Chapter-5

Money (Barter and Money Supply)

Barter System: The primitive worlds’ trade was carried out according to the barter system of exchange.
Economic exchanges without the mediation of money are referred to as barter exchanges.

Barter Exchange: It refers to exchange of goods for goods.

Example, wheat may be exchanged for cloth; house for horses, etc.,
or a teacher may be paid wheat or rice as a payment for his/her
services.

Barter economy or C-C economy: When there is direct barter of

goods and services. In C-C Economy C stands for commodity.

Barter is best?
Only Individual: In an economy which consists of only one individual there cannot be any exchange
of commodities and hence there is no role for money.

Family at Island: Even if there is more than one individual but these individuals do not take part in
market transactions, example: family living on an isolated island, money has no function for them.

More than One: However, as soon as there is more than one economic agent who engage
themselves in transactions through the market, money becomes an important instrument for
facilitating these exchanges.

Double Coincidence of want: It refers to the immediate fulfillment of each other wants. An example
suggests that “wheat may be exchanged for cloth; house for horses, etc., or a teacher may be paid
wheat or rice as a payment for his/her services.” All are the example of double coincidence of wants.

However in real life, it is very difficult to find the double coincidence of want. It leads to huge cost and
time. For the understanding of the concept better, solve the puzzle in picture.

5.1 Money | P A n a n d A c a d e m y | M o n e y
Limitation of barter Exchange
1) Lack of Double Coincidence of want: Let you aware about the facts:
 It works only when both buyer and seller are ready to
exchange each other's goods. A barter system is an old
 It is very rare in real life. method of exchange.
 It is difficult to find such a person every time. In barter system, This system has been used for
exchange becomes quite limited and increases trading cost. centuries and long before
 Double coincidence of wants means that goods in possession of money was invented. People
two different persons must be useful and needed by each exchanged services and goods
other. It is the main basis of barter system of exchange. But it is for other services and goods in
rare. return.

2) Lack of common measure of value: The history of bartering dates all

 All commodities are not of equal value. the way back to 6000 BC.
 Absence of common measurement tools and mechanisms. Introduced by Mesopotamia
tribes, bartering was adopted by
 Parties suffer a huge loss in case of necessities goods. Phoenicians.

3) Lack of standard of Deferred(Future) Payment: Due to following Due to lack of money, bartering
reason: became popular in the 1930s
 Goods which need to be repaid might lose or gain its value at during the Great Depression. It
the time of repayment. Hence, it leads to conflicts at the time was used to obtain food and
of repayment. various other services. It was
done through groups or between
people who acted similar to
4) Lack of store of value:
banks. If any items were sold, the
 Difficult for the people to store value as most of the goods owner would receive credit and
don’t posses durability. the buyer’s account would be
 In reverse it can degrade the value of the goods. debited.
 Most of the goods like wheat, rice, cattle etc. are likely to
deteriorate with the passage of time or involve heavy cost of
storage.

5.2 Money | P A n a n d A c a d e m y | M o n e y
What is Money?
Money is anything which generally accepted as a medium of exchange, measure of value, store value
and means for standard of deferred payment.
Term money is used to cover all such things like coins, paper notes, cheque, demand draft etc. Money
can be any commodity chosen by common consent, by the people of country as an instrument of
exchange.
Money has overcome the drawbacks of Barter System:
Medium of Exchange.
Measure of Value.
Store of Value.
Standard of Deferred Payment.

Various Definition of Money

Legal definition of money

 Legally, money is anything proclaimed by law as a medium of exchange.
 Paper notes and coins (together called currency) is money as a matter of law.
 Nobody can refuse its acceptance as medium of exchange.
 In other words, it is legal tender. It means people have to accept it legally for different payments.
 Currency is also called FIAT money because it commands ‘FIAT’ (order/authority) of the
government.
Functional definition of money: Functional definition of money refers to money as anything that
performs four basic functions,
 It serves as a medium of exchange.
 It serves as a standard unit of value.
 It serves as a means for future / contractual payments or standard of deferred payments.
 It serves as a store of value. According to this, definition of money includes notes and coins as
well as chequeable deposits with the banks.
Narrow definition of money: Functional definition of money is a narrow definition of money. It
includes only notes, coins and demand deposits as money. In other words, in its narrow definition,
money includes only those things that function as money in terms of:
 Medium of exchange.
 Measure of value.
 Standard of future/Deferred payments.
 Store of value.
Broad definition of money:
 A broad definition of money also includes time deposits/term deposits with the banks or post
offices as a component of money.
 These deposits can be converted into demand deposits on a short notice, and are “Near money
assets”. Money assets and near money assets together make up a definition of money.

