Meaning of Money

Money is defined as something that is generally accepted by society as a medium of

exchange and which can act as a unit of account, a store of value, and be used for
repayment of debt. Money developed as a better alternative to the barter system of trade
that had existed across the world since ancient times.

Money is an economic unit that functions as a generally recognized medium of exchange for
transactional purposes in an economy. Money provides the service of reducing transaction
cost, namely the double coincidence of wants. Money originates in the form of a commodity,
having a physical property to be adopted by market participants as a medium of exchange.

Money is commonly referred to as currency. Economically, each government has its own
money system. Crypto currencies are also being developed for financing and international
exchange across the world.

Money is a liquid asset used in the settlement of transactions. It functions based on the
general acceptance of its value within a governmental economy and internationally through
foreign exchange. The current value of monetary currency is not necessarily derived from the
materials used to produce the note or coin. Instead, value is derived from the willingness to
agree to a displayed value and rely on it for use in future transactions. This is money's
primary function: a generally recognized medium of exchange that people and global
economies intend to hold, and are willing to accept as payment for current or future
transactions.

“Money is a matter of functions for a medium, a measure, a standard, a store.”

Money is anything that is generally accepted as a medium of exchange, a store of value, a

measure of value, and a means for the standard of deferred payment. Money considers
everything that can be used for an accomplishment of a business transaction and settlement of
the business claims, like currency notes, coins, cheques, etc. There is not just one definition
of money, instead, it can be defined legally, functionally, based on liquidity, and based on
scope.
Major Functions of Money

The main functions of money in a modern economy can be seen as follows:

 Medium of Exchange: The primary and unique function of money is to serve as a

medium of exchange. It resolves the issue of double coincidence of wants and
facilitates economic exchanges with ease.

The use of money facilitates exchange, exchange promotes specialisation Increases

productivity and efficiency a good monetary system is, therefore, of immense utility
to human society. Money is also called a bearer of options or generalised purchasing
power because it provides freedom of choice to buy things he wants most from those
who offer best bargain.

 Unit of Account: Money is the common standard for measuring the relative worth of
goods and services. This makes it easier to compare values and setting prices.

Money serves as a unit of account or a measure of value. Money is the measuring rod,
i.e., it is the units in terms of which the values of other goods and services are
measured in money terms and expressed accordingly Different goods produced in the
country are measured in different units like cloth m metres, milk in litres and sugar in
kilograms.
Without a common unit, exchange of goods becomes very difficult Values of all
goods and services can be expressed easily in a single unit called money Again
without a measure of value, there can be no pricing process. Without a pricing process
organised marketing and production is not possible. Thus, the use of money as a
measure of value is the basis of specialised production.

 Store of Value: Money also serves as a store of value. People can hold their wealth in
the form of money. Money provides a liquid store of value because it is easy to spend
and store. Wealth can be stored in terms of money for future. It serves as a store value
of goods in liquid form. By spending it, we can get any commodity in future. Keynes
places great emphasis on this function of money. Holding money is equivalent to
keeping a reserve of liquid assets because it can be easily converted into other things.

 Standard of Deferred Payments: Money facilitates transactions that are not settled
immediately but require a future payment. Deferred payments are payments which are
 made some time in the future. Debts are usually expressed in terms of the money of
account. Loans are taken and repaid in terms of money.

 Means of Payment: Money is used to settle debts and pay for obligations, including
taxes, fees, and fines.

Types of Money

Economies across the world make use of various forms of money as can be seen below:

1. Commodity Money

Commodity money is that type of money that possesses intrinsic value of its own,
independent of any governing body. This means the money itself contains a worth.
Numerous commodities such as gold, silver, copper, chocolate beans, etc, have been used as
Commodity Money.

2. Metallic Money

Metallic Money refers to money that is made up of pure and superior metals like gold and
silver. Convenience, storability, high-value density, and easy portability led metallic money
to take the place of commodity money.

