holding cash balances
:holding cash balances :
• 1.1. Transaction demand for money.
Income motive
Business motive
• 2.2. Precautionary demand for money
Precautionary demand for money
• 3.3. Speculative demand for money
• TRANSACTION DEMAND FORTRANSACTION
DEMAND FOR MONEYMONEY People use their
money for day to day People use their money
for day to day transactions.
• The demand for money fort transactions. The
demand for money for transaction motive varies
in direct transaction motive varies in direct
proportion to change on money income.
• proportion to change on money income.
 Cont…
• INCOME MOTIVEINCOME MOTIVE The income motive is meant to
bridge theThe income motive is meant to bridge the interval
between the receipt of income interval between the receipt of
income and its disbursement.
• For this purpose and its disbursement. For this purpose money
kept by the people depends on money kept by the people depends
on the following purposes:
• the following purposes:
1.1. The size of income The size of income
2.2. The nature of transaction The nature of transaction
3.3. The time gap between receipts income The time gap between
receipts income and expenditure. and expenditure.
• BUISINESS MOTIVEBUISINESS MOTIVE It is meant to “bridge the
time of incurring It is meant to “bridge the time of incurring
business costs and that of the receipts of business costs and that of
the receipts of the sale proceeds.” this refers to the sale proceeds.”
• this refers to the transaction motive of business people.
transaction motive of business people.
• They keep cash balances to make They keep cash balances to make
payments to labor, inputs, suppliers….payments to labor, inputs,
suppliers…. This amount of money depends on the This amount of
money depends on the volume of transactions the true nature of
volume of transactions the true nature of business, etc..business,
etc..
• PRECAUTIONARY DEMAND FORPRECAUTIONARY
DEMAND FOR MONEYMONEY
• The precautionary demand relates to “the The
precautionary demand relates to “the desire to
provide for contingencies desire to provide for
contingencies requiring sudden expenditure and
for requiring sudden expenditure and for
unforeseen opportunities of advantage sun fore
seen opportunities of advantages purchase.
• SPECULATIVE DEMAND FORSPECULATIVE DEMAND FOR
MONEYMONEY Lord Keynes defined it as “the desire or
Lord Keynes defined it as “the desire or earning profit by
knowing better than the earning profit by knowing better
than the market, what the future will bring fort”. market,
what the future will bring fort”.
• People keep some money for this purpose People keep
some money for this purpose to take advantage of market
move mints to take advantage of market movements
regarding the future changes in the save regarding the
future changes in the save of interest or bond prices.
Paper currency standard system (Managed
currency standard)
• In the 20th century, both silver and gold lost their former importance within
monetary systems, and monometallic system was abandoned by all nations.
• It was set up in 1976 at the Conference in Kingston (Jamaica), when the gold
lost its role of monetary standard:
 Under this system, the currency of the country is made of paper.
• Generally, the currency system is managed by the CB of the country.
• Today, almost all countries in the world have managed currency standard
systems.
• The paper currency standard system is a fiat system:
 does not allow free convertibility of the currency into a metallic standard;
 money is given value by government fiat (is intrinsically useless)
• The value of the money is set by the supply and demand for money and by the
supply and demand for other goods and services in the country.
• The value of the money depends on its purchasing power.
Advantages of paper currency system
• 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.
• 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.
Disadvantages of paper currency system
• First important disadvantage:
 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.
• Second important disadvantage:
 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.
 Principle of Note Issue
• At present, all the countries of the world have
adopted paper standard.
• In fact this standard has proved a boon to the
modern monetary system. The central bank of
a country, which plays an important role in the
paper standard, is assigned the job of note
issue.
• (a) It should inspire public confidence, and, for
this, it must be based on sufficient reserves of
gold and silver.
• (b) It should be elastic in the sense that money
supply can be increased or decreased in
accordance with the needs of the country.
• (c) It should be automatic and secure.
• To ensure a good note issue system, two
principles of note issue have been advocated:
• (1) Currency principle and
• (2) Banking principle.
• Currency Principle:
• The currency principle is advocated by the ‘currency school’
comprising Robert Torrens, Lord Overstone, G. W. Norman and
William Ward. Currency principle is based on the assumption
that a sound system of note issue should command the greatest
public confidence. This requires that the note issue should be
backed by 100 per cent gold or silver reserves. Or in other
words, paper currency should be fully convertible into gold or
silver.
• Thus, according to the currency principle, the supply of paper
currency is subjected to the availability of metallic reserves and
varies directly with the variations in the metallic reserves.
• Banking Principle:
• The banking principle is advocated by the ‘banking school’, the
important members of which are Thomas Tooke, John Fullarton
James, Wilson and J.W. Gilbart. The banking principle is based on
the assumption that the common man is not much interested in
getting his currency notes converted into gold or silver.
