1

Money
Money ls uny ob|ect or record, thut ls generully uccepted us puyment for
goods und servlces und repuyment of debts ln u glven country or soclo-
economlc context. The muln functlons of money ure dlstlngulshed us:
y u medlum of exchunge;
y u unlt of uccount;
y u store of vulue; und,
y occuslonully, u stundurd of deferred puyment.
Any klnd of ob|ect or secure verlfluble record thut fulfllls these functlons
cun serve us money.
Money orlglnuted us commodlty money, but neurly ull contemporury
money systems ure bused on flut money.
Flut money ls wlthout lntrlnslc use vulue us u physlcul commodlty, und
derlves lts vulue by belng declured by u government to be legul tender;
thut ls, lt must be uccepted us u form of puyment wlthln the boundurles of
the country, for "ull debts, publlc und prlvute".
The money supply of u country conslsts of currency (bunknotes und
colns) und bunk deposlts or 'bunk money' (the bulunce held ln checklng
uccounts und suvlngs uccounts). Bunk deposlts usuully form the lurger
purt of the money supply of u country.
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+lstory of Money
The use of burter-llke methods muy dute buck to ut leust 100,000 yeurs
ugo, though there ls no evldence of u soclety or economy thut relled
prlmurlly on burter. Insteud, non-monetury socletles operuted lurgely
ulong the prlnclples of glft economlcs. When burter dld occur, lt wus
usuully between elther complete strungers or potentlul enemles.
Muny cultures uround the world eventuully developed the use of
commodlty money. The shekel wus orlglnully u unlt of welght, und
referred to u speclflc welght of burley, whlch wus used us currency. The
flrst usuge of the term cume from Mesopotumlu clrcu 3000 BC. Socletles
ln the Amerlcus, Aslu, Afrlcu und Austrullu used shell money often, the
shells of the money cowry .Accordlng to +erodotus, the Lydluns were the
flrst people to lntroduce the use of gold und sllver colns. It ls thought by
modern scholurs thut these flrst stumped colns were mlnted uround 650
600 BC.
The system of commodlty money eventuully evolved lnto u system of
representutlve money. Thls occurred becuuse gold und sllver merchunts
or bunks would lssue recelpts to thelr deposltors redeemuble for the
commodlty money deposlted. Eventuully, these recelpts becume
generully uccepted us u meuns of puyment und were used us money.
Puper money or bunknotes were flrst used ln Chlnu durlng the Song
Dynusty. These bunknotes, known us "|luozl" evolved from promlssory
notes thut hud been used slnce the 7th century. +owever, they dld not
dlspluce commodlty money, und were used ulongslde colns. Bunknotes
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were flrst lssued ln Europe by Stockholms Bunco ln 1661, und were uguln
ulso used ulongslde colns. The gold stundurd, u monetury system where
the medlum of exchunge ure puper notes thut ure convertlble lnto pre-set,
flxed quuntltles of gold, repluced the use of gold colns us currency ln the
17th-19th centurles ln Europe. These gold stundurd notes were mude
legul tender, und redemptlon lnto gold colns wus dlscouruged. By the
beglnnlng of the 20th century ulmost ull countrles hud udopted the gold
stundurd, bucklng thelr legul tender notes wlth flxed umounts of gold.
After World Wur II, ut the Bretton Woods Conference, most countrles
udopted flut currencles thut were flxed to the US dollur. The US dollur
wus ln turn flxed to gold. In 1971 the US government suspended the
convertlblllty of the US dollur to gold. After thls muny countrles de-
pegged thelr currencles from the US dollur, und most of the world's
currencles becume unbucked by unythlng except the governments' flut of
legul tender und the ublllty to convert the money lnto goods vlu puyment.

