AFC 301: Principles and Practices of banking

Chapter 2
Money and the Payment System

Definition of Money

Money is certainly a “complex concept”. Money is known and recognized by everyone. Money is
the generally acceptable medium of exchange. Different economists defined money in different
ways, such as,

i. "Money is what money does."- Francis Walker.

ii. Money is "anything that is generally acceptable as a means of exchange (i.e., as a means
of setting debts) and that at the same time acts as a measure and a store of value.” -
Crowther.
iii. Money is “anything which is widely accepted in payment for goods, or in discharge of
other kinds of business obligation.” – D. H. Robertson.
iv. Money is “one thing that possesses general acceptability.” – E. R. A. Seligman.

Money is anything that is generally acceptable as a means of payment in the settlement of all
transactions, including debt.

General acceptability as a means of payment or as a medium of exchange is the unique feature of

money.

Money is any good that is widely used and accepted in transactions involving the transfer of goods
and services from one person to another.

Chronological Development of Money

Development of money has passed through various stages in accordance with time, place and
circumstances with the progress of economic civilization of mankind. Economists have recognized
five such stages in the evolution of money.

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(i) Animal money
In the early days of civilization in the primitive farming communities’ money took the
form of animals. Domestic animals like cows, sheep, goats, etc. were used as money.
Cattle occupy a place of pride as wealth.
(ii) Commodity money
In the earliest period of human civilization, any commodity that was generally
demanded and chosen by common consent was used as money. Goods like furs, skins,
salt, rice, wheat, utensils, weapons etc. were commonly used as money. Such exchange
of goods for goods was known as ‘Barter Exchange’. The particular commodity chosen
to serve as money depends upon various factors like location, environment, cultural and
economic standard of the community.
(iii) Metallic money
With progress of human civilization, commodity money changed into metallic money.
Metals like gold, silver, copper, bronze, etc. were used as they could be easily handled
and their quantity can be easily ascertained. It was the main form of money throughout
the major portion of recorded history.
(iv) Paper money
It was found inconvenient as well as dangerous to carry gold and silver coins from place
to place. So, invention of paper money marked a very important stage in the
development of money. Paper money is regulated and controlled by Central bank of the
country (Bangladesh Bank in Bangladesh). At present, a very large part of money
consists mainly of currency notes or paper money issued by the central bank.
(v) Credit money
Emergence of credit money took place almost side by side with that of paper money.
People keep a part of their cash as deposits with banks, which they can withdraw at their
convenience through cheques. The cheque (known as credit money or bank money),
itself, is not money, but it performs the same functions as money. Credit cards and Debit
cards are also a form of credit money which are also known as plastic money.

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Functions of Money

Static functions:

The functions of money can be summed up in the following couplet:

"Money is a matter of functions four

A medium, a measure, a standard and a store".

1. Medium of exchange: Money allows goods and services to be traded without the need
for a barter system. Barter systems rely on there being a double coincidence of wants
between the two people involved in an exchange.
2. Measure of value/Unit of account: This refers to anything that allows the value of
something to be expressed in an understandable way, and in a way that allows the value
of items to be compared.
3. Standard of deferred payment: This refers to the expressing of the value of a debt i.e.
if people borrow today, then they can pay back their loan in the future in a way that is
acceptable to the person who made the loan.
4. Store of value: This can refer to any asset whose “value” can be used now or used in the
future i.e., its value can be retrieved at a later date. This means that people can save now
to fund spending at a later date. People want to keep a part of their assets fully liquid for
the uncertain future. Money is hundred percent liquid.

Dynamic Functions:

 Money activated idle resources and puts them into productive channels.
 It thus, helps in increasing output, employment and income.
 It helps to measure national income and distribute national income into different factors of
production.
 It helps in converting savings into investment.
 Through the creation of new money, governments of modern economies can spend more
than what they can.

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  Money makes social and economic intimacy among different persons in social life. As a
medium of exchange, it helps people do some work which are not commercial. For
example, gift, fine, tax, wedding festival etc.

