Meaning and Classification of Money

11. Money- Meaning, Functions, Classification and Gresham’s Law Objectives: After studying this lesson, you will be able to understand,

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The meaning of money.

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The different functions of money

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The classification of money.

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Meaning of Grasham’s law

11.1 Definition of money

11.2 Functions of Money

11.2.1 Main Functions 11.2.2 Secondary Functions 11.2.3 Contingent Functions 11.2.4 Other functions of money

11.3 Classification of money:

11.3.1 Legal Tender Money; 11.3.2 Optional money:

11.3.3 Metallic Money:

11.3.3.1 Standard Money: 11.3.3.2 Token money: 11.3.3.3 Subsidiary money:

11.4 Paper Money:

11.4.1 Representative Paper Money: 11.4.2 Convertible Paper Money: 11.4.3 Inconvertible paper money; 11.4.4 Fiat Money:

11.5 Gresham’s Law:

11.6

Summary

11.7 Check your progress

11.8 Key concepts

11.9 Self Assessment questions

11.10 Answers to check your progress

11.11 Suggested Readings

----------------------------------------------------------------------------------------------------------11.1 Definitions of money:

----------------------------------------------------------------------------------------------------------Money has been defined differently by different economists, as there is no unanimity over its definition. Some definitions are too extensive while others are too narrow. For  example, Walker’s definition is too wide. In Walker’s words” Money is what money does”. According to this definition, we can include all those things in money, which  perform the functions of money. Thus money does not comprise metallic coins and currency notes only. It also includes cheques, hundies, bills of exchange, etc., because they also perform the functions of money. On the other hand, Robertson’s definition of  money is rather narrow. According to him, Money is a “commodity, which is used to denote anything which is widely accepted in a payment for goods or in discharge of other   business obligations”. According to this definition, metallic money alone deserves to be called money in the strict sense of the term because it alone is generally acceptable by the  people, left to them. This definition unnecessarily narrows down the field of money.

Some economists define money in legal terms saying that ‘anything which the state declares as money is money”. Thus, money possesses legal sanction to discharge debts and perform other functions of money. But legal sanction alone is not a significant factor  in making money generally acceptable. The bank deposits or credit money are not legal tender money but these are generally acceptable in payment and actually constitute a major part of the circulating medium.

 None of above definitions is satisfactory since they are either two wide or too narrow. A suitab suitable le defini definitio tion n of money money should should emphas emphasize ize not only only the import important ant functi functions ons of  money, but also its basic characteristic, namely, general acceptability. From this point of  view view,, Crow Crowth ther er;; s defi defini niti tion on appe appear arss to be ideal ideal defi defini niti tion. on. He defi define ness mone money y as ‘anything that is generally acceptable as a means of exchange and that at the same time

acts as a measure and as a store of value”. This definition points out that money should  perform all the three important functions of being a medium of exchange, a standard of  value, and a store of value. Besides, money should be a commodity, which is generally acceptable by the community in payment for anything. In other words, the commodity chosen as money must be universally acceptable within community in exchange for  goods and services or in payment of debts.

11.2 Functions of Money:

The most general way to define money is to lay down its main functions. The various functions of money can be classified into four groups.

1) Main Main Func Functi tion onss 2) Secon Seconda dary ry Func Functi tion onss 3) Cont Contin inge gent nt Func Functi tions ons 4) Othe Otherr Func Functi tion ons. s.

Let us now try to understand initially about the main functions of money.

11.2.1 Main Functions:

These are also referred to as original functions of money. Following are the two main functions of money:

a) Money Money is a Medi Medium um of of exch exchange ange::  b) Money Money is a measur measuree of value value

Money is a Medium of Exchange:

This may be considered as the most basic function of money. Money has the quality of  general acceptability. As such, all exchanges take place in terms of money. In ancient

times, commodities used to be exchanged for commodities. That was known as Barter  system. system. But, with the lapse of time, time, the barter system proved difficult difficult and inconvenient inconvenient for for the the peopl people. e. The The main main diff diffic icul ulty ty of the the barte barterr syst system em was was the the lack lack of doubl doublee coincidence of wants. It was on account of the difficulties and inconveniencies of barter  that money came into existence. In the modern money exchange system, the prices of  goods and services are expressed in terms of money. On account of the use of money, the exchange transactions have now come to be divided into two parts. parts. One is purchases and another one sale. Thus, in the modern society money acts as intermediary are sales and  purchases. It is on this account that money is referred to as the medium of exchange. The difficulty of the lack double coincidence of wants no longer exists now on account of the invent invention ion of money. money. Since Since money money is genera generall lly y accept acceptabl able, e, everyo everyone ne accepts accepts it in exchange for goods and services and utilizes it for purchasing goods and services of his choice. Money thus, promotes specialization among individuals, firms and regions.