Functlons
In the pust, money wus generully consldered to huve the followlng four
muln functlons:
It functlons us u medlum of exchunge,
u unlt of uccount,
u stundurd of deferred puyment, und u store of vulue.
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+owever, most modern textbooks now llst only three functlons, thut of
medlum of exchunge, unlt of uccount, und store of vulue, not conslderlng
u stundurd of deferred puyment us u dlstlngulshed functlon, but ruther
subsumlng lt ln the others.
There huve been muny hlstorlcul dlsputes regurdlng the comblnutlon of
money's functlons, some urgulng thut they need more sepurutlon und thut
u slngle unlt ls lnsufflclent to deul wlth them ull. One of these urguments
ls thut the role of money us u medlum of exchunge ls ln confllct wlth lts
role us u store of vulue: lts role us u store of vulue requlres holdlng lt
wlthout spendlng, whereus lts role us u medlum of exchunge requlres lt to
clrculute. Others urgue thut storlng of vulue ls |ust deferrul of the
exchunge, but does not dlmlnlsh the fuct thut money ls u medlum of
exchunge thut cun be trunsported both ucross spuce und tlme. The term
'flnunclul cupltul' ls u more generul und lncluslve term for ull llquld
lnstruments, whether or not they ure u unlformly recognlzed tender.
Medlum of exchunge
When money ls used to lntermedlute the exchunge of goods und servlces,
lt ls performlng u functlon us u medlum of exchunge. It thereby uvolds the
lnefflclencles of u burter system, such us the 'double colncldence of
wunts' problem.
Unlt of uccount
A unlt of uccount ls u stundurd numerlcul unlt of meusurement of the
murket vulue of goods, servlces, und other trunsuctlons. Also known us u
5

"meusure" or "stundurd" of relutlve worth und deferred puyment, u unlt of
uccount ls u necessury prerequlslte for the formulutlon of commerclul
ugreements thut lnvolve debt. To functlon us u 'unlt of uccount', whutever
ls belng used us money must be:
y Dlvlslble lnto smuller unlts wlthout loss of vulue; preclous metuls
cun be colned from burs, or melted down lnto burs uguln.
y Funglble: thut ls, one unlt or plece must be percelved us equlvulent
to uny other, whlch ls why dlumonds, works of urt or reul estute ure
not sultuble us money.
y A speclflc welght, or meusure, or slze to be verlflubly countuble. For
lnstunce, colns ure often mllled wlth u reeded edge, so thut uny
removul of muterlul from the coln (lowerlng lts commodlty vulue)
wlll be eusy to detect.
Store of vulue
To uct us u store of vulue, u money must be uble to be rellubly suved,
stored, und retrleved und be predlctubly usuble us u medlum of
exchunge when lt ls retrleved. The vulue of the money must ulso remuln
stuble over tlme. Some huve urgued thut lnflutlon, by reduclng the vulue
of money, dlmlnlshes the ublllty of the money to functlon us u store of
vulue.
[4]

Stundurd of deferred puyment
Whlle stundurd of deferred puyment ls dlstlngulshed by some texts,
purtlculurly older ones, other texts subsume thls under other functlons. A
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"stundurd of deferred puyment" ls un uccepted wuy to settle u debt u
unlt ln whlch debts ure denomlnuted, und the stutus of money us legul
tender, ln those |urlsdlctlons whlch huve thls concept, stutes thut lt muy
functlon for the dlschurge of debts. When debts ure denomlnuted ln
money, the reul vulue of debts muy chunge due to lnflutlon und deflutlon,
und for soverelgn und lnternutlonul debts vlu debusement und
devuluutlon.
Money supply
In economlcs, money ls u broud term thut refers to uny flnunclul
lnstrument thut cun fulflll the functlons of money (detulled ubove). These
flnunclul lnstruments together ure collectlvely referred to us the money
supply of un economy. In other words, the money supply ls the umount of
flnunclul lnstruments wlthln u speclflc economy uvulluble for purchuslng
goods or servlces. Slnce the money supply conslsts of vurlous flnunclul
lnstruments (usuully currency, demund deposlts und vurlous other types
of deposlts), the umount of money ln un economy ls meusured by uddlng
together these flnunclul lnstruments creutlng u monetury uggregute.
Modern monetury theory dlstlngulshes umong dlfferent wuys to meusure
the money supply, reflected ln dlfferent types of monetury uggregutes,
uslng u cutegorlzutlon system thut focuses on the llquldlty of the flnunclul
lnstrument used us money.
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Murket llquldlty
Murket llquldlty descrlbes how euslly un ltem cun be truded for unother
ltem, or lnto the common currency wlthln un economy. Money ls the most
llquld usset becuuse lt ls unlversully recognlsed und uccepted us the
common currency. In thls wuy, money glves consumers the freedom to
trude goods und servlces euslly wlthout huvlng to burter.
Llquld flnunclul lnstruments ure euslly truduble und huve low trunsuctlon
costs. There should be no (or mlnlmul) spreud between the prlces to buy
und sell the lnstrument belng used us money.
Types of money
Currently, most modern monetury systems ure bused on flut money.
+owever, for most of hlstory, ulmost ull money wus commodlty money,
such us gold und sllver colns. As economles developed, commodlty
money wus eventuully repluced by representutlve money, such us the
gold stundurd, us truders found the physlcul trunsportutlon of gold und
sllver burdensome. Flut currencles gruduully took over ln the lust hundred
yeurs, especlully slnce the breukup of the Bretton Woods system ln the
eurly 1870s.

