What is Money?

Before the development of a medium of exchange, people would barter to obtain the goods and services they needed. This is basically how it worked: two individuals each possessing a commodity the other wanted or needed would enter into an agreement to trade their goods. This early form of barter, however, does not provide the transferability and divisibility that makes trading efficient. For instance, if you have cows but need bananas, you must find someone who not only has bananas but also the desire for meat. What if you find someone who has the need for meat but no bananas and can only offer you bunnies? To get your meat, he or she must find someone who has bananas and wants bunnies. The lack of transferability of bartering for goods, as you can see, is tiring, confusing and inefficient. But that is not where the problems end: even if you find someone with whom to trade meat for bananas, you may not think a bunch of them is worth a whole cow. You would then have to devise a way to divide your cow (a messy business) and determine how many bananas you are willing to take for certain parts of your cow. To solve these problems came commodity money, which is a kind of currency based on the value of an underlying commodity. Colonialists, for example, used beaver pelts and dried corn as currency for transactions. These kinds of commodities were chosen for a number of reasons. They were widely desired and therefore valuable, but they were also durable, portable and easily stored. Another example of commodity money is the U.S. currency before 1971, which was backed by gold. Foreign governments were able to take their U.S. currency and exchange it for gold with the U.S. Federal Reserve. If we think about this relationship between money and gold, we can gain some insight into how money gains its value: like the beaver pelts and dried corn, gold is valuable purely because people want it. It is not necessarily useful - after all, you can't eat it, and it won't keep you warm at night, but the majority of people think it is beautiful, and

they know others think it is beautiful. Gold is something you can safely believe is valuable. Before 1971, gold therefore served as a physical token of what is valuable based on people's perception . Impressions Create Everything: The second type of money is fiat money, which does away with the need to represent a physical commodity and takes on its worth the same way gold did: by means of people's perception and faith. Fiat money was introduced because gold is a scarce resource and economies growing quickly couldn't always mine enough gold to back their money requirement. For a booming economy, the need for gold to give money value is extremely inefficient, especially when, as we already established, value is really created through people's perception. Fiat money, then becomes the token of people's apprehension of worth the basis for why money is created. An economy that is growing is apparently doing a good job of producing other things that are valuable to itself and to other economies. Generally, the stronger the economy, the stronger its money will be perceived (and sought after) and vice versa. But, remember, this perception, although abstract, must somehow be backed by how well the economy can produce concrete things and services that people want. That is why simply printing new money will not create wealth for a country. Money is created by a kind of a perpetual interaction between concrete things, our intangible desire for them, and our abstract faith in what has value: money is valuable because we want it, but we want it only because it can get us a desired product or service. How is it Measured? To make money more discernible for measurement purposes, they have separated it into three categories: M1 This category of money includes all physical denominations of coins and currency, demand deposits , which are checking accounts and now accounts, and travelers' checks. This category of money is the narrowest of the three and can be better visualized as the money used to make payments.

M2 With broader criteria, this category adds all the money found in M1 to all time-related deposits, savings deposits, and noninstitutional money-market funds. This category represents money that can be readily transferred into cash. M3 The broadest class of money, M3 combines all money found in the M2 definition and adds to it all large time deposits, institutional money-market funds, short-term repurchase aggrements, along with other larger liquid assets.

By adding these three categories together, we arrive at a country's money supply, or total amount of money within an economy. How Money is Created: Now that we've discussed why and how money, a representation of perceived value, is created in the economy, we need to touch on how the central bank (the Federal reserves in the U.S.) can manipulate the money supply. Among other things, a central bank has the ability to influence the level of a country's money supply. Let's look at a simplified example of how this is done. If it wants to increase the amount of money in circulation, the central bank can, of course, simply print it, but as we learned, the physical bills are only a small part of the money supply. Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market. When the central bank buys these government securities, it puts money in the hands of the public. How does a central bank such as the Federal Reserve pay for this? As strange as it sounds, they simply create the money out of thin air and transfer it to those people selling the securities! To shrink the money supply, the central bank does the opposite and sells government securities. The money with which the buyer pays the central bank is essentially taken out of circulation. Keep in mind that we are generalizing in this example to keep things simple.