3. Paper Money

Paper money consists of currency notes issued by the government or the central bank of a
country.

4. Fiat Money

 Fiat Money refers to Government-issued money, not backed by any physical

commodity like gold and silver, but by the Government that issued it.

o This type of money does not have any intrinsic value as such. Rather, they
derive their value from the guarantee provided by the issuing authority.

 Currency notes and coins in India are examples of fiat money.

o In India, every currency note and coin bears on its face, a promise from
the Governor of RBI that if someone produces them to RBI or any other
 commercial bank, RBI will be responsible for giving the person purchasing
power equal to the value printed on them.

 Fiat Money is also called legal tenders as they cannot be refused by any citizen of the
country for settlement of any kind of transaction.

o Cheques drawn on savings or current accounts and Demand Deposits

(DD) are not legal tenders as they can be refused by anyone as a mode of
payment.

5. Bank Money or Credit Money

 Bank Money or Credit Money refers to money held in the form of demand deposits
with commercial banks.

 Demand deposits of banks are withdrawable through cheques. However, a cheque by

itself is not money, it is only a credit instrument that is used and accepted as a
medium of exchange.

o Therefore, credit money is regarded as ‘near money’.

6. Plastic Money

Plastic money is a term that is used predominantly in reference to the hard plastic cards in
place of actual bank notes. They can come in many different forms such as cash cards, credit
cards, debit cards, etc.

7. Helicopter Money or Helicopter Drop

 Helicopter Money or Helicopter Drop refers to increasing the supply of money in an

economy through measures such as more spending, tax cuts, etc.

 It is, basically, an expansionary fiscal or monetary policy that involves printing large
sums of money and distributing it to the public in order to stimulate the economy.

 The term ‘Helicopter Drop’ was coined by the American economist Milton Friedman
in 1969.

8. Digital Money or Electronic Money

 Digital Money or Electronic Money refers to any means of payment that exists in a
purely electronic form.

 Unlike other forms of money, Digital Money is not physically tangible.

 At present, this form of money is increasingly becoming prevalent with the rise of
online banking and digital wallets.
Money Supply
The total money held by the public of a country at a specific point of time is known
as Money Supply. It consists of both cash and deposits that can be easily used as cash. The
money supply of a country has a major impact on its economy. If there is a rise in the money
supply of an economy, it will be shown as a decline in interest rates and the price of goods
and services. However, if there is a decline in the money supply of an economy, it will be
shown as a rise in the interest rates and price of goods and services, along with an increase in
the bank reserves.

Money supply is a stock concept. It refers to the entire stock of money (of all types) held by
the people of a country at a point of time. Money supply includes only that stock of money
which is held by people, other than the suppliers of money themselves. In other words,
money supply refers to the stock of money held by the public or those who demand money.

Money supply does not include stock of money held by the government, and stock of money
held by the banking system of a country. The government and the banking system of a
country are suppliers of money or are the producers of money. Hence, money held by them is
not a part of the stock of money held by the people.

 The total stock of money in circulation among the public at a particular point in
time is called money supply or supply of money.

 It is to be noted the term ‘public’ refers to households, firms, local authorities,

companies, etc, and does not include the government and banks.

o Thus, public money does not include money held by

 the government

 the RBI (in the form of CRR), and

 the commercial banks (in the form of SLR).

 Money, forming part of the Supply of Money, can be in the following forms:

o Currency Notes and Coins (CU)

o Demand Deposits such as Saving Bank Deposits (DD) – These are those
deposits that can be withdrawn on demand from banks.
 o Other Deposits such as Time Deposits/Term Deposits/Fixed Deposits – These
are those deposits that can be withdrawn only after a specific time.

o Money held in Post Office Saving Accounts.

o Deposits of Banks in other Banks/RBI (except CRR).

