4 essential functions of money

7/25/2019 4 Essential Functions of Money

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The Evolution Of Money

Money evolved as human society grew more sophisticated and required a more

sophisticated means of transacting business.

The following section describes in very simple terms the evolutionary stages of money--how

it evolved from real money to magic money.

1. Barter: One of the first monetary systems was barter. Barter is simply trading a product

or a service for other products and services. or e!ample" if a farmer had a chic#en and

needed shoes" the farmer could trade chic#ens for shoes. The obvious problem

with barteris that it is slow" tedious" and time-consuming. $t is hard to measure relative

values. or e!ample" what if the cobbler did not want a chic#en% Or if he did" how many

chic#ens were his shoes really worth% & faster more efficient means of e!change was

needed" so money evolved.

On a side note" however" if the economy continues to slide downward and money remains

tight" you will see barter increase. One good thing about barter is that it is hard for the

government to ta! barter transactions. The ta! department does not accept chic#ens.

'. (ommodities: To speed up the process of e!change" groups of people came to agree on

tangible items that represented value. )eashells were some of the first forms of commodity

money. )o were stones" colored gems" beads" cattle" goats" gold" and silver. *ather than

trade chic#ens for the shoes" the chic#en farmer might simply give the cobbler si! colored

gems for the shoes. The use of commodities sped up the process of e!change. more

business could be done in less time.

Today" gold and silver remain the commodities that are internationally accepted as money.

This is the lesson $ learned in +ietnam. ,aper money was national" but gold was

international" accepted as money even behind enemy lines.

. *eceipt money: To #eep precious metals and gems safe" wealthy people would turn their

gold" silver" and gems over for safe#eeping to people they trusted. That person would then

issue the wealthy person a receipt for his or her precious metals and gems. This was the

start of ban#ing.

*eceipt money was one of the first financial derivatives. &gain" the word derivative means

derived from something else--/ust as orange /uice is derived from an orange and an egg is

derived from a chic#en. &s money evolved from a tangible item of value into a derivative of

value" a receipt" the speed of business increased.

$n ancient times" when a merchant traveled across the desert from one mar#et to the ne!t"

he would not carry gold or silver for fear of being robbed along the way. $nstead" he carried

with him a receipt for gold" silver" or gems in storage. The receipt was a derivative of

valuables he owned and held in storage. $f he purchased products at his faraway
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destination" he would then pay for his products with the receipt--a derivative of tangible

value.

The seller would then ta#e the receipt and deposit it in his ban#. *ather than transfer gold"

silver" and gems bac# across the desert to the other ban#" the two ban#ers in the two cities

would simply balance or reconcile the trading accounts between buyer and seller with debitsand creditsagainst receipts. This was the start of the modern-day ban#ing and monetary

system. Once again" money evolved and the speed of business increased. Today" modern

forms of receipt money are #nown as chec#s" ban# drafts" wire transfers" and debit cards.

The core business of ban#ing was best described by the third 0ord *othschild as facilitating

the movement of money from point &" where it is" to point B" where it is needed.

. ractional reserve receipt money: &s wealth increased through trade" ban#ers2 vaults

became filled with precious commodities such as gold" silver and gems. Ban#ers soon

reali3ed that their customers had little use for the gold" silver" and gems themselves.

*eceipts were much more convenient for transacting business. *eceipts were much lighter"

safer" and easier to carry. To ma#e more money" ban#ers transitioned from storing wealth tolending wealth. 4hen a customer came in wanting to borrow money" the ban#er simply

issued another receipt with interest. $n other words" ban#ers reali3ed that they did not need

their own money to ma#e money. Ban#ers began effectively printing money.

4ith more money in circulation" people felt richer. There was no problem with this e!panded

money supply as long as everyone didn2t want his or her gold" silver" or gems bac# at the

same time. $n modern terms" economists would say" The economy grew because the

money supply e!panded.

5. iat money: 4hen ,resident 6i!on severed the 7.). dollar from the gold standard in

1891" the 7nited )tates no longer needed gold" silver" or gems" or anything else in its vaultsto create money.