• Therefore 100 per cent metallic reserves may not be necessary
against note issue. It is sufficient to keep only a certain
percentage of total paper currency in the form of gold or silver
reserves. The banking principle of note issue is derived from the
practice of the commercial banks to keep only a certain
proportion of cash reserves against their total deposits.
 Four system for Note issue
• 1. Maximum Fiduciary issue
• 2. fixed fiduciary issue
• 3. proportional reserve system
• 4. Minimum reserve system
 Gold standard
 It replaced the bimetallic standard in the late of 19 th century.
 It is a monetary system in which the basic unit of currency is defined as a fixed
weight of gold.
 The gold standard was an international standard:
 it allowed the determining of the value of a country’s currency in terms of
other countries’ currencies by comparing the content in gold of two currencies.
this represents the metal parity between the two currencies.
 Because exchange rates were fixed, the gold standard caused the price levels
around the world to move together.
 The types of gold standard were:
 Gold coin standard
 Gold bullion standard
 Gold exchange standard
 Gold coin standard
• Before World War I, the world economy operated under the gold coin standard,
meaning that the currency of most countries was convertible directly into gold.
• It was the classical form of gold standard.
• Gold was recognized as a means of settling domestic and international payments.
• There were no restrictions on the use of gold and it could be melted down or be sent to
a Mint for conversion to coins.
• Import and export of gold were freely allowed.
• It allowed the full convertibility of banknotes into gold on demand (at a fixed price) at
the issuing bank.
• The exchange rate between currencies was fixed by comparing their gold content.
• Tying currencies to gold resulted in an international financial system with fixed
exchange rates between currencies.
• The fixed exchange rates under the gold standard had the important advantage of
encouraging world trade by eliminating the uncertainty that occurs when exchange
rates fluctuate.
 Gold bullion standard
• It was adopted by some countries after the World War I, as increased expenditures
to fund the war effort exposed the weaknesses of the gold coin standard.
• Paper money was the main form of exchange and it could be however exchanged
for gold at any time:
 but the convertibility of banknotes into gold was limited as an equivalent
amount to one bullion of gold.
• As it was unlikely that there would be a great demand for converting banknotes to
gold at any given time:
 the banks could issue banknotes in excess of the value of the gold they were
holding.
• This monetary system could not last long as many major currencies were highly
over and under valued, leading to a distortion in the balance of payment position.
• England withdrew from the gold standard in 1931, USA in 1933, and Italy,
France, Belgium, Switzerland and Holland kept it until 1936.
 Gold exchange standard (II)
• It included the following rules:
 A reserve currency was chosen:
 All non-reserve countries agreed to fix their exchange rates to the
reserve currency at some announced rate (a fix parity).
 To maintain the fixity, these non-reserve countries would hold a
stock of reserve currency assets.
 The reserve currency country agreed to fix its currency value to a
weight in gold.
 The reserve country agreed to exchange gold for its own currency with
other CBs within the system, upon demand.
• One key difference between this system and the gold standard was that the
reserve country did not agree to exchange gold for currency with the
general public, only with other CBs.
• If the non-reserve countries accumulated the reserve currency, they could
demand exchange for gold from the reserve country’s CB.
• Thus, gold reserve flowed away from the reserve currency country.
PRINCIPLES GOVERNING GOLD STANDARD

a) There should be free movement of gold between

countries;
b) There should be automatic expansion or contraction of
currency and credit with the inflow and outflow of gold;
c) The governments in different countries should help
facilitate the gold movements by keeping their internal
price system flexible in their respective economies.
ADVANTAGES OF GOLD STANDARD
 It was an easy system to introduce and operate.
 It provided for a very high level of stability in
exchange rates which promoted both
international investments and trade.
 The Price Specie Adjustment Mechanism
provided an in-built system for achieving trade
equilibrium.
 It provided a fully secured system for settlement
of international transactions.
 DISADVANTAGES OF GOLD STANDARD
 The cost of manufacturing gold gradually increased to levels
beyond the official prices. This would result in stoppage of gold
production which had an adverse effect on international
liquidity.
 Countries with persistent trade deficit suffered from recessions
resulting in reduced investments and unemployment.
 The system had no flexibility to adjust money supply in times of
economic crisis such as natural disasters, war, recession etc. In
such situations the system had to be repeatedly discontinued.
 To avoid the negative effects of reduced money supply,
countries would break the equality between gold reserves and
money supply, thereby diluting the system.
 REASONS FOR FAILURE
 Violation of Rules of Gold Standard
 Restrictions on Free Trade
 Inelastic Internal Price System
 During the inter-war period, the monetary authorities
sought to maintain both exchange stability as well as
price stability.
 This was impossible because exchange stability is
generally accompanied by internal price fluctuations.
 Unbalanced Distribution of Gold
 External Indebtedness