Since money is a medium of exchange, it bestows upon the holder the power to command mark market etabl ablee good goodss and serv servic ices es at his his own own optio option n when whenev ever er he needs needs them them.. If the the individual concerned has no money, he may have to borrow it to acquire the necessary command over marketable goods and services for his own benefit.

Money is a Measure of Value:

The second important function of money is that it measures the value of goods and services. In other words, the prices of all goods and services are expressed in terms of  money. Since all values are expressed in terms of money, it is easier to determine the rate of exchange between various types of goods and services in the community. But the   people enjoyed enjoyed no such facility facility under under the barter system system.. In view of its function function as a measure of value, money also serves as a unit of account. It means that all records are kept and maintained in terms of the monetary unit, for instance in India Rup ee.

It may however, be pointed out that money still presents a difficulty in its role as a collective measure of values. The difficulty is that the value of money itself is subject to changes from time to time.

11.2.2 Secondary Functions:

Money as a standard of Deferred Payments;

In the absence of money, borrowing and lending were difficult or borrowed and lending amount could be returned only in terms of goods and services, but the modern money economy has greatly facilitated the borrowing and lending process in terms of money. In other words, money now acts as the standard of deferred payments for the following reasons: the value of money is stable compared to the values of other commodities, Money is more durable compared to other commodities: Money has the quality of general acceptability. Hence it continues to be always desirable. But in its role as a standard of  deferred payments, money also suffers from certain drawbacks. They are; its own value is not wholly stable. On the contrary, its its value keeps on fluctuating from time time to time. As a consequ consequence ence,, debtors debtors and credit creditors ors are differ different ently ly affect affected ed at differ different ent times. times. For  instance, if the value of money depreciates on account of a price rise, the creditors lose while debtors gain.

Money is a Store of Purchasing Power:

Money should have store of value character. Otherwise it is of no use in saving under   barter system. Because savings in terms of goods and services are not permanent and some of which happened to be perishable. Thus savings done in terms of money under  moder modern n money money econo economy my are are more more perm perman anent ent and mone money y made made possi possibl blee capit capital al accumulation, which is an essential, prerequisite of economic growth. Money also serves as an excellent store of wealth, as it can be easily converted into other marketable assets,

such as, land machinery, plant etc., but money can perform this function satisfactorily only if its own value is fairly stable.

As a store of value, people’s peo ple’s preference of money over other assets flows essentially from the characteristic liquidity of money and the uncertainty about the future value of nonmoney assets. By acting as a store of value, money provides a link between the present and the future.

As mentioned earlier, though there are contingent and other functions of money, but as a studen studentt of UG, it is suffic sufficien ientt to learn learn above above stated stated import important ant functi functions ons of money. money. However, list out the contingent and other functions in brief in the following.

11.2.3 Contingent functions : money will act as the basis of credit to be created by

commercial banks, money also facilitates the distribution of social income among the   popula populati tion on in an econom economy, y, money money helps helps to equali equalize ze margin marginal al utili utilitie tiess and margin marginal al  productivities and money increases productivity of capital.

11.2.4 Other functions of money : Money helps to maintain repayment capacity, money

represents generalized purchasing power and money gives liquidity to capital.

11.3 Classification of money:

Different economists on the basis of different criteria have classified money. On the basis of legality , money can be classified under two heads:

11.3.1 Legal Tender Money;

It is that money which is accepted as a means of payment both by the Govt as well as the  people. This type of money has legal sanction behind it. No one refuse to accept it as a means of payment.

Legal tender money can be further subdivided under two heads: a) limited legal tender, b) unlimited legal tender.

forced to accept beyond beyond a Limited Legal Tender is that money which no person can be forced certain maximum limit. The Govt under statute fixes the maximum limit. For example 1,2,5,10,20 and 25 paise coins are legal tender only up to a sum of rupees twenty-five. If  some one is called upon to accept the small coins beyond be yond the maximum limit of Rs 25/- is  perfectly free to refuse them. But up to the limit of Rs. 25/-, he cannot refuse the small coins under the provisions of the law.

Un-Limited Legal Tender is that money which a person has to accept up to any limit,

 because  because it is an unlimited unlimited legal tender. This type of money accepted by the people to an unlimited extent. For example, one rupee coin’s, fifty paise coins and paper notes of all denominations are unlimited legal tender in India.