5.3 Money | P A n a n d A c a d e m y | M o n e y
What is Money Supply?
It refers to total volume of money held by public at a particular point of time in an economy.

Features of Money Supply: It includes 'money held by public only'.

 Public signifies : money using sector (Individual and business firm)
 Not includes : money-creating sector (Govt. and banking system)
 It is stock concept. (concerned with a particular point of time)

Measures of Money Supply (MMS)

Since 1977, four alternative measures of money supply (M1, M2, M3 and M4) have been proposed over
the time.
Details of measurement are as follows:
1) M1
 First basic measure of money supply.
 Also known as Transaction money.
 M1 = Currency and coins with public + Demand Deposits of Commercial Banks + Other deposits
with RBI.
 Currency and coins with public: Notes and coins held by public and not by government and
banks.
 Also termed as Fiat money (under the law, must accepted for all debts).
 Legal tender money.
 Demand deposits of commercial banks: DD of public with banks. Only Net DD is included. Inter
bank’s deposits are excluded.
 Other Deposits with RBI: Held by RBI on behalf of foreign Banks and govt., PFI, WB, IMF etc.
 It doesn't include deposits of Indian Government and Commercial banks with RBI.
2) M2
 It is broader concept of money supply as compared to M1.
 M2 = M1 + savings deposit with Post office saving Bank (POSB).
 Reason: Saving of Post office could not withdraw able by cheque, so they could not deposit into
bank.
3) M3
 It is broader concept of money supply as compared to M1.
 M3 = M1 + Net Time deposits with Banks.

4) M4
 M4 = M3 + Total deposits with POSB (Excluding NSC)

Important to know about M1, M2, M3 and M4

 All above MMS represent different degree of Liquidity. (M1 = Most Liquid, M4 = Least Liquid).
 M3 widely used as a MMS and also known as "aggregate monetary resources of the society.
 M1 and M2 are generally known as NARROW money measure supply concepts, whereas M3 and M4
are known as broad MMS concepts.

High -powered money

Produced by the RBI and the govt.
It consist two thing:
 Currency held with public,

5.4 Money | P A n a n d A c a d e m y | M o n e y
  Cash reserves with Banks
Money consists of currency and demand deposits, while HPM consists of currency and cash
reserves with banks.

Function of money
Primary Function: Most important function of money, which must perform in every country.
 Medium of Exchange;
 Measure of Value.
Secondary Function: Functions which are supplementary to main function. Also known as
'Derivative function'.
 Standard of Deferred Payment
 Store of value (Asset Function of Money)
Primary function or Main function: Primary function includes the most important functions of money,
which it must perform in an economic system irrespective of time and place. The following two
functions are included under this category.
a) Medium of exchange
Money when used as a medium of exchange helps to eliminate the basic limitation of barter
trade, that is, the lack of double coincidence of wants.
Individuals can exchange their goods and services for money and then can use this money to
buy other goods and services according to their needs and convenience.
Thus, the process of exchange shall have two parts: a sale and a purchase.
The ease at which money is converted into other goods and services is called “liquidity of
money”.
b) Measure of value /unit of account
Another important function of money is that it serves as a common measure of value or a unit
of account.
Under barter economy there was no common measure of value in which the values of
different goods could be measured and compared with each other. Money has also solved this
difficulty.
Money works as a common denominator into which the values of all goods and services are
expressed.
When we express the values of a commodity in terms of money, it is called price and by
knowing prices of the various commodities, it is easy to calculate exchange ratios between
them.
Secondary Functions
c) Standard of deferred payments
Credit has become the life and blood of a modern capitalist economy.
In millions of transactions, instant payments are not made.
The debtors make a promise that they will make payments on some future date. In those
situations money acts as a standard of deferred payments.
It has become possible because money has general acceptability, its value is stable, and it is
durable and homogeneous.
d) Store of Value
Wealth can be conveniently stored in the form of money. Money can be stored without loss in
value.
In this way, money acts as a bridge between the present and the future.
Money means goods and services. Thus, money serves as a store of value.
It is also known as asset function of money.

5.5 Money | P A n a n d A c a d e m y | M o n e y
 Characteristics or features of money
a) Durability: Money must be durable and not likely to deteriorate rapidly with frequent handling.
Currency notes and coins are being used repeatedly and shall continue to do so for many years.
b) Medium of exchange: Money is the thing that acts as a medium of exchange for the sale and
purchase of goods and services.
c) Weight: Money must be light in weight. Paper money is better than metal coins because it is light in
weight.
d) Measure of value: It not only serves as medium of exchange but also acts as a measure of value. The
value of all the goods and services is expressed in terms of money.

5.6 Money | P A n a n d A c a d e m y | M o n e y