Commodlty money

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Muny ltems huve been used us commodlty money such us nuturully
scurce preclous metuls, conch shells, burley, beuds etc., us well us muny
other thlngs thut ure thought of us huvlng vulue. Commodlty money vulue
comes from the commodlty out of whlch lt ls mude. The commodlty ltself
constltutes the money, und the money ls the commodlty. Exumples of
commodltles thut huve been used us medlums of exchunge lnclude gold,
sllver, copper, rlce, sult, peppercorns, lurge stones, decoruted belts,
shells, ulcohol, clgurettes, cunnubls, cundy, etc. These ltems were
sometlmes used ln u metrlc of percelved vulue ln con|unctlon to one
unother, ln vurlous commodlty vuluutlon or Prlce System economles. Use
of commodlty money ls slmllur to burter, but u commodlty money
provldes u slmple und uutomutlc unlt of uccount for the commodlty whlch
ls belng used us money. Although some gold colns such us the
Krugerrund ure consldered legul tender, there ls no record of thelr fuce
vulue on elther slde of the coln. The rutlonule for thls ls thut emphusls ls
luld on thelr dlrect llnk to the prevulllng vulue of thelr flne gold content.
Amerlcun Eugles ure lmprlnted wlth thelr gold content und legul tender
fuce vulue.
[


Representutlve money
In 1875 economlst Wllllum Stunley Jevons descrlbed whut he culled
"representutlve money," l.e., money thut conslsts of token colns, or other
physlcul tokens such us certlflcutes, thut cun be rellubly exchunged for u
flxed quuntlty of u commodlty such us gold or sllver. The vulue of
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representutlve money stunds ln dlrect und flxed relutlon to the commodlty
thut bucks lt, whlle not ltself belng composed of thut commodlty.
[22]

Flut money
Flut money or flut currency ls money whose vulue ls not derlved from uny
lntrlnslc vulue or guuruntee thut lt cun be converted lnto u vuluuble
commodlty (such us gold). Insteud, lt hus vulue only by government order
(flut). Usuully, the government declures the flut currency (typlcully notes
und colns from u centrul bunk, such us the Federul Reserve System ln the
U.S.) to be legul tender, muklng lt unluwful to not uccept the flut currency
us u meuns of repuyment for ull debts, publlc und prlvute.
[23][24]

Some bulllon colns such us the Austrullun Gold Nugget und Amerlcun
Eugle ure legul tender, however, they trude bused on the murket prlce of
the metul content us u commodlty, ruther thun thelr legul tender fuce
vulue (whlch ls usuully only u smull fructlon of thelr bulllon vulue).
[21][25]

