Money and its concepts

Module 1
 Definitions of Money
There is no commonly acceptable definition of money
Some define money as anything acceptable as
payment of goods and services or in settlement of
debt.
Some say money is anything that performs the
function of medium of exchange, measure of value
and store of value .
Harry G Johnson has given four approaches to define
the concept of money :
 Approaches of money
Approaches

Central Banking
Conventional Chicago Gurley and
or Redcliffe
Approach Approach Shaw Approach
Approach
1. Conventional Approach
In this approach money is defined on the basis of its
functions. “ Money is what money does.”
In words of R P Kent, “ Money is anything that is
commonly used and generally accepted as a medium of
exchange or as a standard of value.”
Geoffrey Crowther says, “ Money can be defined as
anything that is generally acceptable as a mean of
exchange and at the same time acts as a measure and store
of value.”
Gist of this definition: Money= Notes +coins + Demand
Deposits
2. Chicago Approach
Given by Nobel Laureate Friedman. He says, “ Money
is temporary abode of purchasing power.”
In monetary economy, every transaction has two
aspects: sale and purchase. It is essential to hold
purchasing power in terms of money till such time the
transaction is performed.
So Money= Currency+ Demand Deposit+ Time
Deposit
This definition widened the scope of concept of
money
3. Gurley and Shaw Approach
This approach says money should include all
instruments which are close substitute of each other.
So Money= Currency+ DD +TD +Saving Bank Deposit
+Shares +Bonds +……..
Credit instruments issued by financial intermediaries
–banking and non-banking and thrift societies like
LIC, Saving Bank etc have high quality of liquidity. So
these should be also included in money.
4. Central Banking or Redcliffe Approach
This approach also includes credit in the definition of
money. So credit extended by NBFI including
unorganized institutions is also included in definition
of money.
Money= Currency+ DD+ TD+ Saving Deposit+
Shares+ Bonds+ Securities+ Credit from unorganized
sector
Characteristics of Money
General acceptability
Voluntary Acceptability
Medium of Exchange
Money is a mean not an end
Government control
Liquid Asset
Money is not a veil
Functions of Money
Primary

Secondary

Contingent

Static and Dynamic

 Functions of money
Primary Functions Secondary Functions
Medium of Standard of
Exchange Deferred Payments
Measure of Value Store of Value
Transfer of value
 Functions of Money
Contingent Functions Static and Dynamic Functions
 Basis of Credit Creation Static Functions
 Maximum Satisfaction Dynamic functions
 Distribution of National
Income
 Bearer of option
 Guarantee of Solvency
 Increase in the liquidity of
capital
 Importance of Money
Direct importance in the
Indirect importance in the
field of Economics field of Economics

 In consumption Freedom from barter

 In production Solution of Central Economic
 In exchange problems
 In trade Basis of Credit
 In distribution Index of Economic
 In public finance Development
 Capital formation Increase in mobility of capital
Measure of social welfare
National and international
unity
 Disadvantages of Money
Economic Evils Social Evils
 Instability of value Encourages materialism
 Trade cycles Tendency of Exploitation
 Over- Capitalization Increase in immoral
 Economic wastage tendencies
 Unequal distribution of
wealth
 Problem of black money
Difficulties of Barter system
Absence of double coincidence of wants
No standard of measurement
Absence of subdivision
Difficulty of storage
 Role of money
A money is a function of a medium, a measure, a
standard and a store of value.
There are four major role of money:
 It acts as a medium of exchange
 It helps in measuring the value of goods and
services
 It is a generally or globally accepted standards
of payments in return for goods and services
and for deferred payments.
 The value of money can be stored and used by
the holder for future requirements.
Simile of money
Cash
Currency
Income
Profit
Wealth Wage
Funds Property
Finance Financial Resources
Capital
Riches
Credit
Treasure
Payment
Gold and silver
Salary
Equity
 Crypto currency
A crypto currency (or crypto currency) is a digital
asset designed to work as a medium of exchange that
uses strong cryptography to secure financial
transactions, control the creation of additional units,
and verify the transfer of assets. Crypto currencies are
a kind of alternative currency and digital currency (of
which virtual currency is a subset). Crypto currencies
use decentralized control as opposed to centralized
digital currency and central banking systems. 
Theories of money (value of money)
Quantity theory of money and prices
Fishcer’s transactions approach
The Cambridge cash balance approach
Friedman’s quantity theory of money and prices
Keynesian theory of money and prices
How is the general price level determined? Why
does price level change? Classical or pre- Keynesian
economists answered all these questions in terms of
quantity theory of money.
Quantity theory of money and prices