Technically" prior to 1891" the 7.). dollar was a derivative of gold. &fter 1891" the 7.).

dollar became a derivative of debt. )evering the dollar from gold was ban# robbery of

ungodly proportions.

iat money is simply money bac#ed by government2s good and credit. $f anyone messes

with the government and central ban#2s monopoly on money" the government has the

power to put that group or person in /ail for fraud and counterfeiting. iat money means all

bills payable to the government" such as ta!es" must be paid in that nation2s currency. ou

cannot pay your ta!es with chic#ens.
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Etymology

The word "money" is believed to originate from a temple ofHera,located on Capitoline,one of Rome's

seven hills. In the ancient world Hera was often associated with money. The temple of!no onetaatRome was the place where the mint of #ncient Rome was located.$%&The name "!no" may derive from

the Etr!scan goddessni(which means "the one", "!ni)!e", "!nit", "!nion", "!nited"* and "oneta" either

from the +atin word "monere" (remind, warn, or instr!ct* or the ree- word "moneres" (alone, !ni)!e*.

In the estern world, a prevalent term for coin/money has been specie, stemming from +atin in specie,

meaning 'in -ind'

4 essential functions of MoneyGenerally, economists have defined four types of functions of money which are as follows:

(i) Medium of exchange

(ii) Measurement of value;

(iii) Standard of deferred payments

(iv) Store of value.

hese four functions of money have !een summed up in a couplet which says: Money is a matter offunctions four, a medium, a measure, a standard and a store.

(i) Money as a Unit of Value:

Money measures the value of various goods and services which are produced in an economy. "n otherwords, money wor#s as unit of value or standard of value. "n !arter economy it was very difficult todecide as to how much volume of goods should !e given in exchange of a given $uantity of acommodity.

Money, !y performing the function of common measure of value, has saved the society from thisdifficulty. %ow the value of various goods and services are expressed in terms of money such as &s.' per metre, &s. *+ per #ilogram etc. "n this way, money wor#s as common measure of value !y

expressing exchange value of all goods and services in money in the exchange mar#et. y wor#ing asa unit of value, money has facilitated modern !usiness and trade.

(ii) Medium of Exchange:

&ight from the !eginning, money has !een performing an important function as medium ofexchange in the society. Money facilitates transactions of goods and service as a medium ofexchange. -roducers sell their goods to the wholesalers in exchange of money. holesalers sell thesame goods to the consumers in exchange of money.
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"n the same way, all sections of society sell their services in exchange of money and with that !uygoods and services which they need. Money, wor#ing as medium of exchange, has eliminatedinconvenience which was faced in !arter transactions. /owever, money can operate as medium ofexchange only when it is generally accepted in that role. an# money can !e treated as money simplyon the !asis of their general accepta!ility for they are highly useful.

(iii) Standard of Deferred Payments:

Modem economic setup is !ased on credit and credit is paid in the form of money only. "n reality thesignificance of credit has increased so much that it will not !e improper to call it as the foundationstone of modem economic progress. Money, !esides !eing the !asis of current transactions, is alsothe !asis of deferred payments. 0nly money is such a commodity in whose form accounts of deferredpayments can !e maintained in such a way so that !oth creditors and de!tors do not stand to lose.

(iv) Store of Value:

"t was virtually impossi!le to store surplus value under !arter economy; the discovery of money hasremoved this difficulty. ith the help of money, people can store surplus purchasing power and useit whenever they want. Saving in money is not only secure !ut its possi!ility of !eing destroyed is

very less. esides, it can !e used whenever need !e. y facilitating accumulation of money, moneyhas !ecome the only !asis of promoting capital formation and modern production techni$ue andcorporate !usiness facilitated there from.