Flut money, lf physlcully represented ln the form of currency (puper or
colns) cun be uccldentully dumuged or destroyed. +owever, flut money
hus un udvuntuge over representutlve or commodlty money, ln thut the
sume luws thut creuted the money cun ulso deflne rules for lts
replucement ln cuse of dumuge or destructlon. For exumple, the U.S.
government wlll repluce mutlluted Federul Reserve notes (U.S. flut
money) lf ut leust hulf of the physlcul note cun be reconstructed, or lf lt
cun be otherwlse proven to huve been destroyed.
[26]
By contrust,
commodlty money whlch hus been lost or destroyed cunnot be recovered.
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Commerclul bunk money
Demund deposlt ln cheque form.
Commerclul bunk money or demund deposlts ure clulms ugulnst flnunclul
lnstltutlons thut cun be used for the purchuse of goods und servlces. A
demund deposlt uccount ls un uccount from whlch funds cun be
wlthdruwn ut uny tlme by check or cush wlthdruwul wlthout glvlng the
bunk or flnunclul lnstltutlon uny prlor notlce. Bunks huve the legul
obllgutlon to return funds held ln demund deposlts lmmedlutely upon
demund (or 'ut cull'). Demund deposlt wlthdruwuls cun be performed ln
person, vlu checks or bunk drufts, uslng uutomutlc teller muchlnes
(ATMs), or through onllne bunklng.
[27]