= 1 Rupee

= 73. 14Rupee
 Country KUWAIT USA INDIA VIETNAM IRAN

Vietnamese
Currency Kuwait Dinar US Dollar Indian Rupee Dong Iranian Rial

Symbol

76,899.77 1,38,630.97
Value 1 KWD 3.29 USD INR 240.80
VND IRR

Cost of 1 Loaf
bread 0.28 KWD 1.32 USD Rs. 26 13603.47 33501.06

Cost of 1 gm 12.05 39.67 Rs. 3280 894064.36 1681720.56

Gold
Qty of Qty of
money money

& &

Value of
money Prices
Relationship
between

 Value of money and quantity of money is inverse

o When value of money is more; quantity of money is less.
o When value of money is less; quantity of money is more.
 Prices and quantity of money is direct
o When price of the product increases; quantity of money
increases.
o When price of the product decreases; quantity of money
decreases.
 Graphical
Representation
 Quantity
theory of
money and
prices

Transactional

Sophisticated crude
Crude version (18th century, David Humes and Adam
Smith)
M = kP, or P = I/kM, where P= Money
supply or price; M = Quantity of money
and k = constant proportionality.
 Crude Quantity Theory of Money is that the
price level is strictly proportional to
the money supply. In other words, the Crude
Quantity Theory taught that an x percent
increase in money supply will lead to an x
percent increase in the price level.
 If, for example, k is 3, M is three times the price
level.
Sophisticated version
P = f(M) – functional approach
Transactional approach of money and
prices
 Irving Fisher proposed this theory called as Fisher’s theory of
money and prices in his book ‘the purchasing power of
money – its determination and relation to credit interest and
crises.
 Simple exchange of equation = M x V= P X Y
Fisher has explained his theory in terms of his equation of
exchange:
 PT=MV+ M V
 Where
 P = price level, or 1 /P = the value of money;
 M = the total quantity of legal tender money;
 V = the velocity of circulation of M;
 M = the total quantity of credit money;
 V = the velocity of circulation of M;
 T = the total amount of goods and services exchanged
 MV= PY

Total amount of goods

Prices of goods
Velocity of money

Quantity of money
 MV PT

Supply of money Demand of money

 Unchanged

MV M’V’ PT

Bank deposits

Supply of money = demand for money

 Assumptions
Constant velocity of Money
Constant volume of trade and transactions
Price level is a passive factor
Money is only medium of exchange
Constant relationship between M and M’
Long period
 Conclusion
Demand of money

Supply of money

Changes in the price level

Monetary policies
 Criticism of Fisher’s theory
1. Interdependence of the variables
2. Unreal assumptions of long period
3. Unreal assumptions of full employment
4. Static theory
5. Truism – MV = PT
6. It fails to explain trade cycle
7. Ignores other determinants of price level
8. No integration of monetary theory with price theory
9. It ignores money as a store of value
10. No discussion of velocity of money.
11. One sided theory
12. No direct proportionate relationship between M and P
Cambridge Cash Balance Approach
 As an alternative to Fisher’s quantity theory of money,
Marshall, Pigou, Robertson, Keynes, etc. at the Cambridge
University formulated the Cambridge cash-balance approach.
 Fisher’s transactions approach emphasized the medium of
exchange functions of money. The level of transactions
generated by
 The level of nominal income (PY)
 On the other hand, the Cambridge cash-balance approach
was based on the store of value function of money.
 According to cash-balance approach, the demand for money
and supply of money determine the value of money. This
approach, considers the demand for money and supply of
money at a particular moment of time.
Since, at a particular moment the supply
of money is fixed, it is the demand for
money which largely accounts for the
changes in the price level.
As such, the cash-balance approach is also
called the demand theory of money.

