Definition of Money

Course Title

MONEY & BANKING

BBA-3rd

Course Outlines

Money and exchange value of money. Commercial banking Central banking Monetary policy and Credit control Sources of Finance Financial Instruments and Financial Intermediaries.

MONEY

Money is one of the wonderful inventions of man. Money has been defined differently by different economists.Classified into three groups:1. Descriptive definitions2. Legal definitions3. General acceptability definitions.

Money (Cont’d…)

1. Descriptive definitions:This definition mainly stress on the functions of money and not what the money is. They are considered as partial and narrow definitions of money. For example:By Crowther “Anything that is generally acceptable as a means of exchange and that at the same time acts as a measure and store of value”. By Coulborn “A means of valuation and payment”.By Cole “Anything that is widely used as a mean of payments and is generally acceptable in settlement of debts”.

Money (Cont’d…)

2. Legal definitions:This definition mainly stress on the state theory of money (i.e. there should be state force for a thing to be declared and accepted as money)For example:By professor knap “Anything which is declared by the state as money is money”.By professor Hartly “Money should be legal tender”.

Money (Cont’d…)

3. General Acceptability definitions:According to Seligman ,”Money is one thing that possesses general acceptability”. By Kents, “Money is anything which is commonly used and generally accepted as a medium of exchange or as a standard of value “.By S.Mishkins has describe money as , “Anything that is generally accepted in payment for goods and services or in the repayment of other kinds of debts”.The definition of money which is generally accepted is defined

as under: “Money is anything that is regularly used in economic transactions and serves as a medium of exchange a unit of account and a store of value”.

What Money is Not !

Money is different from: -Wealth (or “Net Worth”): current value of all assets owned by an entity (person, organization, nation,…) net of all liabilities owed. • Example: His wealth is $10,000 -Income: the flow of earnings of an entity per unit of time • Example: His income is $10,000 per year

Money and Near Money

The assets which can be easily and quickly transferred into money without loss in value are

called near monies. It consists of time deposit, treasury bills,

government securities, saving bonds. Near money can not be directly used for making

payments, they are first converted into proper money.

It directly affects the money supply.

Components of Money Supply

The money supply is the amount of financial instruments within a specific economy available for purchasing goods or services. The money supply is the quantity of money available in the economy. The money supply is usually measured as three escalating categories. M1= C + demand deposits + travelers’ Cheques + other chequeable depositsM2= M1 + small time deposits + savings deposits + money market mutual funds + money market deposit accountsM3= M2 + large time deposits + repurchase agreements + institutional money market + mutual fund balances

Stages in Development of Money

The development of money in the present form has evolved through the Five stages. 1. Commodity money2. Metallic money3. Paper money4. Credit money5. Electronic money.

Stages in Development of Money (cont’d…)

1. Commodity Money (~ 9000 BC): Commodity money is the money which is made up of precious metals like gold or silver or any other valuable commodity like wheat, skin, arrows etc. There are two forms of commodity money.

Full-bodied money - money whose value as a good in non-money purpose is equivalent to its value as a medium of exchange. For example, if the market value of 1 ounce of gold is $400 and the government made 1 ounce gold coins, then the face value of the coin would equal $400. If the government made 1 ounce gold coins and the face value of the coin is equal to $500, while the market value of the gold is $400? The government created a value of $100 out of thin air! The process of creating value by printing money is called seigniorage.


Representative full-bodied money - money that inherently has little value, such as paper bills, but the money can be converted into a commodity, such as gold and silver. For example, in the United States before 1933, if you had dollar bills, you could exchange the bills for gold at the government's exchange rate ($20 per ounce). Most of mankind used some form of commodity money before the 20th century, but commodity money has been replaced by fiat money.


2. Metallic Money (~9000BC) :It consists of coins, made of gold, silver, copper or nickel. Metallic money varies in weight, fineness and

in value.Coinage: …is the coining of metal by stamping it on

its both sides for preventing it from clipping,

debasement etc. by competent authority.


3. Paper money (China ~1300 AD; first U.S. use 1862):The term paper money refers to the notes issued by governments and central banks. paper money may be

representative, convertible, fiat. Representative paper money:…is that money which is

fully backed by equivalent metallic reserves. Convertible paper money: Money which is convertible

into coins on demand is called convertible paper money. It does not backed by metallic reserves.

Fiat Money - issued by governments and central banks. This money cannot be used as anything else, and cannot be exchanged for another commodity from government. For example, if the Pak rupee bill was not used as money, it has no other functions other than being fancy paper.


4. Credit money or bank money (Medieval Italy & Catalonia, 5th-15th c. AD): Credit money issued by financial institutions. Banks, credit unions, and other financial institutions offer checking accounts to people and businesses. Cheques

• Cheques are another way of paying for things, but They are not legal tender

• They are not even money.• Cheques are instructions to the bank to take funds from

your account and transfer those funds to the person or firm whose name is written in the “Pay to the Order of” line.

• When you give someone a Cheque in exchange for a good or service, it is not a final payment;

Cheques (cont’d…)

• A series of transactions must still take place that lead to the final payment

• The whole process is time consuming and expensive;


5. Electronic money (first U.S. use in 1990’s): Improve the efficiency of the payments system. Two major innovations were introduced.

Automated teller machine (ATM) - ATMs are connected together through networks. The network allows customers to not only access their accounts at financial institutions 24 hours a day, 7 days a week, but from almost every city in the Pakistan.