Measure of value

oney acts as a standard meas!re and common denomination of trade. It is th!s a basis for )!oting andbargaining of prices. It is necessary for developing efficient acco!nting systems. 0!t its most important

!sage is as a method for comparing the val!es of dissimilar ob1ects.

oney

Moneyis any ob1ect or record that is generally accepted as paymentfor goods and servicesand

repayment of debtsin a given socio/economic conte2t or co!ntry. The main f!nctions of money are

disting!ished as3 amedi!m of e2change4a !nit of acco!nt4a store of val!e4and, occasionally in the past,
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astandard of deferred payment.#ny -ind of ob1ect or sec!re verifiable record that f!lfills these f!nctions

can be considered money.

oney is historically an emergent mar-et phenomenonestablishing a commodity money, b!t nearly all

contemporary money systems are based on fiat money.$5&6iat money, li-e any chec- or note of debt, is

witho!t intrinsic !se val!eas a physical commodity. It derives its val!e by being declared by agovernment to belegal tender4 that is, it m!st be accepted as a form of payment within the bo!ndaries of

the co!ntry, for "all debts, p!blic and private"$citation needed&. 7!ch laws in practice ca!se fiat money to ac)!ire

the val!e of any of the goods and services that it may be traded for within the nation that iss!es it.

The money s!pplyof a co!ntry consists ofc!rrency(ban-notes and coins* andban- money(the balance

held in chec-ing acco!ntsand savings acco!nts*.0an- money, which consists only of records (mostly

comp!teri8ed in modern ban-ing*, forms by far the largest part of the money s!pply in developed nations

Types of money

C!rrently, most modern monetary systems are based on fiat money. However, for most

of history, almost all money was commodity money, s!ch as gold and silver coins. #s

economies developed, commodity money was event!ally replaced by representative

money, s!ch as the gold standard,as traders fo!nd the physical transportation of gold

and silver b!rdensome. 6iat c!rrencies grad!ally too- over in the last h!ndred years,

especially since the brea-!p of the 0retton oods systemin the early 9%:;s.

Commodity money

Main article:Commodity money

# 9%95 0ritish old sovereign
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any items have been !sed as commodity moneys!ch as nat!rally scarce precio!s

metals, conch shells, barley, beads etc., as well as many other things that are tho!ght

of as having val!e. Commodity money val!e comes from the commodity o!t of which it

is made. The commodity itself constit!tes the money, and the money is the commodity.

E2amples of commodities that have been !sed as medi!ms of e2change

incl!de gold, silver, copper,rice, salt, peppercorns, large stones, decorated belts,

shells, alcohol, cigarettes, cannabis, candy, etc. These items were sometimes !sed in a

metric of perceived val!e in con1!nction to one another, in vario!s commodity val!ation

or ?merican Eaglesare imprinted with their gold content and

legal tender face val!e.$>:&

Representative money

Main article:Representative money

In 9@:A, the 0ritish economist illiam 7tanley evonsdescribed the money !sed at the

time as "representative money". Representative money is money that consists of to-en

coins, paper moneyor other physical to-ens s!ch as certificates, that can be reliablye2changed for a fi2ed )!antity of a commodity s!ch as goldor silver. The val!e of

representative money stands in direct and fi2ed relation to the commodity that bac-s it,

while not itself being composed of that commodity.$>@&

Fiat money

Main article:Fiat money
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old coins are an e2ample of legal tender that are traded for their intrinsic val!e, rather than their

face val!e.

6iat money or fiat c!rrency is money whose val!e is not derived from any intrinsic val!e

or g!arantee that it can be converted into a val!able commodity (s!ch as gold*. Instead,

it has val!e only by government order (fiat*. s!ally, the government declares the fiat

c!rrency (typically notes and coins from a central ban-, s!ch as the 6ederal Reserve

7ystemin the .7.* to be legal tender, ma-ing it !nlawf!l to not accept the fiat c!rrency

as a means of repayment for all debts, p!blic and private. $>%&$B;&

7ome b!llion coinss!ch as the#!stralian old !ggetand#merican Eagleare legal

tender, however, they trade based on the mar-et priceof the metal content as

a commodity, rather than their legal tender face val!e(which is !s!ally only a small

fraction of their b!llion val!e*.$>:&$B9&

6iat money, if physically represented in the form of c!rrency (paper or coins* can be

accidentally damaged or destroyed. However, fiat money has an advantage over

representative or commodity money, in that the same laws that created the money can

also define r!les for its replacement in case of damage or destr!ction. 6or e2ample, the

.7. government will replace m!tilated 6ederal Reserve notes(.7. fiat money* if at

least half of the physical note can be reconstr!cted, or if it can be otherwise proven tohave been destroyed.$B>&0y contrast, commodity money which has been lost or

destroyed cannot be recovered.