Features of Money Supply: -

1. Money supply includes the money held by the public in an economy only. Here, ‘public’
means that sector of the country, which is money-using, i.e., firms and individuals. However,
it does not include the money-creating sector of a country, as the amount of money or cash
held by them does not mean the actual circulation of money in the country, The money-
creating sector of a country includes the Banking system and Government.

2. Money Supply is a Stock Concept. It means that the money supply is concerned with a
particular point of time.

Components of the Money Supply: -

Two main components of the money supply are:

1. Currency (includes coins and notes)

2. Demand deposits

1) Currency: Currency money is also known as Fiat Money, which means the money that
must be accepted for all of the debts under law. In other words, fiat money is the money
that is under the order or fiat from the government to act as money. Another name for
currency and coins with public component of M 1 is Legal Tender Money. It is because
the money can be used legally for the payment of debts and other obligations.

i. Coins: There were two types of coins – full bodied standard coins and token coin.
Under Managed Currency System that prevails these days, full-bodied standard coins
have little utility. Hence, these are no longer in circulation. Indian Rupee is neither a
full-bodied standard coin nor is it a perfect token coin. Coins o the denomination of
50paisa, 25 paisa, are token coins.
 ii. Currency Notes: The government and the central bank of the country both issue the
currency notes. In India, government issues One rupee note, while the Reserve Bank
of India issues all other currency notes.

2. Demand Deposits:

i. Demand Deposits of Commercial Banks: The second component of M1 includes the

demand deposits of the public with the commercial banks. The account holder of demand
deposits can en-cash them anytime by the issue of cheques. As the demand deposits are
readily accepted as a means of payment, they are treated as the currency held. However,
only net demand deposits are included in M 1. It means that all inter-bank deposits are
excluded from this component. Inter-bank deposits are the deposits that are held by the
banks on the behalf of other banks. As these kinds of deposits do not include money held
by the public, they are not included in the money supply.

ii. Other Deposits with Reserve Bank of India: The last component of M1 includes the
deposits held by the Reserve Bank of India on behalf of foreign governments and banks,
IMF, World Bank, Public Financial Institutions, etc. However, the deposits of commercial
banks and the Indian Government with the Reserve Bank of India are not included in this
component. ‘Other deposits with RBI’ do not play a significant role in the formation of
the monetary policy of India because it constitutes a small part of M1.

Measures of Money Supply

Till 1967-68, only the narrow measure of the money supply was used by the Reserve Bank of
India (RBI). However, since 1977, four measures of money supply have evolved in the
economy, i.e., M1, M2, M3, and M4.

1. M1

The first and basic measure of the money supply is M1, which is also known
as Transaction Money. It is called transaction money because this measure can be
directly used to make transactions. The three different components of M 1 are Currency
and coins with public, Demand deposits of Commercial Banks, and Other deposits with
RBI. All of these components can be easily used as a medium of exchange; therefore, it is
the most liquid measure of the money supply.
 M1 = Currency and coins with public + Demand deposits of commercial banks +
Other deposits with Reserve Bank of India

M1 = C + DD + OD

2. M2

The second measure of the money supply is M 2, and is a broader concept as compared to
M1. It includes M1 and savings deposits with the post office savings bank. One cannot
withdraw Savings Deposits with Post Office Saving Bank through cheque; therefore, it
cannot be included in demand deposits with the bank, resulting in the evolution of M2.

M2 = M1 + Savings Deposits with Post Office Saving Bank

3. M3

The third measure of the money supply is M 3 and is a broader concept as compared to
M1. It includes M1 and Net Time Deposits with Bank.

M3 = M1 + Net Time Deposits with Banks

4. M4

The last measure of the money supply is M4, and is a broader concept as compared to
M1 and M3. It includes M3 and Total Deposits with Post Office Saving Bank, but does not
include NSC (National Saving Certificate).

M4 = M3 + Total Deposits with Post Office Saving Bank

Important Facts related to the Measures of Money Supply

1. All four measures of money supply represent a different level or degree of liquidity.
M1 is the most liquid measure of supply, and M4 is the least liquid measure of supply.