Store of value

Demand for money Transaction

They argued that a certain portion of the
money supply will not be used for
transactions; instead, it will be held for the
convenience and security of having cash on
hand. This portion of cash is commonly
represented as k, a portion of nominal income
(P. Y).

The Cambridge equation is thus:

 Second: Keynes’s Theory of Money:
Liquidity Preference Theory
 • In 1936, economist John M. Keynes wrote his influential
book- The General Theory of Employment, Interest Rates,
and Money.
 In this book, he developed his theory of money demand,
known as the liquidity preference theory, which is a theory
of
 money demand that emphasized the importance of interest
rate.
 Keynes rejected the classical view that velocity was a
constant.
 In his theory, Keynes believed that there are three motives
for individuals to hold money: the transaction motive, the
precautionary motive, and the speculative motive.
Transaction Motive: Keynes agreed with the classical
theory that money is used as a medium of exchange. So
people’s demand for money is for the purpose of transactions;
and as income rises, people have more transactions and will
hold more money.
Precautionary Motive: In addition to holding money to
carry out current transactions, Keynes observed people hold
money to be used in future for unexpected needs and
emergencies.
Since the amount of money held depends on the amount of
transactions people expect to make, money demand is again
expected to rise with income.
Speculative Motive
 Keynes suggested that people also hold money as a store of
wealth.
 Because wealth is tied closely to income, the speculative
motive for money demand is related to income.
 Keynes assumed that people stored wealth with either money
or bonds.
Keynes modeled money demand as the demand for
the real quantity of money (real balances) (M/P) .
In other words, if prices double, you must hold twice
the amount of M to buy the same amount of items, but
your real balances stay the same.
So people choose a certain amount of real balances
based on the interest rate, and income.
 Following the publication of Keynes’s the General Theory of
Employment, Interest and Money in 1936 economists discarded
the traditional quantity theory of money. But at the University
of Chicago “the quantity theory continued to be a central and
vigorous part of the oral tradition throughout the 1930s and 1940s.”
 At Chicago, Milton Friedman, Henry Simons, Lloyd Mints, Frank
Knight and Jacob Viner taught and developed ‘a more subtle and
relevant version’ of the quantity theory of money in its theoretical
form “in which the quantity theory was connected and integrated
with general price theory.” The foremost exponent of the Chicago
version of the quantity theory of money who led to the so-called
“Monetarist Revolution” is Professor Friedman. He, in his essay
“The Quantity Theory of Money—A Restatement” published in
1956′, set down a particular model of quantity theory of money. 
 Friedman‘s restatement of the
quantitative theory
Friedman’s Modern Quantity Theory of Money
According to Friedman, total income (Y) is
explained by nominal wealth (W) and the returns
(r) that it generates. Explicitly:

Y = Wr.

If wealth and returns are estimated via

expectations of lifelong streams, then Y is really
permanent income. According to the quantity
theory, money demand is proportional to the
value of nominal transactions, which should be a
function of permanent income.
Restatement, Continued
This implies that the cash balances “constant” k, or
equivalently, the circular velocity of money V in
MV=Py, is really a (stable) function of a few well-
defined variables.
 
Interpretation: Over any reasonable period of time, the
rates of return in this function will all move together
(in “lock-step”). That is, the yield curve maintains a
constant shape, even though it may shift up or down.
Thus, substitutions among assets are not likely to take
place except on the very short run. Therefore, f and k
are quite stable, so that the results of the traditional
quantity theory still obtain.
Criticism
 Friedman’s reformulation of the quantity theory of money has
evoked much controversy and has led to empirical verification
on the part of the Keynesians and the Monetarists. Some of
the criticisms leveled against the theory are discussed as
under.
 Very Broad Definition of Money
 Money not a Luxury Good
 More Importance to Wealth Variables
 Money Supply not Exogenous
 Ignores the Effect of Other Variables on Money Supply
 Does not consider Time Factor
 No Positive Correlation between Money Supply and
Money GNP
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