Classification/ forms/ Types of Money

A. Natural Money: Money is of different natures. Again, different countries have different
natures of money. Natural money is of two forms:

1. Real/Actual money: The money by which day to day transactions are done is called
real/actual money. For example, Dollar, Taka, Rupee, metallic money etc.

2. Account money: It is the name of money by which accounts are kept. Each country's money
has name by which all accounts and records are made. This name is called account money. For
example, Taka in Bangladesh, Dollar in USA, Rupee in India etc.

Real/Actual money is divided into two classes.

(a) Metallic money: Money made of metal is called metallic money. It is of two types.

(i) Full-bodied/Standard money: The money whose face value is equal to its
intrinsic value, i.e., worth of metallic content is called full-bodied/ standard
money. In the past, coins made from silver and gold were regarded as standard
money and the system was called gold and silver standard.
(ii) Token money: This money refers to a coin which face value is more than its
intrinsic value. These coins are made of cheap metals, like, nickel, copper,
bronze, etc. For example, coins of 5, 10, 25, and 50 paisa, 1, 2, and 5 taka coins
in Bangladesh.

(b) Paper money: Paper money consists of currency notes issued by the financial authority
of central bank of the country. It has no intrinsic value. It is of four kinds.

(i) Representative Paper money: This type of money consists of notes issued
against the equivalent amount of gold, silver or foreign currency reserve.

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 This money can be issued by the government himself or by the financial
authority or central bank on behalf of the government.
(ii) Convertible paper money: The money in exchange of which the
government is compelled to give equal amount of gold, silver or other
metallic money is called convertible paper money. The commitment written
on the money implies its convertible character. For example, 10 to 1000
Taka notes of Bangladesh.
(iii) Inconvertible/Fiat money: The money which is circulated only by the
formal order of the government and for which no metal or foreign currency
are paid is called inconvertible/fiat money. For example, 1, 2 and 5 Taka
notes of Bangladesh.
(iv) Managed money: Lord Keynes has advocated it. The money which is
circulated by the government or central bank to achieve certain objectives
like stabilizing price level, reducing unemployment etc. is called managed
money. This is both of convertible and inconvertible in nature.

B. Legal money: From the legal viewpoint, money is divided into two classes.

1. Legal tender money: Money circulated under government law and people are compelled
to accept as a medium of exchange is called legal tender money. It is of two types.

(iii) Limited legal tender: The money more than certain amount of which is not
compelled to accept by the people legally is called limited legal tender. For
example, coins of 5, 10, 25 and 50 paisa of Bangladesh. People are not
compelled to accept these coins more than 10 Taka.
(iv) Unlimited legal tender: The money by which transaction of any value can be
done and people are compelled to accept any quantity legally is termed as
unlimited legal tender. For example, notes of 1 to 1000 Taka of Bangladesh.

2. Optional/Near money: If the acceptance of money is not compulsive and it depends only
on the will of the people then it is termed as optional/near money. It may be classified into two
classes.

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 (v) Bank/Credit money: It denotes cheques, bank draft, pay order, etc. issued by
the banking institutions.
(vi) Other optional money: In this category we include postal order, prize bond,
treasury bill etc.

Characteristics of a good money

1. General Acceptability
An important quality of money is its acceptance. Good money requires acceptance to all
without any hesitation. Since the law declares Money as the legal tender, it has an inherent
quality of general acceptability. Money has no utility of its own. Mainly it is used as a
medium of exchange. So, it must be made from such thing which is acceptable to all.
2. Portability
Apart from its acceptance, good money also requires portability. If people can carry or
transfer money from one place to another, then it is good money. The things which are of
small volume and higher value should be used for money. For this objective paper money
has been introduced in modern economy.
3. Durability
Acceptance and portability aside, the material used to make money must last for a long
time without losing its value. For example, ice and fruits are not good money since they
lose their value quickly with the passage of time. After all, ice melts and fruits perish.
Therefore, durability is an essential quality of good money. Money should be made from
strong paper with higher stability.
4. Divisibility
Talking about the qualities of good money, it is important to remember the divisibility of
money. If someone wants to buy a smaller unit of a commodity, then divisibility of money
can make it possible. For example, cows cannot function as good money. This is because
one cannot divide a cow without making it lose its value.
5. Homogeneity
Look at two 100 taka notes. They look and feel identical, right? They also have the same
value. In fact, nobody can distinguish between two currency notes right out of the mint.