Coinage

Main article:Coin

These factors led to the shift of the store of val!e being the metal itself3 at first silver,

then both silver and gold, at one point there was bron8e as well. ow we have copper

coins and other non/precio!s metals as coins. etals were mined, weighed, andstamped into coins. This was to ass!re the individ!al ta-ing the coin that he was getting

a certain -nown weight of precio!s metal. Coins co!ld be co!nterfeited, b!t they also

created a new !nit of acco!nt, which helped lead to ban-ing.#rchimedes'

principleprovided the ne2t lin-3 coins co!ld now be easily tested for theirfineweight of
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metal, and th!s the val!e of a coin co!ld be determined, even if it had been shaved,

debased or otherwise tampered with (see !mismatics*.

In most ma1or economies !sing coinage, copper, silver and gold formed three tiers of

coins. old coins were !sed for large p!rchases, payment of the military and bac-ing ofstate activities. 7ilver coins were !sed for midsi8ed transactions, and as a !nit of

acco!nt forta2es, d!es, contracts and fealty, while copper coins represented the

coinage of common transaction. This system had been !sed in ancient Indiasince the

time of the aha1anapadas. In E!rope, this system wor-ed thro!gh the medievalperiod

beca!se there was virt!ally no new gold, silver or copper introd!ced thro!gh mining or

con)!est.$citation needed&Th!s the overall ratios of the three coinages remained ro!ghly

e)!ivalent.

Paper moneyMain article:Banknote

H!i8i c!rrency, iss!ed in 99?;

In premodernChina, the need for credit and for circ!lating a medi!m that was less of ab!rden than e2changing tho!sands of coppercoins led to the introd!ction of paper

money, commonly -nown today as ban-notes. This economic phenomenon was a slow

and grad!al process that too- place from the late Tang Dynasty(?9@%;:* into

the 7ong Dynasty(%?;9>:%*. It began as a means for merchants to e2change heavy

coinage for receiptsof deposit iss!ed aspromissory notesfrom shops of wholesalers,
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notes that were valid for temporary !se in a small regional territory. In the 9;th cent!ry,

the 7ong Dynastygovernment began circ!lating these notes amongst the traders in

theirmonopoli8edsalt ind!stry. The 7ong government granted several shops the sole

right to iss!e ban-notes, and in the early 9>th cent!ry the government finally too- over

these shops to prod!ce state/iss!ed c!rrency. Fet the ban-notes iss!ed were still

regionally valid and temporary4 it was not !ntil the mid 9Bth cent!ry that a standard and

!niform government iss!e of paper money was made into an acceptable nationwide

c!rrency. The already widespread methods of woodbloc- printingand then


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reasons, paper c!rrency was held in s!spicion and hostility in E!rope and #merica. It

was also addictive, since the spec!lative profits of trade and capital creation were )!ite

large. a1or nations established mintsto print money and mint coins, and branches of

their treas!ry to collect ta2esand hold gold and silver stoc-.

#t this time both silver and gold were considered legal tender, and accepted by

governments for ta2es. However, the instability in the ratiobetween the two grew over

the co!rse of the 9%th cent!ry, with the increase both in s!pply of these metals,

partic!larly silver, and of trade. This is calledbimetallismand the attempt to create

a bimetallicstandard where both gold and silver bac-ed c!rrency remained in

circ!lation occ!pied the efforts ofinflationists. overnments at this point co!ld !se

c!rrency as an instr!ment of policy, printing paper c!rrency s!ch as the nited

7tates reenbac-, to pay for military e2pendit!res. They co!ld also set the terms at

which they wo!ld redeem notes for specie, by limiting the amo!nt of p!rchase, or the

minim!m amo!nt that co!ld be redeemed.

0an-notes with a face val!e of A;;; of different c!rrencies

0y 9%;;, most of the ind!striali8ing nations were on some form of gold standard, with

paper notes and silver coins constit!ting the circ!lating medi!m.


