MONETARY SYSTEM

Dr Sowmya S
MODULE: 1
CONTENTS
 MEANING OF MONEY
 DEFINITION OF MONEY
 FUNCTIONS OF MONEY
 ROLE OF MONEY
 VALUE OF MONEY
 THEORIES OF VALUE OF MONEY
INTRODUCTION
 Money is considered as one of the greatest
inventions of man.
 Money in modern economies has almost
replaced barter and is the “standard
measuring rod”.
 “ Money is a little like an airplane-marvelous
when it works, frustrating when it is
immobilized and tragic when it crashes”.
-C Lowell Harris
INTRODUCTION
 Money is not an end in itself. It is a means to
an end.
 It cannot satisfy human wants directly, it is
only a ‘yellow barbarian metal’(standard
money) or a ‘bit of paper’.
 But it definitely acts as an effective tool or
medium of exchange.
DEFINITION OF MONEY
1. “In order for anything to be called as money, it
must be accepted fairly widely as an instrument of
exchange”.
-A C Pigou
2. “money is anything that is habitually and widely
used as means of payment and is generally
acceptable in the settlement of debts”
-G D H Cole
DEFINITION OF MONEY
3. “Money constitutes all those things which
are at any time and place, generally current
without doubt or special enquiry as a means
of purchasing commodities and services and
of defraying expenses”
-Alfred Marshall
4. “ Money is what money does”.
-Walker
 “ the only essential requirement is general
acceptability. Money….. Need not itself be
valuable. It must, indeed, be relatively
scarce, since it would hardly do if money
could be plucked off every tree. But,
provided precautions are taken to keep it
relatively scarce and, it may be added,
comparatively invariable in amount-money
can consist of things as worthless as a scrap
of paper or the scratch of a clerk’s pen in
the books of a bank”.
-Crowther
 “money is anything that is generally
acceptable as a means of exchange and at
the same time acts as a measure and a store
of value”
- Crowther
MEANING:
 Money is something chosen by common
consent as a medium of exchange, widely
accepted in settlement of transactions
including future payments and received by
all without any special tests of quality or
quantity.
BARTER SYSTEM
 The system of exchange without money is
called barter system.
 It is exchange of goods for goods.
 It was an unsatisfactory with following
difficulties.
1. Lack of double coincidence of wants.
2. Lack of a common measure of value.
3. Indivisibility of certain articles.
4. Lack of a store of value.
5. Lack of standard of deferred payment.
CLASSIFICATION OF MONEY
 Commodity money
 Metallic money
 Paper money
 Credit money
 Legal tender money
 Money proper and money of account
 Money and Near money
 Digital money.
COMMODITY MONEY
 Non- metallic commodity money
 Metallic money

 (Full bodied coins- those whose face value is

equal to the intrinsic value i.e, the value of
the metal contained in it and token coins-
those whose face value is greater than their
intrinsic value)
PAPER MONEY
 Representative money-backed by gold or
silver 100 percent.
 Convertible paper money- paper money that
can be converted into standard coins or
bullion.
 Inconvertible paper money- paper money
that cannot be converted into standard coins
or bullion.
FIAT OR CREDIT MONEY
 It is fiduciary money.
 Issued by government or central bank.
 Issued by commercial bank.
LEGAL TENDER MONEY AND
OPTIONAL MONEY
 Legal tender money- by law every individual is bound
to accept the legal tender money in exchange for
goods and services and in payment of debt.

 Legal tender money is of 2 types.

 Limited legal tender- these are coins accepted in

payment upto a limited extent.

 Unlimited legal tender- these are money accepted

upto any extent for payment of debt. All paper notes
are unlimited legal tender.
MONEY PROPER AND MONEY OF
ACCOUNT
 Money proper- actual medium of exchange
that circulates in an economy or the actual
money in which contracts or debts are settled
like the Indian Rupee, American Dollar.