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 This is an important quality of good money – homogeneity. If money is not homogeneous,
then transactions will become uncertain as people would be unsure of what they are
receiving.
6. Cognisibility
The ability to recognize money is critically important. Today, we can look at a currency
note and tell its value. If money is not cognizable, then people can find it difficult to
determine if they are dealing with money or some inferior asset.
7. Stability
Of all the qualities of good money, stability is probably the most essential one. The value
of money cannot change for a long period of time and hence remain stable. If the value of
money keeps changing, then it will fail to function as a measure of value and as a standard
of deferred payment.
8. Malleability
Things should be malleable which will be used for money. Because melting is essential for
shaping and marking activities.
9. Decimal coinage system
For easy and rapid transaction and exchange money should be based on decimal coinage
system. It is an international system.

Differences between Money and Near Money

The key difference between money and near money is their immediate availability and direct use
as a medium of exchange. Money is a medium of exchange that can be used directly to purchase
goods and services. Near money is assets that are easily convertible to cash, but require some time
or effort to do so and are not directly used as a medium of exchange.

Table: Differences between Money and Near Money

Basis of comparison Money Near money
Anything widely accepted as a Assets that are easily
medium of exchange, unit of convertible to cash but are not
1. Definition
account, and store of value. directly used as a medium of
exchange.

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 Cash, coins, checks, and bank Savings accounts, bill of
2. Examples deposits exchange, bond, time
deposits, share etc.

Highly liquid and can be used Highly liquid, but requires

3. Liquidity immediately for transactions. some time or effort to convert
to cash and use for
transactions.
Money is the legal tender. In case of near money, the
4. Legal tender assets do not have any similar
legal status.
Money is directly used for while as near money is an
5. Direct use making any live transaction. indirect medium of exchange
of transactions.

Money is not an income near money assets are income

6. Income
yielding asset. yielding assets.

Difference between Narrow Money and Broad Money

Some differences between narrow money and broad money are drawn in the following table.

Narrow money Broad money

1. Sum of currency with the people and 1. Sum of currency with people and demand
demand deposit in commercial banks is termed and term deposits in commercial banks is
as narrow money. called as broad money.

2. Equation or narrow money is: 2. Equation of broad money is:

MN = C + D MB = C + D + T
Where, MN, C and D stand for supply of ⸫ MB = MN + T
narrow money, currency with people and Where, MB and T imply broad money and term
demand deposit respectively. deposit respectively.

3. Narrow money can be used as a medium of 3. Term deposit of broad money cannot be used
exchange in any time. freely as a medium of exchange.

4. Conversion of narrow money into cash flow 4. Term deposit needs time to be converted into
does not face any problem. cash and there occurs money spent.

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 5. Narrow money is highly liquid. So, it is 5. It is less liquid than narrow money.
more popular than broad money in institutional
and functional purposes.
6. It is less related with national income. 6. It is more related with national income and
for this it is preferable in making financial
policies and planning.

Black Money

Black money is a great problem in the economy. It is mainly associated with income and property
taxes. An individual or institution has to pay property or income tax if the amount of property or
income exceeds a certain limit. This limit is termed as "exemption limit". Many individuals or
institutions do not place their account of assets to the authority to bypass the income or property
tax. This unaccounted income or property is called black income or black property and money
value of it is termed as black money.

So, we can say if any individual or institution has such type of money account which is not placed
to tax authority for avoiding tax obligation then it is called black money.

Black money can be created in the following ways:

 Unorganized money market- unauthorized credit institutions;

 Goods selling without keeping written records;
 Bribe;
 Subscription without appropriate account under the names of political and other
organizations;
 Legally earned money but used in illegal business;
 Showing lower value of export and higher value of import;
 Legal business but profit is not declared fully;
 Showing lower value in deed in case of land selling;
 Actual house rent is not shown in case of house renting.