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part of the >;th cent!ry and contin!ing across the world !ntil the late >;th cent!ry, when

the regime of floating fiat c!rrencies came into force. Gne of the last co!ntries to brea-

away from the gold standardwas the nited 7tates in 9%:9.

o co!ntry anywhere in the world today has an enforceable gold standardor silverstandardc!rrency system.

Commercial bank money

Main article:Demand deposit

Demand depositin che)!e form

Commercial ban- money or demand depositsare claims against financial instit!tions

that can be !sed for the p!rchase of goods and services. # demand deposit acco!nt is

an acco!nt from which f!nds can be withdrawn at any time by chec- orcashwithdrawal

witho!t giving the ban- or financial instit!tion any prior notice. 0an-s have the legal

obligation to ret!rn f!nds held in demand deposits immediately !pon demand (or 'at

call'*. Demand deposit withdrawals can be performed in person, via chec-s or ban-

drafts, !sing a!tomatic teller machines(#Ts*, or thro!gh online ban-ing.$B?&

Commercial ban- money is created thro!gh fractional/reserve ban-ing, the ban-ing

practice where ban-s-eep only a fractionof their depositsin reserve(as cash and other

highly li)!id assets* and lend o!t the remainder, while maintaining the sim!ltaneo!s

obligation to redeem all these deposits !pon demand. $B:&$B@&Commercial ban- money

differs from commodity and fiat money in two ways, firstly it is non/physical, as its

e2istence is only reflected in the acco!nt ledgers of ban-s and other financial

instit!tions, and secondly, there is some element of ris- that the claim will not be f!lfilled

if the financial instit!tion becomes insolvent. The process of fractional/reserve ban-ing

has a c!m!lative effect of money creationby commercial ban-s, as it e2pands money
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s!pply(cash and demand deposits* beyond what it wo!ld otherwise be. 0eca!se of the

prevalence of fractional reserve ban-ing, the broad money s!pplyof most co!ntries is a

m!ltiple larger than the amo!nt of base moneycreated by the co!ntry's central ban-.

That m!ltiple (called the money m!ltiplier* is determined by the reserve re)!irementor

otherfinancial ratiore)!irements imposed by financial reg!lators.

The money s!pply of a co!ntry is !s!ally held to be the total amo!nt of c!rrency in

circ!lation pl!s the total amo!nt of chec-ing and savings deposits in the commercial

ban-s in the co!ntry. In modern economies, relatively little of the money s!pply is in

physical c!rrency. 6or e2ample, in December >;9; in the .7., of the @@AB.5 billion in

broad money s!pply (>*, only %9A.: billion (abo!t 9;* consisted of physical coins

and paper money.

Digital moneyDigital c!rrencies gained moment!m in before the >;;; tech b!bble. 6loo8and0een8were partic!larly

advertised as an alternative form of money. hile the tech b!bble ca!sed them to be short lived, many

new digital c!rrencies (s!ch asbitcoin* have reached some, albeit generally small !serbases.

onetary policy

The control of the amo!nt of money in the economy is -nown as monetary policy. onetary policy is the

process by which a government, central ban-, or monetary a!thoritymanages the money s!pplyto

achieve specific goals. s!ally the goal of monetary policy is to accommodateeconomic growthin an

environment of stable prices. odern day monetary systems are based on fiat money and are no longer

tied to the val!e of gold. # failed monetary policy can have significant detrimental effects on an economy

and the society that depends on it. These incl!dehyperinflation, stagflation, recession,

high !nemployment,shortages of imported goods, inability to e2port goods, and even total monetary

collapse and the adoption of a m!ch less efficient barter economy

overnments and central ban-s have ta-en both reg!latory and free

mar-etapproaches to monetary policy. 7ome of the tools !sed to control the money

s!pply incl!de3

changing the interest rateat which the central ban- loans money to (or borrows

money from* the commercial ban-s

c!rrency p!rchases or sales

increasing or lowering government borrowing

increasing or lowering government spending
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manip!lation of e2change rates

raising or lowering ban- reserve re)!irements

reg!lation or prohibition of private c!rrencies

ta2ationor ta2 brea-s on imports or e2ports of capital into a co!ntry

Market liquidity

Main article: Market liquidity

Market liquiditydescribes how easily an item can be traded for another item, or into the common c!rrency

within an economy. oney is the most li)!id asset beca!se it is !niversally recognised and accepted as

the common c!rrency. In this way, money gives cons!mers the freedomto trade goods and services

easily witho!t having to barter.