 Money of accounts- money in which debts,

price contracts and general purchasing power
is expressed . It is the form of money in which
accounts are maintained for instance in
Germany after the 1st world war money of
account was the American dollar, whereas the
money proper was the German mark.
MONEY AND NEAR MONEY
 Money-readily acceptable means of payment
for example currency notes, coins and
demand drafts.
 Near Money- assets which are highly liquid
but not perfectly liquid. They act as money
for example treasury bills, bonds, savings
certificates, bills of exchange. The bill of
exchange is in the fact the most liquid of all
assets and the best example of near money.
All these assets are close substitutes for
money and thus called ‘money substitutes’ or
near money.
ROLE OF MONEY

 Money facilitates and motivates all

economic activity relating to consumption,
production, exchange and distribution.
 Money plays major role in capitalist and
mixed economy, plays less role in socialist
economy.
 Source of income(public revenue) to the
government.
 Facilitates trade and commerce both
national and international.
FUNCTIONS OF MONEY

 Walker said “ money is what money does”

emphasizing the functions money performs.
 “money is a matter of four functions
 A medium,
 A measure,
 A standard,
 A store.
PRIMARY FUNCTIONS
1. Money as Medium of Exchange.
2. Money as a Standard Measure of Value.
SECONDARY FUNCTIONS
3. Money as a Standard of Deferred Payments
4. Money as a Store of Value
CONTINGENT FUNCTIONS
 Helps the distribution of national income.
 Basis of bank credit.
 Imparts liquidity and uniformity to wealth.
 Equalizes marginal utility.
STATIC AND DYNAMIC
FUNCTIONS
 Paul Einzig classifies the functions of money as
‘static and dynamic’.
 He puts the primary and secondary functions into
the category of static functions.
 He points out the dynamic functions of money are
those by which money influences the working of
the economy by influencing price level, level of
consumption, volume of production, and
distribution of wealth in the economy.
 The dynamic functions thus determine the
economic trends: inflation, deflation, booms, and
depressions.
STATIC AND DYNAMIC
FUNCTIONS
 All these phenomena are caused by changes
in money supply wherein price change thus
affecting level of production, income and
unemployment.
 It helps to determine the monetary policy to
the government
ESSENTIALS OR CHARACTERISTICS
OF GOOD MONEY
 General acceptability.
 Cognizability
 Durability
 Portability
 Storability
 Stable and limited in supply.
 Divisibility.
 Homogenuity.
 Economical
CIRCULAR FLOW OF MONEY
 The circular flow model demonstrates how
money moves through society.
 Money flows from producers to workers as
wages and flows back to producers as
payment for products.
 In short, an economy is an endless circular
flow of money.
CIRCULAR FLOW OF MONEY
CIRCULAR FLOW OF MONEY
CIRCULAR FLOW OF MONEY
 The models can be made more complex to
include additions to the money supply, like
exports, and leakages from the money
supply, like imports.
 When all of these factors are totaled, the
result is a nation's gross domestic product
(GDP) or the national income.
 Analyzing the circular flow model and its
current impact on GDP can help governments
and central banks adjust monetary and fiscal
policy to improve an economy.
 Sectors of a Circular Flow Model
 There are different types of circular flow
models, each with a different number of
sectors it tracks.
 Each sector within a circular flow model may
be designated with a capital letter often
used to describe how to calculate GDP.
 Household Sector
 In a two-sector model, circular flow models
start with the household sector that engages
in consumption spending (C). Households
contribute to an economy by working (giving
away time and labor) and by buying products
(giving away money). In return, households
consume products and utilize government
programs.
 Business Sector
 In a two-sector model, circular flow models
also include the business sector that
produces the goods. Businesses absorb a
variety of production costs including labor,
materials, and overhead. As a result, many
companies are able to manufacture products
that benefit other parties.
 Government Sector
 In a three-sector model, government sector
cash flows are included. The government
injects money into the circle through
government spending (G) on programs such
as Social Security and the National Park
Service. It also extracts money from
households and businesses by way of taxes.
 Foreign Sector
 In a four-sector model, money also flows into
the circle through exports (X), which bring in
cash from international buyers from the
foreign sector. By extension, this indicates
that the two-sector or three-sector models
are domestic activity only. The foreign sector
is different from the domestic sector as
there may be administrative inefficiencies
that result in lost cash flow due to import
taxes, duties, or fees.
 Financial Sector
 In a five-sector model, cash flow from the
financial sector is added. This includes
banks and other institutes that provide cash
flow via lending services. Some circular flow
models also outline investor activity, as
cashflow from entrepreneurs and investors
may represent an inflow to businesses while
net profits from the company represent an
outflow.
DEMAND FOR AND SUPPLY OF
MONEY
 The theories of money depends on demand
and supply of money.
 Demand for money was that money was
demanded for completing the business
transactions.
 The demand for money depended on the
volume of trade or transactions.
 Transactions motive
 Precautionary motive
 Speculative motive
TRANSACTIONS MOTIVE
a) Income motive: from the point of
consumers who want income to meet the
household expenditure.
b) Business motive: from the point of view of
the businessmen, who require money and
want to hold it in order to carry on their
business.
PRECAUTIONARY MOTIVE

