1. Barter System and Its Difficulties
Before money, the barter system (direct exchange of goods for goods) was used. It had severe limitations that made large-scale trade impossible:
| Difficulty | Explanation | Example |
|---|---|---|
| Double Coincidence of Wants | Both parties must simultaneously want exactly what the other has | A tailor wanting food must find a farmer who wants tailoring — exactly |
| Lack of Common Measure of Value | No standard unit to express the value of all goods in terms of each other | With n goods, there are n(n−1)/2 exchange ratios to remember |
| Indivisibility of Goods | Some goods cannot be divided for small transactions | Cannot give half a cow to buy a loaf of bread |
| Difficulty of Storing Value | Perishable goods cannot store purchasing power over time | Wheat rots, livestock die — wealth cannot be stored reliably |
| Difficulty in Deferred Payments | Hard to specify future obligations in goods (whose quality and quantity may differ) | Agreeing to repay a loan of "10 kg wheat" — wheat quality varies |
Money solves all these problems simultaneously — it is the solution to the failures of barter.
2. Money — Meaning and Definition
Money is anything that is generally accepted as a medium of exchange, a measure of value, a store of value, and a standard of deferred payment.
Key definitions:
- Walker: "Money is what money does." — Money is defined by its functions, not its physical form.
- Crowther: "Money is anything that is generally acceptable as a means of exchange and at the same time acts as a measure and store of value."
Essential Properties of Money
- General acceptability: Everyone must accept it as payment — the core requirement.
- Durability: Must not deteriorate quickly.
- Portability: Easy to carry.
- Divisibility: Can be divided into smaller units for exact transactions.
- Uniformity: Each unit identical to every other unit.
- Scarcity: Limited supply — prevents inflation from oversupply.
- Stability of value: Value should not fluctuate widely over time.
3. Functions of Money
Functions of money are divided into three categories:
A. Primary (Main) Functions
| Function | Explanation | Barter problem solved |
|---|---|---|
| Medium of Exchange | Money acts as an intermediary in all transactions — goods are sold for money, money used to buy other goods. Separates the act of selling from buying. | Eliminates double coincidence of wants |
| Measure of Value (Unit of Account) | Money provides a common unit to express the value of all goods and services. Prices are quoted in money terms, enabling easy comparison. | Eliminates need for countless exchange ratios |
B. Secondary (Derived) Functions
| Function | Explanation | Barter problem solved |
|---|---|---|
| Store of Value | Money can be saved and used in the future — it preserves purchasing power over time (unlike perishable goods) | Eliminates the problem of storing perishable wealth |
| Standard of Deferred Payment | Money is used to specify future obligations — loans can be given and repaid in money; credit transactions possible | Enables borrowing, lending, and deferred transactions |
C. Contingent (Other) Functions
- Distribution of national income: Payments to factors of production (wages, rent, interest, profit) are made in money — facilitating income distribution.
- Basis of credit: Banks create credit on the basis of money deposits — money enables the entire banking and credit system.
- Transfer of value: Wealth can be transferred across space and time through money (impossible with land or buildings).
4. Types of Money
| Type | Definition | Example |
|---|---|---|
| Commodity Money | Goods with intrinsic value used as money | Gold, silver coins, cattle, salt (historically) |
| Metallic Money | Coins made of metals (full-bodied or token) | Gold, silver, copper coins; modern ₹1, ₹2, ₹5, ₹10 coins |
| Paper Money | Currency notes issued by the central bank — legal tender | ₹10, ₹100, ₹500, ₹2,000 notes issued by RBI |
| Credit / Bank Money | Deposits in banks — cheques drawn on them function as money | Demand deposits (savings/current accounts); cheques, drafts, NEFT |
| Near Money | Highly liquid financial assets that are not money themselves but easily convertible to money | Treasury bills, time deposits, government bonds |
| Legal Tender | Money that must be accepted by law for settlement of debts Limited legal tender: coins (accepted up to a limit) Unlimited legal tender: currency notes |
RBI currency notes = unlimited legal tender; coins = limited |
5. Supply of Money — Measures (M1, M2, M3, M4)
The Supply of Money (Money Stock) refers to the total stock of money available in an economy at a given point in time. RBI of India defines four measures:
| Measure | Components | Type |
|---|---|---|
| M1 (Narrow Money) |
Currency with public + Demand Deposits with commercial banks + Other deposits with RBI | Most liquid; smallest; Narrow Money |
| M2 | M1 + Savings deposits with Post Office Savings Bank | Slightly broader than M1 |
| M3 ★ (Broad Money) |
M1 + Net Time Deposits (Fixed Deposits) with commercial banks | Most commonly used; also called Broad Money; used by RBI for policy |
| M4 | M3 + Total deposits with Post Office Savings Organisation (excluding NSC) | Widest measure; least liquid |
Order of liquidity (highest to lowest): M1 > M2 > M3 > M4
Order of size (smallest to largest): M1 < M2 < M3 < M4
M3 is the most widely used measure for monetary policy — when RBI says it is targeting "money supply," it almost always refers to M3.
Components of M1 — Explained
- Currency with public: Notes and coins held by the public (not in banks). This is the most familiar form of money.
- Demand deposits: Balances in current accounts and savings accounts that can be withdrawn on demand — they function as money through cheques and transfers.
- Other deposits with RBI: Small deposits held by foreign central banks and other official entities with RBI — negligible in practice.
6. Demand for Money
The Demand for Money (Liquidity Preference) is the desire of people to hold wealth in the form of liquid money (cash) rather than interest-bearing assets. Keynes identified three motives:
| Motive | Reason for Holding Money | Depends on |
|---|---|---|
| Transaction Motive | For day-to-day purchases — food, transport, rent. People need cash to bridge the gap between income receipt and expenditure. | Income level — higher income → more transactions → higher demand |
| Precautionary Motive | For unexpected contingencies — medical emergencies, sudden repairs, unemployment. A safety buffer. | Income level — higher income → more precautionary holding |
| Speculative Motive | Holding money to take advantage of future investment opportunities — especially in bonds. When bond prices are expected to fall (interest rates rise), people hold money instead. | Interest rate — higher interest rate → lower speculative demand (bonds more attractive) |
Liquidity Trap
At very low interest rates, people expect rates to rise (bond prices to fall) — so everyone holds money instead of bonds. The speculative demand for money becomes perfectly elastic (horizontal). In this situation, monetary policy (increasing money supply) becomes ineffective — extra money is simply hoarded. This is the Liquidity Trap.
7. Quantity Theory of Money
The Quantity Theory of Money (Fisher's Equation of Exchange) establishes a relationship between money supply and price level:
Where: M = Money supply; V = Velocity of circulation (number of times money changes hands in a year); P = General price level; Q = Real output/transactions.
Implication: If V and Q are constant, doubling M will double P — a proportional relationship between money supply and price level. This is the theoretical basis for the statement: "Excessive money supply causes inflation."
Limitation: In practice, V and Q are not constant — so the relationship is not strictly proportional. Modern monetary economics goes beyond this simple equation.