+i)!id financial instr!ments are easily tradableand have lowtransaction costs. There sho!ld be no (or

minimal*spreadbetween the prices to b!y and sell the instr!ment being !sed as money.

Methods of Note Issue

0oth the principles of, note iss!e mentioned above, have serio!s defects. The monetary e2pertsJ by

coordinating the advantages of both the principles have evolved vario!s systems or methods of

notes iss!e. The main systems of note iss!e prevalent in different co!ntries of the world are (9**


14/19

'" Minimum Reserve $ystem%The proportional reserve system of note iss!e has been replaced

by minim!m reserve system in ;; million in


15/19

/owever, the representative paper money has certain disadvantages:

(a) Since gold and silver reserves are to !e maintained, these metals cannot !e put to other uses,

(!) &epresentative paper money system lac#s elasticity !ecause under this system money supply

cannot !e increased unless e$uivalent amount of metallic reserves are #ept,

(c) "t is not suita!le for the poor nations which have deficiency of gold and silver.

#. $on!erti%le Paper Money:

he paper money which is converti!le into standard coins is called converti!le paper money.

"he main characteristics of con!erti%le paper money are:

(a) he individuals can get their paper money converted into cash,

(!) he paper money is !ac#ed !y gold and silver reserves. ut, on the assumption that all the

currency notes are not simultaneously presented !y the pu!lic for encashment, the value of metallic

reserves is less than the value of the notes issued,

(c) he reserves comprise of (i) metallic portion containing gold, silver and standard coins, and (ii)

fiduciary portion containing approved securities.

(d) Generally, the pu!lic gets gold and silver in exchange for paper money for ma#ing foreign

payments.

"he main ad!antages of the con!erti%le paper money are:

(a) "t economises the use of valua!le metals.

(!) "t is flexi!le !ecause money supply can !e increased without maintaining cent per cent metallic

reserves.

(c) "t inspires pu!lic confidence !ecause paper money is converti!le into standard coins,

(d) "t facilitates foreign trade !ecause paper money is converted into gold and silver to ma#e foreignpayments.

"he disad!antages of the con!erti%le paper money are:

(a) Since the paper currency under this system is not cent per cent !ac#ed !y gold and silver, there is

a fear of over+issue of money supply and the resultant danger of inflation,


16/19

(!) he converti!le paper money does not inspire as much pu!lic confidence as the representative

paper money.

&. 'ncon!erti%le Paper Money:

he paper money which is not converti!le into standard coins or valua!le metals is calledinconverti!le paper money. 6nder the system of inconverti!le paper money, the monetary authority

maintains no metallic reserves against paper currency. "t also gives no guarantee to convert the

paper currency into gold and silver.

"he merits of incon!erti%le paper money are as follo(s:

(a) Such a paper currency system economises the use of valua!le metals,

(!) "t is also elastic in the sense that the monetary authority can change money supply according to

the needs of the economy without #eeping proportionate metallic reserves.

"he in)con!erti%le paper money also has the follo(ing demerits:

(a) he danger of paper currency, leading to inflation, always exists in this system,

(!) "t inspires less pu!lic confidence than a system of representative paper money.

4. *iat money

1iat money is only a variety of inconverti!le paper money. 1iat money is !ac#ed neither !y the

metallic nor the fiduciary reserves. "n other words, the monetary authority gives no guarantee to

convert fiat money into valua!le metals. 8ccording to 9eynes, 1iat money is &epresentative (or,

o#en) Money (i.e., something the intrinsic value of the material su!stance of which is divorced from

its monetary face value) now generally made of paper except in the case of small denominations +

which is created and issued !y the State, !ut is not converti!le !y law into anything other than itself

and has no fixed value in terms of an o!ective standard.

4 essential functions of money

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