2. M3 is also known as Aggregate Monetary Resources of the Society and is widely

used as a measure of supply.

3. M1 and M2 are usually known as Narrow Money Supply Concepts; however, M3 and
M4 are known as Broad Money Supply Concepts.
THE CONCEPT OF MONEY MULTIPLIER:
The Money Multiplier refers to how an initial deposit can lead to a bigger final increase in
the total money supply.

For example, if the commercial banks gain deposits of £1 million and this leads to a final
money supply of £10 million. The money multiplier is 10.

The money multiplier is a key element of the fractional banking system.

1. There is an initial increase in bank deposits (monetary base)

2. The bank holds a fraction of this deposit in reserves and then lends out the rest.

3. This bank loan will, in turn, be re-deposited in banks allowing a further increase in
bank lending and a further increase in the money supply.

The money supply is defined as

The Reserve Ratio:

The reserve ratio is the % of deposits that banks keep in liquid reserves.

For example 10% or 20%

Formula for money multiplier:

 In theory, we can predict the size of the money multiplier by knowing the reserve
ratio.
 If you had a reserve ratio of 5%. You would expect a money multiplier of 1/0.05 =
20. This is because if you have deposits of £1 million and a reserve ratio of 5%.
You can effectively lend out £20 million.
Using the Reserve ratio to influence monetary policy:

In theory, if a Central Bank demands a higher reserve ratio – it should have the effect of
acting like deflationary monetary policy. A higher reserve ratio should reduce bank
lending and therefore reduce the money supply.

Money Multiplier in the real world:

In a simple theory of the money multiplier, it is assumed that if the bank lends $90 – all
of this will return. However, in the real world, there are many reasons why the actual
money multiplier is significantly smaller than the theoretically possible money multiplier.

1. Import spending. If consumers buy imports the money leaves the economy

2. Taxes. A percentage of income will be taken in taxes.

3. Savings. Not all money is spent and circulated; a significant percentage will be saved

4. Currency Drain Ratio. This is the % of banknotes that individual consumers keep in
cash, rather than depositing in banks. If consumers deposited all their cash in banks, there
would be a bigger money multiplier. But, if people keep funds in cash then the banks
cannot lend more.

5. Bad loans. A bank may lend out $90 but the company goes bankrupt and so this is
never deposited bank into the banking system.

6. Safety reserve ratio. This is the % of deposits a bank may like to keep above the
statutory reserve ratio. i.e. the required reserve ratio may be 5%, but banks may like to
keep 5.2%.

7. It might not be possible to lend more money out. Just because banks could lend 95%
of their deposits doesn’t mean they can, even if they wanted to. In a recession, people
may not want to borrow, but they prefer to save.

8. Banks may not want to lend Also, at various times, the banks may not want to lend, e.g.
during a recession they feel firms and individuals more likely to default. Therefore, the
banks end up with a higher reserve ratio.

Therefore, due to these factors, the reserve ratio and money multiplier are theoretical.
HIGH POWERED MONEY:

The money produced by the Reserve Bank of India (RBI) and the Government is known
as High-powered Money (H). It includes Currency held by the public and Cash reserves
with the banks. High-powered Money is different from Money (M), as Money includes
currency and demand deposits of an economy; however, High-powered Money includes
cash reserves with banks and the currency of an economy. H is high-powered than Money
(M) because cash reserves with the banks serve as an actual base for demand deposit
generation of an economy.

High powered money or powerful money refers to that currency that has been issued by
the Government and Reserve Bank of India. Some portion of this currency is kept along
with the public while rest is kept as funds in Reserve Bank. Thus, we get the equation as

H=C+R

Where H = High Powered Money

C = Currency with the public (Paper money + coins)

R = Government and bank deposits with RBI

Thus the sum total of money deposited with the public and the funds of banks is termed
as powerful money. It is mainly created by the central bank. Since funds of commercial
banks play an important role in the creation of credit. so it is very important to study
about funds. Reserve Fund is of two types: (i) Statutory Reserve Funds of banks which is
with the central bank (RR) and (ii) Extra Reserve Fund(ER).