 Precautionary motive for holding money

refers to the desire of the people to hold
cash balances for unforeseen contingencies
SPECULATIVE MOTIVE

 Speculative motive relates to the desire to

hold one’s resources in liquid form in order
to take advantage of market movements
regarding the future changes in the rate of
interest(or bond prices)
SUPPLY OF MONEY
 The supply of money like the demand for
money conforms to the ‘stock’ concept and
not the ‘flow’ concept.
 The supply of money means the supply of
money to hold.
 Money must always be held by someone,
otherwise it cannot exist.
 Hence, the supply of money means the sum
total of all the forms of money which are
held by a community at any given moment.
THEORIES OF VALUE OF MONEY
 Increase in the supply of money can cause an
increase in prices assuming that the supply of
goods remains the same. It includes:

 Determination of the value of money.(factors

governing price fluctuations).

 Measurement of changes in the value of

money(or prices)
THE VALUE OF MONEY-
MEANING
 It is the quantity of goods and services in
general that will be exchanged for a unit of
money.
 It is the purchasing power.
 it has inverse relationship with price level
changes.
 When price level falls, value of money rises
and when price level rises, the value for
money falls.
DETERMINATION OF VALUE OF MONEY-
THE QUANTITATIVE THEORY OF MONEY
 The concept of the quantity theory of money
(QTM) began in the 16th century.
 As gold and silver inflows from the Americas
into Europe were being minted into coins,
there was a resulting rise in inflation.
 This development led economist Henry
Thornton in 1802 to assume that more money
equals more inflation and that an increase in
money supply does not necessarily mean an
increase in economic output.
 The quantity theory of money states that
there is a direct relationship between the
quantity of money in an economy and the
level of prices of goods and services sold.
 According to QTM, if the amount of money
in an economy doubles, price levels also
double, causing inflation (the percentage
rate at which the level of prices is rising in
an economy).
 The consumer, therefore, pays twice as much
for the same amount of the good or service.
 Another way to understand this theory is to
recognize that money is like any other
commodity: increases in its supply decrease
marginal value (the buying capacity of one
unit of currency).
 So an increase in money supply causes prices
to rise (inflation) as they compensate for the
decrease in money's marginal value.
 The original theory was considered orthodox
among 17th century classical economists and
was overhauled by 20th-century economists
Irving Fisher, who formulated the above
equation, and Milton Friedman
 It is built on the principle of "equation of
exchange":
Total Spending=M×VC
where:
M=amount of money
VC=velocity of circulation
​Thus, if an economy has US$3, and those $3
were spent five times in a month, total
spending for the month would be $15.
THE THEORY'S CALCULATIONS

 The theory, also known as the Fisher Equation,

is most simply expressed as:

 MV=PT

where:
M=Money Supply
V=Velocity of Circulation
P=Average Price Level
T=Volume of Transactions of Goods and Services
QTM ASSUMPTIONS

 the theory assumes that V (velocity of

circulation) and T (volume of transactions)
are constant in the short term.
 These assumptions, however, have been
criticized, particularly the assumption that V
is constant. The arguments point out that the
velocity of circulation depends on consumer
and business spending impulses, which
cannot be constant.
QTM ASSUMPTIONS

 The theory also assumes that the quantity of

money, which is determined by outside
forces, is the main influence of economic
activity in a society.
 A change in money supply results in changes
in price levels and/or a change in supply of
goods and services. It is primarily these
changes in money stock that cause a change
in spending. And the velocity of circulation
depends not on the amount of money
available or on the current price level but on
changes in price levels.
QTM ASSUMPTIONS

 Finally, the number of transactions (T) is

determined by labor, capital, natural
resources (i.e. the factors of production),
knowledge and organization. The theory
assumes an economy in equilibrium and at
full employment.
 Essentially, the theory's assumptions imply
that
 the value of money is determined by the
amount of money available in an economy.
 An increase in money supply results in a
decrease in the value of money because an
increase in money supply causes a rise in
inflation. As inflation rises, the purchasing
power, or the value of money, decreases. It
therefore will cost more to buy the same
quantity of goods or services.
 As QTM says that quantity of money
determines the value of money, it forms the
cornerstone of monetarism.
What is Monetarism?
 Monetarism is a school of economic thought that became

influential in the 1970s. Milton Friedman, the Nobel prize-

winning economist, was the biggest proponent of the
principles of monetarism during that period.
 A key tenant of Monetarist economic thought is that the

money supply is the chief driver of a nation’s economic

activity.
 Hence, governments and central banks could stabilize the

economy by prioritizing monetary policy over fiscal policy.

 In their view, a steady increase in money supply with a

predictable velocity could increase the demand for goods

and services in the market.
 Moreover, if there were an increase in demand for goods

or services, it would result in higher employment and

better wages.
 However, a predictable velocity may not be constantly
achievable in many economic conditions.
KEYNES THEORY OF MONEY
 It is also called as income theory of money.
 It is proposed by modern theorists, the
keynesians.
 They do not deny that changes in money
supply can bring about changes in the price-
level.
 However, what they deny is that there is a
simple, direct and easily predictable relation
between the quantity of money and the level
of prices.
What is Keynesianism?
 British economist John Maynard Keynes developed the Keynesian

economic theory in response to the great depression that ravaged the

domestic economy prior to World War ll.
 Keynes advocated greater government expenditure and lower taxes in
the face of economic distress to stimulate the demand-side of the
domestic economy.
 In other words, Keynesians are open advocates of government holding the

responsibility to stabilize the economy through fiscal measures, unlike

the monetarists who advocated for the reduced role of government.
 They argue that an economy in trouble would continue on its downward

trajectory unless the government actively took an interest in promoting

consumer demand.
 Moreover, when in recession, people tend to panic and reduce their

spending to save money.

 Keynesians believe that this can create a paradoxical deterioration of
economic output.
 This is why the government needs to improve aggregate demand through

timely intervention.
 In other words, increased demand would make it necessary for suppliers
to produce more which possibly lead to more job opportunities and
generates profits for reinvestment.
 Keynes in his “general theory of employment,
interest and Money’ has deviated from conventional
thinking and put forward the following equation.
 Y=C+S
 E=C+I
 Y=E
 C+S=C+I
 Hence S=I
 Where
 Y=Total Income
 E= Total Expenditure
 C=Consumption
 I=Investment
 S= Savings
ASSUMPTIONS:
 Savings and investment in any economy are
equal.
 It is the equilibrium state in above case.
 When savings is not equal to investment,
then it is the state of disequilibrium.
 When savings are more than investment, the
price level falls or the value of money rises.
 If investment exceeds savings the price level
goes up or the value of money falls.