11.3.2 Optional money:

It is that money, which ordinarily accepted by the people, but has no legal sanction  behind it. No one can be forced to accept this type of money against his wishes. It is optioned money. If the persons is paying this money enjoys high credit in the market, everyone will readily accept it. But as pointed out above, no one can be forced to accept it. Different types of credit instruments like cheques, hundies and bills of exchange are examples of optional money.

Money can be classified under two sub-heads on the basis of the commodity used in making it.

1) Meta Metall llic ic mone money y

2) Paper aper money oney

11.3.3 Metallic Money:

This money is made of a particular metal (i.e., Gold, Silver, Copper, Nickel, etc.,). Metallic Money is further classified under three sub heads:

a) Standa andarrd Mone Money y  b)  b) Toke Token n Mon Money ey c) Subs Subsid idia iary ry Mon Money ey

11.3.3.1 Standard Money:

This is also referred to as the principle money or full-bodied money. Standard coins are made of gold or silver. These coins are made of a well-defined weight and fineness. Standard money has the following characteristics:

1) Standa Standard rd coin is the princip principal al coin of the country. country. As such, such, it is the medium medium of  exchange exchange and also the money of account. When the standard standard coin is made of one metal, the monetary system is known as mono-mettalism. If this metal is gold, the system is referred to as gold mono-metallism. In case, the standard coin is made of silver only, the system is known as silver mono-metalism. Some times, the standard coins are made of gold as well as of silver. In other words, two types of  standard coins are in circulation- one made of gold and the other of silver. Such a monetary system is known as Bi-metalism.

2) The Face value value of standard standard money money is equal equal to its its intrinsic intrinsic value. value. The face face value of  standard standard money is always equal to its metallic metallic or intrinsic intrinsic value. In other words, the standard coin comprises metal whose value is equal to its face value. If some one melts down a standard standard coin and sells the bullion bullion in the market, market, he suffers no loss because the coin contains metal equivalent to its face value. That is why the standard money is known as full-bodied money. For example, the Indian rupee  before 1893 was a standard coin. It had in it silver whose metallic value was equal to its face value.

3) There There is free free coinag coinagee of standard standard money. money. A specia speciall charac character terist istic ic of standar standard d money is that it is minted under free coinage. Under free coinage as is well known, the mint is open to the public. Under the system, the people have the right to take their gold or silver to the mint for getting it converted into coins. For this service rendered to the citizens, the mint some times charges fee, but some times it does not. The main advantage of this system is that there is no shortage of coins in the country. Whenever the people experienced shortage of coins they can take their gold or silver to the mint and get it converted into coins.

4)

Standard Standard money is unlimi unlimited ted legal tender tender money. money. An important important characteris characteristic tic of  standa standard rd money money is that that its its unlimi unlimited ted legal legal tender tender,, becaus becausee it’s it’s the princi principal pal monetary unit of the country. All big payments can be made in terms of standard money to an unlimited extent.

11.3.3.2 Token money:

The token money is used for making smaller payments. It serves as a subsidiary for  standard money. It is generally made of inferior and light metals, such as, copper, nickel etc, Token money is different from standard money in several respects, I shall then briefly in the following sentences:

1) There There is no free free coinage coinage of token token money. money. The governme government nt only mines mines this, this, the  public enjoys no right to take the metals to the mint and get them converted into token coins. 2) The face face value of of token money money is higher than its its intrinsic intrinsic value. 3) Token money money is limit limited ed legal tender tender money: money: Token Token coins can can be used for for making making  payments only to a limited extent. No one can be forced to accept then coins  beyond a certain limit. 4) Token money money is a subsidi subsidiary ary of standard standard money: money: Token Token coins coins are generally generally used used for making payments in smaller transactions. As such, they act as subsidiaries of  standard coins. Let us see the merits and demerits d emerits of standard coins in brief:

Merits of Standard Coins:

a) Insp Inspir iree grate graterr confi confiden dence ce  b) Means Means of storin storing g purchas purchasing ing power  power  c) Easy Easy accepta acceptabil bility ity in in foreign foreign count countrie riess d) No fear fear of infl inflat atio ion n

Demerits of Standard Coins:

a) Not Not econ econom omiical cal  b) Standa Standard rd money money is not not elast elastic ic

 Now let us also study the merits and demerits de merits of Token coins:

Merits of Token Coins:

a) Econ Econom omic ical al use use of of meta metals ls  b) Token Token curren currency cy is much much more more elast elastic ic

Demerits of Token Coins:

a) Insp Inspir iree less less conf confid idenc encee  b)  b) Cons Consis ista tabi bili lity ty c) Fear Fear or or over over-i -iss ssue ue d) Accept Acceptabi abilit lity y within within the the countr country y e) Limi Limite ted d leg legal al tend tender  er 

11.3.3.3 Subsidiary money:

Subsidiary coins are issued to facilitate smaller payments. The main characteristics of  subsidiary coins are:

a) The subsidiar subsidiary y coins are are low-value low-value coins and and are made of lighte lighterr metals. metals.  b) They facili facilitate tate the exchange exchange of low-price low-priced d goods and and services services c) There There coins coins are not subject subject to free free coinage, coinage, they are are issued issued by the governme government nt itself  d) All subs subsidi idiary ary coin coinss are token token coin coinss e) The The rela relati tion onsh ship ip of subs subsid idia iary ry coin coinss with with the the stan standa dard rd coin coinss is defi define ned d and determined under statute.

11.4 Paper Money:

Paper money has along history to its credit. China was the first in the world to make use of this in the 9th century and it began in India in the 19th century.

Paper money can be classified under three heads:

1) Repres Represent entati ative ve Paper Paper Money Money 2) Conve Convert rtib ible le Pape Paperr Money Money 3) In-Conv In-Convert ertibl iblee Pape Paperr Money Money

11.4.1 Representative Paper Money:

This type of paper money is fully backed up by fold and silver reserves. In the beginning to avoid wastage of metals the paper currency was issued. Hence, the monetary authority maintained metallic reserves equivalent to the value of paper notes issued. The demand for converting paper notes into cash was met by making use of gold and silver kept in rese reserv rves es.. Thus Thus,, under under the the syst system em of repr repres esent entat ativ ivee pape paperr mone money, y, gold gold and and silv silver  er  equivalent to the value of paper notes issued were kept in reserves by the monetary authority.

Main advantages and disadvantages of Representative money are as follows:

Advantages of Representative money :

a) No fear fear of infl inflati ation on  b) Econom Economy y in use use of valuab valuable le metal metalss c) Publ Public ic con confi fide denc ncee

Disadvantages of Representative money:

a) No sav savin ing g in gol gold d and and silv silver  er   b)  b) Lack Lack of elas elasti tici city ty c) Unsuit Unsuitabl ablee for for poore poorerr count countrie riess

11.4.2 Convertible Paper Money:

It refers to that type of paper money, which is convertible into standard coins at the option of the holder. The characteristics of convertible paper money give us a better  understanding of this.

a) The basic basic principle principle underlying underlying this this system system is that the the public for encashm encashment ent does not simultaneously present all the notes. Therefore, the value of gold, silver kept in reserves is less that the value of notes issued by monetary authority.   b) The monetar monetary y author authority ity assure assuress the public public that they can get their their paper notes converted into cash at their option. c) The approved approved securitie securitiess such as gold, gold, and silver silver can be encashed encashed at anytim anytime. e. d) Thus, Thus, gold and silver silver in the reserv reserves es are not kept equiva equivalen lentt to the value of the  paper currency issued, but they are some what less than that of currency under  this system the reserves comprise two portions: i) Metallic Metallic portionportion- this this portion portion contain containss gold, silver silver and standard standard coins coins and, and, ii) Fiduciary potion – this portion contains only approved securities e) Under Under this syste system, m, the people people are given gold and silver silver in exchange exchange for paper  paper  currency for making payments abroad. f) The government government is ever ever ready to buy gold and silver silver at at predeterm predetermined ined rates. rates.

Merits and demerits of the type of money are as follows;

Merits of convertible paper money:

a) Econom Economy y in in use use of valuab valuable le meta metals ls  b)  b) Flex Flexib ibil ilit ity y c) Inspir Inspiree greate greaterr public public confid confidence ence d) Facili Facility ty in foreig foreign n trad tradee

Demerits of convertible paper money:

a) Fear Fear of over over –issu –issuee of paper paper curr currenc ency y  b) It does not inspire inspire as much confid confidence ence as repres representat entative ive money money

Though this system spread to many countries and is widely adopted, it’s the system of  inconvertible money, which is in force.