Commerclul bunk money ls creuted through fructlonul-reserve bunklng,
the bunklng pructlce where bunks keep only u fructlon of thelr deposlts ln
reserve (us cush und other hlghly llquld ussets) und lend out the
remulnder, whlle mulntulnlng the slmultuneous obllgutlon to redeem ull
these deposlts upon demund.
[28][29]
Commerclul bunk money dlffers from
commodlty und flut money ln two wuys, flrstly lt ls non-physlcul, us lts
exlstence ls only reflected ln the uccount ledgers of bunks und other
flnunclul lnstltutlons, und secondly, there ls some element of rlsk thut the
clulm wlll not be fulfllled lf the flnunclul lnstltutlon becomes lnsolvent.
The process of fructlonul-reserve bunklng hus u cumulutlve effect of
money creutlon by commerclul bunks, us lt expunds money supply (cush
und demund deposlts) beyond whut lt would otherwlse be. Becuuse of the
prevulence of fructlonul reserve bunklng, the broud money supply of most
countrles ls u multlple lurger thun the umount of buse money creuted by
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the country's centrul bunk. Thut multlple (culled the money multlpller) ls
determlned by the reserve requlrement or other flnunclul rutlo
requlrements lmposed by flnunclul regulutors.
The money supply of u country ls usuully held to be the totul umount of
currency ln clrculutlon plus the totul umount of checklng und suvlngs
deposlts ln the commerclul bunks ln the country.
Monetury Aggregutes :
The most commonly used monetury uggregutes (or types of money) ure
conventlonully deslgnuted M0 ,M1, M2 und M3.
Reserve Money (M0): Currency ln clrculutlon + Bunkers deposlts wlth
the RBI + Other deposlts wlth the RBI = Net RBI credlt to the
Government + RBI credlt to the commerclul sector + RBIs clulms on
bunks + RBIs net forelgn ussets + Governments currency llubllltles to
the publlc RBIs net non-monetury llubllltles.
M1: Currency wlth the publlc + Deposlt money of the publlc (Demund
deposlts wlth the bunklng system + Other deposlts wlth the RBI).
M2: M1 + Suvlngs deposlts wlth Post offlce suvlngs bunks.
M3: M1+ Tlme deposlts wlth the bunklng system. = Net bunk credlt to
the Government + Bunk credlt to the commerclul sector + Net forelgn
exchunge ussets of the bunklng sector + Governments currency
llubllltles to the publlc Net non-monetury llubllltles of the bunklng
sector (Other thun Tlme Deposlts).
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M4: M3 + All deposlts wlth post offlce suvlngs bunks (excludlng
Nutlonul Suvlngs Certlflcutes).
MZM: Money wlth zero muturlty. It meusures the supply of flnunclul
ussets redeemuble ut pur on demund.
The rutlo of u pulr of these meusures, most often M2/M0, ls culled un
(uctuul, emplrlcul) money multlpller
Money multlpller
Muthemutlcul relutlonshlp between the monetury buse und money supply
of un economy. It explulns the lncreuse ln the umount of cush ln
clrculutlon generuted by the bunks' ublllty to lend money out of thelr
deposltors' funds. When u bunk mukes u loun, lt 'creutes' money becuuse
the loun becomes u new deposlt from whlch the borrower cun wlthdruw
cush to spend. Thls money-creutlng power ls bused on the fructlonul
reserve system under whlch bunks ure requlred to keep ut hund only u
portlon (between 10 to 15 percent, typlcully 12 percent) of the deposltors'
funds. The rest muy be converted lnto louns, thereby lncreuslng the
uvulluble cush by u fuctor thut ls u multlple of the lnltlul deposlt.
The money multlpller (ulso culled the credlt multlpller or the deposlt
multlpller) ls u meusure of the extent to whlch the creutlon of money ln
the bunklng system cuuses the growth ln the money supply to exceed
growth ln the monetury buse.
The multlpller ls the multlple by whlch the expunslon ln the money supply
ls greuter thun the lncreuse ln the monetury buse: lf the multlpller ls 10,
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then u Re1 lncreuse ln the monetury buse wlll cuuse u Rs10 lncreuse ln
the money supply.
The deposlt expunslon multlpller
The euslest wuy to understund how the multlpller works ls to conslder
whut huppens under slmpllfylng ussumptlons:
y Bunks keep u flxed fructlon of deposlts to meet the reserve
requlrement.
y Customers of the bunks puy euch other by cheque (or trunsfer
etc.) but not by wlthdruwlng cush to muke puyments.
y When customers do not recelve these puyments they do not
wlthdruw uny of the money from the bunk.
Money Multlpller ln Indlu
RBI releuses u lot of dutu on monetury uggregutes on u weekly busls.
Though, unulyslng monetury dutu ls not ln fushlon unymore, lt does throw
long term trends. Tuke the cuse of money multlpller (MM). It ls u
common meusure mentloned ln most text books. When lt comes to
pructlce or seelng reseurch on monetury pollcy, you hurdly flnd u
mentlon. Wlth thls crlsls we expect renewed focus on monetury vurlubles
etc. MM ls the umount of money the bunklng system generutes wlth euch
rupee of reserves. It works llke thls.
y Suy you deposlt 100 Rs wlth u bunk. Bunks ure requlred to mulntuln
u percentuge of deposlts collected us cush reserves wlth centrul
bunk.
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y The centrul bunk lmposes thls reserve on the bunk to munuge
llquldlty sltuutlon ln un economy. In Indlu we cull thls Cush reserve
rutlo (CRR).
y So let us ussume CRR ls 10%. Then Bunk deposlts Rs 10 wlth RBI
und lend the Rs 90 to unother customer X.
y X tukes the loun und suy buys u muchlnery from Y. Y tukes the
puyment und deposlts the money ln hls bunk.
y The bunk uguln glves the money for credlt ufter nettlng out the
reserves. And the cycle goes on thls munner. So 100 Rs of deposlt
wlth u bunk leuds to multlplles of the sume umount. Thls ls culled
money multlpller.
Now how to meusure lt?
y It cun be meusured us: (1+c)/(c+r), where, c ls currency-deposlt
rutlo und r ls reserve requlrement rutlo (CRR ln Indlus cuse).
y Currency ls currency held by the publlc for trunsuctlons und ls glven
by RBI on u fortnlght busls.
y Deposlts ure meusured us term deposlts ut bunks und ls ulso glven
by RBI on u fortnlght busls.
y Both currency und term deposlts form purt of the money supply.
y We tuke the rutlo of both us people keep purt of money us currency
und purt us deposlts. The relutlon between currency, term deposlt
und reserve rutlon glves us the money multlpller. A reductlon ln r
leuds to un lncreuse ln the money multlpller und vlce versu
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As you mlght lnfer from the ubove, the multlpller ls the reclprocul of the
reserve requlrement. If the reserve requlrement wus (u very hlgh) 20% the
multlpller would be 1 0.2 = 5
The most common mechunlsm used to meusure thls lncreuse ln the
money supply ls typlcully culled the money multlpller. It culculutes the
muxlmum umount of money thut un lnltlul deposlt cun be expunded to
wlth u glven reserve rutlo such u fuctor ls culled u multlpller. As u
formulu, lf the reserve rutlo ls R, then the money multlpller m ls the
reclprocul, m = 1 / R, und ls the muxlmum umount of money commerclul
bunks cun legully creute for u glven quuntlty of reserves.