Thus H = C + RR + ER

High powered money is also known as secured money (RM) because banks keep with
them Reserve Fund(R) and on the bases of this Demand deposits (DD) are created. Since
the bases of creation of credit is Reserve Fund (R) and Ris obtained as a part of high
powered money (H) Security fund so high powered money is termed as Base money.
Components of high powered money:

As it has been mentioned earlier in this chapter, the following are the important
components which determine High Power Money:

1 Currency with the public

2. Other Deposits with RBI

3. Cash with Banks

4. Banker’s Deposits with RBI.

High powered Money (H) includes currency with Public (C), important reserves of
Commercial banks and other reserve (ER). Thus we get, the equation:

Now of Necessary reserve ratio is RRr and Necessary Reserve of Deposits ratio is RR/D
and Extra Reserve rario is ERr hen revised equation will be

Enclosed figure clears that if supply of high powered money increases AH then Hs curve
jumps up to Hs, demand and supply of high powered money is in equilibrium condition
on E. supply of money is ON when supply of high powered money goes to Hs, then new
point of equilibrium is E, and supply of money in these two OM,. From the enclosed
figure it is also clear that when high powered money increases AH then supply of money
increases to AM.

Sources of high powered money:

The following are the sources of High powered Money:

(1) Claims of Reserve Bank of India; Reserve Bank also provides loans to the
government. This loan is in the form of investment in government securities by the
Reserve Bank. After deducting the deposits of government from quantity of loan of
Reserve Bank quantity of net bank credit to government is calculated. It is also a source
of High Powered Money.

(2) Net Foreign Exchange Assets of Reserve Bank: It is the work of Reserve Bank to
make arrangement for foreign exchange funds. When Reserve Bank purchases foreign
securities by paying the money of the country, then the quantity of foreign exchange
increases which increases high powered money. On the contrary, when Reserve Bank
sells foreign securities then the quantity of foreign exchange with the central bank of the
country decreases. It results decrease in high powered money.

(3) Government’s Currency Liabilities to the Public: Finance Ministry of the Indian
Government is responsible for printing one rupee note and also for coinage. This function
is done through the government for completing money Related Responsibilities toward
the public Thus With the increase in these liabilities, quantity of supply of money will
increase and the quantity of High Powered money will also increase.

(4) Net Non-Monetary Liabilities of Reserve Bank: The non-monetary liabilities of

Reserve Bank are in the form of capital introduced in national fund and statutory fund. Its
main items are-Paid-up Capital, Reserve Fund, Provided Fund and pension fund of the
employees of Reserve Bank of India.

Non-monetary liabilities of Reserve Bank are inversely proportional to high Powered

Money i.e. with the increase in non-monetary liabilities, there will be a decrease in the
quantity of new high powered money. Thus,

H=1+2 +3 – 4

From the above discussion we get information about the source of High Powered Money
but it is also necessary to know that with the changes in these sources or factors, what
changes takes place in the supply of money etc. In fact supply of money is the result of H.
Size of H depends upon the ratio between reserve fund and deposits, and the ratio
between time deposits and demand deposit.

Importance of high powered money:

The following are the importance of High Powered Money:

(1) Base Money: Deposit of Public in a bank and expansion of credit are the base of
supply of money. That is why some economists considered it as base money.

(2) Source of changes: The direction in which change in the high power money takes
place is powered to the direction of change in the supply of money. Thus from this point
of view High Powered Money is also important.
(3) Money Multiplier: What will be money multiplier (M) is declared in economy on
the bases of High Powered Money because supply of money is far more than high power
money.

(4) Monetary Control: A Special attention is paid by the central bank of any country on
High Powered Money at the time of monetary control. Because it is a big part of total
supply of money in a country.