Debit Card• The money in your account is used for payments• Works like a cheque and there is usually a fee for the

transaction

Electronic money (cont’d…)

Credit card• It is a promise by a bank to lend the cardholder

money with which to make purchases.• When the card is used to buy merchandise the

seller receives payment immediately• The money that is used for payment does not

belong to the buyer• Rather, the bank makes the payment, creating

a loan that the buyer must repay.• So, they do not represent money; rather, they

represent access to someone else’s money

Electronic money (cont’d…)

Electronic Funds Transfer Move funds directly from one account to another. Banks use these transfers to handle transactions among

themselvesE-money Used for purchases on the Internet. You open an account by transferring funds to the issuer

of the e-money When shopping online, instruct the issuer to send your e-

money to the merchant It is really a form of private money.Stored-value card Retail businesses are experimenting with new forms of

electronic payment Prepaid cellular cards, Internet scratch cards, calling

cards etc

Alternative Payment Systems

•Autarky: Group distribution rules for sharing and gift giving. No trade takes place, and no use of money.• Barter: The direct exchange of goods for other goods without the use of any medium of exchange• Monetary: People trade goods and services in exchange for money

Problems with Barter Exchange

1. Double coincidences of wants - If you produce shoes and you wanted Coca-Cola, you would have to search for a person who produced Cola-Cola and needs shoes. There could be considerable search time in finding that person

2. Storage - Many goods, like fruits and vegetables, get worse over time. Growers of perishable goods would have a difficult time storing their purchasing power.

Problems with Barter Exchange

3. No common unit of price measurement among goods - If a store had 1,000 products and there was money, this store would have 1,000 price tags. Customers could easily compare products. With barter, there would be 499,500 price exchange ratios. Each good's price would be stated in terms of all other goods.

4. Limited Number of Goods and Services - Business people would have difficulty in writing contracts for future payments of goods and services under a barter system. As a result, a barter society would be only able to produce a limited number of goods and services.

Use of the Currency System

Today, countries use coins and paper bills as money. The value of paper bills and coins is called currency. Money eliminates many of the problems encountered with the barter system and has four functions.

Functions of Money

1. Medium of exchange - Money can be used for payments of goods and services and repayment of debts. The medium of exchange function promotes efficiency. For example, I am an economics instructor. Under a barter system, I would have to go to the market and teach a another person for goods and services that I need. In this case there could be considerable search costs for people wanting economics instruction. With money, I do what I do best and teach for money. Then I take this money and go to the market and buy goods and services that I want. This function of money allows the specialization of labor to occur and eliminates the problem of double coincidence of wants under a barter system.

Functions of Money…Continued

2. Unit of account - Money conveniently allows a way of placing specific values on goods and services. For example, a two-liter of Coca-Cola costs $0.89 while Pepsi costs $0.99. Customers can easily judge which product is cheaper. This function is extremely important for businesses. Businessmen can place a value on buildings, machines, computers, and other assets. This information is recorded on financial statements. Investors read the financial statements and can gauge which companies are profitable. Finally, this function of money eliminates the massive number of price exchange ratios that would occur under a barter system.


3. Store of value - Money has to retain its value. For example, if a two-liter of Coca-Cola costs $0.99 today, then it should cost $0.99 tomorrow. Inflation erodes the "store of value" of money. As the price level increases, the value of money decreases, because each unit of money buys less goods and services. Inflation causes consumers to lose their purchasing power over time. If the inflation rate becomes too high, then money as a "medium of exchange" breaks down too! In countries that have high inflation rates, people will use barter more and immediately exchange their local money for more stable money, such as Euro or U.S. dollars. However, people are still required to use money as a medium of exchange, because government laws legally require people to accept money as a means of payment to pay off a debt or to pay taxes. This legal requirement is known as "legal tender."


4.Standard of deferred payment - This function combines the "medium of exchange" and "unit of account" of money, because debts are stated in terms of a "unit of account," and paid by "medium of exchange." This function of money is extremely important for business transactions that will occur in the future. Businesses and people can borrow or lend money based on future transactions.

Desirable Characteristics of Money

For money to be used by people and businesses, money needs five

desirable properties. 1. Acceptability - The businesses and public accept it as

payment for goods and services. 2. Standardized quality - The same units of money must be

the same size, quality, color, so people are certain what they are getting.

3. Durability - Has to be physically durable or it may lose its value quickly.

4. Valuable relative to its weight - Large amounts of money can be used in transactions and easily carried around.

5. Divisibility - Money must be broken down into smaller units to purchase low value goods and services.

Characteristics of Money

A means of payment

A unit of Account

A Store of Value

A means of payment

• The primary use of money is as a means of payment.

Money is accepted in economic exchanges.• Barter is an alternative to using money but it

doesn’t work very well.• Barter requires a “double coincidence of wants,” meaning that in order for trade to take place both parties must want what the other has.

A means of payment (cont’d…)

• Money finalizes payments so that buyers and sellers

have no further claim on each other.• As economies have become more complex and physically dispersed the need for money has grown.• Just as the division of labor and specialization

allow for efficient production, money allows for efficient exchange.

A unit of Account

We measure value using rupees and paisas. Money is the unit of account that we use to quote prices and record debts. Money can be referred to as a standard of value. Using money makes comparisons of value easy Under barter the general formula for n goods, we will have n (n - 1) / 2 prices Two goods 1 price 3 goods 3 prices 100 goods 4,950 prices 10,000 goods 50 million prices

A Store of Value

For money to function as a means of payment it has to be a store of value too because it must retain its worth from day to day.

The means of payment has to be durable and capable of transferring purchasing power from one

day to the next. Money is not the only store of value; wealth can

be held in a number of other forms. Other stores of value can be preferable to money

because they pay interest or deliver other services.

A Store of Value (cont’d…)

However, we hold money because it is liquid, meaning that we can use it to make purchases.

Liquidity is a measure of the ease with which an asset can be turned into a means of payment

(namely money). The more costly an asset is to turn into money,

the less liquid it is. Constantly transforming assets into money

Definition of Money

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