Different Approaches:

The concept of money is very difficult to define. It belongs to the category of things which are not amenable to any single definition. It is so partly because in the economy money performs not one but four important functions each providing a criterion of moneyless and partly because these criteria are satisfied in different degrees by different assets. Since moneyless is at best a matter of degree, it is possible to draw only an arbitrary dividing line between money and other non- money assets. Money is only one of many kinds of financial assets which consumers, government and business firms hold in their asset portfolios.

Money performs four essential functions as a unit of account, a medium of exchange, a store of value and a standard of deferred payments and other goods perform one or two but not all the monetary functions in the economy. The following discussions set out the four different approaches to the definition of money: 1. Conventional Approach: The conventional approach to the definition of money is the oldest approach. According to this approach, the most important function of money in society is to act as a medium of exchange. Money is what money does. It pays for all the goods and services transacted in the community. Consequently anything is money which functions generally as a medium of exchange in the economy. According to Hawtrey, money is one of those concepts which are definable primarily by the purpose which they serve. Following this approach, Crowther has stated that money is anything that is generally acceptable as a means of exchange (i.e. as a means of settling debts) and, at the same time, acts as a measure and store of value.

Defined on the basis of its functions as a medium of exchange, a nations total stock of money would comprise those things which are generally accepted as the means of payment. This definition of money includes only the currency and the demand deposits in commercial banks as constituting the supply of money i.e. M=C+D. It excludes the time deposits in commercial banks and postal saving deposits. The reason for excluding the time deposits from aggregate money supply is that such deposits must be converted into either currency or demand deposits before these can be spent. Many other assets like short-term treasury securities, savings bonds etc. possess high liquidity in as much as these can be converted into cash or demand deposits with little loss or risk. 2. Chicago Approach: The Chicago Approach to the concept of money is associated with the views of Prof. Milton Friedman and other monetary theorists of the University of Chicago. The Chicago economists have adopted a broader definition of money by including in it besides the currency and chequable or demand deposits, the commercial bank time depositsfixed interest-bearing deposits placed with the commercial banks. Obviously the Chicago Approach to the definition of money conflicts with the conventional approach to the definition of money since commercial bank time deposits are not directly spendable; these do not function as a medium of exchange. For example, if a man owns a fixed time deposit receipt worth Rs. 2000 in commercial bank and wants to use it to buy a TV, he must first exchange his time deposit for currency or demand deposit which can be used to make payment for the purchase of TV. The economists of the Chicago School have advanced two reasons for including time deposits placed with the commercial banks in their definition of money.

First, national income highly correlated with money as they have defined it than with money when it is alternatively defined. Since changes in the money supply bring about predictable changes in national income, their definition comes very close to satisfying the empirical criterion of putting the monitory theory in a good light. Second, the Chicago Approach is based on the theoretical criterion of including in the definition of a single commodity all those things which are perfect substitutes for each other. It is argued by the supporters of the Chicago Approach that commercial bank time deposits are very close substitutes for currency and demand deposits. In practice, time deposits are almost as readily available for spending as are demand deposits or currency since most banks make time deposits available to their customers on demand, although they may require a waiting period of some 30 to 60 days. Consequently, it is better to treat the time deposits in banks as if these were perfect substitutes for currency and demand deposits rather than not to treat them so. 3. Gurley and Shaw Approach: According to John Gurley and Edward Shaw approach, currency and demand deposits are just two among the many claims against financial intermediaries. They emphasise the close substitution relationship between currency, demand deposits, and commercial bank time deposits, saving bank deposits, credit institutions shares and bonds etc. all of which are regarded as alternative liquid stores of value by the public. The Gurley and Shaw approach to the definition of money is akin to the Chicago approach in its objective. Both the approaches include in money the means of payment and those assets which are close substitutes for the means of payment. Despite this similarity, the Gurley and Shaw approach is, however, different from the Chicago approach in its analysis.

Unlike the Chicago approach which considers only time deposits of commercial banks as being close substitutes for the means of payment, the Gurley and Shaw approach includes in the list of close substitutes for the means of payment the deposits of and the claims against all types of financial intermediaries. 4. Central Bank Approach: This approach which has been favoured by the Central Banking authorities, take the broadest possible view of money as though it were synonymous with credit funds lent to the borrowers. The supporters of the Central Bank approach have agreed that similarity between money and other means of financing purchases justifies the use of much broader concept of money, measurable or unmeasurable. Money is identified with the credit extended by a wide variety of sources. The reason for identifying money with credit used in the broadest possible sense of the term lies in the Central Banks historic position that total credit availability constitutes the key variable for regulating the economy.