11.4.3 Inconvertible paper money;

This system prevails in a country when the monetary authority gives no guarantee to convert the paper notes into coin or other valuable metals. Such a type of paper currency circulation account of the high credit enjoyed by the monetary authority. The following are its characteristics.

a) Under this this system. system. The issuin issuing g authority authority keeps no no metallic metallic reserves reserves behind behind paper  currency nor does it guarantee the convertibility of paper note into coins and metals metals.. It’s It’s possib possible le that that the issui issuing ng author authorit ity y backs backs up the note-i note-iss ssue ue with with government securities, treasury bills and even bonds.  b) Such Such type of paper curre currency ncy can be issued issued at best only only in limited limited quantit quantity y but if  need arises, the issuing authority may tissue more paper notes without metallic cover.

11.4.4 Fiat Money:

Lastly, this is only a variety of in convertible fiat money and is issued generally at a time of crisis. That is why it’s sometimes referred to as emergency currency. No reserves of  any type are kept behind and are neither backed up by the metallic and fiduciary cover. The monetary authority gives no guarantee to convert fiat money into metallic coins. The main characteristics of fiat money may be summed up as follows:

a) Fiat Fiat money money is issu issued ed in limit limited ed quantit quantities ies  b) Fiat Fiat money money is is issue issued d at a time time of crisi crisiss c) There is no-cover no-cover (metallic (metallic or fiducia fiduciary) ry) behind it

The fact of the matter is that fiat money is an extra-ordinary type of money and is issued under special circumstances. Fiat money is however, is an unlimited legal tender.

At the outset, the above mentioned are the different types of money which have been and are being used in the countries to carry on their daily transactions. The divisions and subdivisions made it easier, though money has undergone many changes from barter system to the present day paper currency, however we may call it, it is highly essential.

11.5 Gresham’s Law:

Queen Elizabeth of England wanted to reform the currency system which was existed during the time of her grandfather to have a single unified currency in order to strengthen the trade and commerce in the country. She was introduced reform of the currency sytem sytem  by issuing new coins of better weights and shape with the hope that public will deposit the old debased coins in treasury and very soon the work of currency reforms would be succe success ssfu full lly y acco accomp mpli lish shed ed.. But to her utte utterr dima dimay y she she foun found d that that the the new new coins coins disappeared from the circulation no sooner these were issued from the mint. Upset by this situation the queen on the advise of her minister consulted Sir Thomas Grasham who was the master of the mint under queen Elizabeth. Elizabeth. Grasham enquired enquired about the phenomenon

in 1558 and came to the conclusion that bad money drives out good money. This has to  be come to known as Grasham’s law.

When two kinds of money in circulation the problem before the government is to keep them concurrently in circulation. When the two currencies having the legal value have different intrinsic or real value in the domestic or foreign market then the money having higher market value is set to be under valued currency while other set to be over valued currency. A money over valued by the government is that which has less purchasing  power in the market. In such a situation the over valued currency will tend to drive out the under valued currency from circulation. The under valued currency is withdrawn from monetary use melted and diverted to non monetary uses. Grasham’s law is based on this observation.

A basic aspect of Grasham’s law is that the under valued money can remain in circulation at home only if it will circuated at a premium. This conclusion follows from the fact that  people will not spend the under valued money at home on the same basis as the over  valued money when they can get relatively more for the under valued money in foreign countries.

11.6

Summary

Money has been defined differently by different economists, as there is no unanimity over its definition. Some definitions are too extensive while others are too narrow. And as  par as concerned with the classification of money, different forms of money and its advantages as well as disadvantages also discussed in this lesson. We also covered what is Grasham’s law and its importance. It is in this view money has been playing key role in an economy. However, money no doubt, is a significant and important factor in the operations of a modern economy, yet its limitations cannot be overlooked or ignored in any fair evaluation of the role played by it.

11.7 11.7 Chec Check k your your pro progr gres esss

Whether the following statements are true or false w alker  1. “ Money is what money does” said by walker  2.

Money is in the normal sense, means currency

3. Measure of value is an essential function of money

11.8 Key concepts

Medium of exchange Measure of value Store of value Differed Payments Representative Money Fiat money

11.9 Self Assessment questions

1 Define money and explain its main functions

2. Explain the various types of money and briefly mention their characteristics 4. Distinguish between Convertible and inconvertible paper money 5. What is Grasham’s law

11.10 Answers to check your progress

1. false 2. False 3 True

11.11 Suggested Readings

Ackley Gardner : Macro economic theory

Ward R A: Monetary theory and policy Rana & Verma : Macro economic eco nomic analysis Hajela TN: Monetary economics Ghatak : Monetary economics in developing economies