The Role of Money
Topic Twenty-Six

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Money is anything generally acceptable as a medium of exchange. It is most common in the form of coins and banknotes. Before money was used, there was barter which involved the exchange of goods for other goods. Barter allowed trade to occur between countries. However, there were limitations. The main limitation of barter was that of the goods to be traded must have been of the same value. For example, if Barbados wanted to import $100.00 million worth of fruits from Japan and Barbados was willing to give vegetables to Japan for the fruits, the fruits and vegetables must be of the same exact value. Another problem with barter was that of indivisibility. Some goods are not divisible. The solution was money in the form of coins and notes which is legal tender.

Legal tender

Legal tender is any official medium of payment recognized by law that can be used to meet a financial obligation. The national currency is legal tender in practically every country. Creditors are obligated to accept legal tender towards repayment of a debt. Legal tender can only be issued by the national body that is authorized to do so in respective countries such as the Central Bank of countries.

Functions of Money

Money has four major functions; they are:

  • Medium of exchange –consumers use money in exchange for goods and services which they buy.
  • Unit of account - the unit of account is the unit in which values of goods and services are stated, recorded and settled. For example a cell phone is valued at TT$1000 while a notebook is valued at TT$20.
  • Standard of deferred payment - this function of money allows for settlement of debts in the future.
  • Store of value - this function of money allows households to maintain the value of their wealth.

Characteristics or Qualities of Money

  • Acceptability - money must be accepted by everyone in the economy. This acceptance is for the purpose of the exchange of money for goods and services.
  • Divisibility - this relates to money being easily divided into smaller denominations for transactional purposes.
  • Durability - this simply refers to the physical wear and use ofmoney over a period of time. If money is easily destroyed or damaged it will not be useful.
  • Limited supply - in order for money to retain its worth, it must be limited in supply. The more money in circulation the less it is valued by the economy.
  • Portability - it is necessary for money to be easily transported so that people can carry it around with them easily.
  • Uniformity - money within that specific currency must look the same. This also allows for money to be counted and measured accurately.

Money Substitutes

Money substitutes are used for the purchase of goods and services instead of cash. These include:

Debit and Credit Cards - debit cards are used to pay for goods and to withdraw money at cash machines. The money is automatically taken from your current account when you spend it, so you must have enough money in your account or an agreed overdraft to cover the transaction. On the other hand, credit cards are not linked to your current account and is a credit facility that enables you to buy things immediately, up to a pre-arranged limit, and pay for them at a later date.

Cheques – a cheque is a negotiable document to transfer money either in physical form or to effect transfer from one account to another. Unless or otherwise stated, a cheque is a signed unconditional order addressing the bank to credit it by the issuer. The issuer of the cheque will have an account with the bank to which it is connected. The account can be either savings type or a current account.

Demand for Money

There are three main reasons or motives for demanding money which are as follows:

Transactions motive – because it is necessary to have money available for transactions, money will be demanded.

Precautionary motive – this is where people often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate payment.

Speculative motive – like other stores of value, money is an asset. The demand for an asset depends on both its rate of return and its opportunity cost. Typically, money holdings provide no rate of return and often falls in value due to inflation. The opportunity cost of holding money is the interest rate that can be earned by lending or investing money. The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other asset.

Types of Money

The following are the kinds of money:

Representative money - consists of token coins, other physical tokens such as certificates that can be reliably exchanged for a fixed quantity of a commodity such as gold. Representative money thus stands in direct and fixed relation to the commodity which backs it,

Fiat money - is any money whose value is determined by legal means, rather than the strict availability of goods and services which are named on the representative note. Fiat money is created with a type of credit money (typically notes from a Central Bank) and usually trades against each other in value in an international market, as with other goods.

Credit money - is any claim against a physical item that can be used for the purchase of goods and services. Credit money differs from commodity and fiat money in that it is not payable on demand. In addition, there is some element of risk that the real value upon fulfillment of the claim will not be equal to real value expected at the time of purchase.

Definitions of Money

The definition of money is the total supply of money in circulation in a given economy at a given time. There are several measures for the money supply, such as M1, M2, and M3. The money supply is considered an important instrument for controlling inflation. In order to control the money supply, regulators have to decide which particular measure of the money supply to target. The broader the targeted measure, the more difficult it will be to control that particular target. The following are the various definitions of money:

M1 – includes all coins, currency held by the public, traveler's checks, checking account balances and balances in credit unions.

M2 - includes M1, plus savings and small time deposits, overnight repos at commercial banks and non-institutional money market accounts. This definition is a key economic indicator used to forecast inflation.

M3 - includes M2, plus large time deposits, repos of maturity greater than one day at commercial banks and institutional money market accounts.

Narrow Definition of Money – is M1

Broad Definition of Money – M2 and M3.

Creation of Money

Money is created in the economy when the commercial banks lend the deposits that they receive less the reserve that they are required to hold at the Central Bank.

The following is an example of how money can be created in the financial system by making loans of increased deposits:

The government issues a treasury bill. This is simply a promise to pay the holder/investor a specified sum of money on a particular future date. For example, assume that the government issues $1,000,000 worth of bonds.

  1. The Central Bank issues a cheque, in the amount of $1,000,000 (the proceeds from the sale of the Bills) and makes it payable to the government. The government sells the Bills through the Central Bank who is its banker.
  2. The $1,000,000 of bonds is recorded as an asset by the Central Bank – money owed to the Central Bank is an asset to the Central Bank. With its power to generate income and raise taxes, it is assumed that the government will honour this debt; it is therefore risk-free investment for the local investors.
  3. The government deposits the cheque in its own account. The government hires employees and purchases products and services with the $1,000,000 and it does so by writing cheques.
  4. For simplicity, assume that all of this $1,000,000 goes to one bank. The commercial bank now claims $1,000,000 in new liabilities because their liabilities would have increased. The bank will have to hold 10 percent or $100,000 in reserve and the remainder it can lend. This lending of money that it has on deposit is how money is created. If the $1,000,000 is held by the bank as notes, then this bank can lend $900,000 ($1,000,000 - $100,000 to be held as reserves with the central bank) to borrowers.
  5. These loans are in the form of money transfer. The person who gets the loan will purchase items from a store. The store then deposits this $900,000 into its bank. Its bank will now hold 10 percent of that $900,000 (90,000) and lend the remainder ($810,000).
  6. The new borrower of the $810,000 will then purchase items and the seller will deposit the $810,000 into his/her bank that will be required to hold 10 percent of $810,000 ($81,000) and lend the remainder ($729,000).
  7. The process continues and will eventually sum to $9,000,000. Therefore the initial $1,000,000 would have grown to $9,000,000 meaning the financial or banking system would have created money in the sum of $9,000,000 ($900,000 + $810,000 + $729,000 ... = $9,000,000). When the initial $1,000,000 is added to this $9,000,000, the change in money supply will be $10,000,000.

Money Multiplier

The creation of money as in the above case is done through what is known as the money multiplier. This is done through the reserve requirement ratio which is the statutory limit that commercial banks must hold with the Central Bank. The Central Bank can affect the money supply by controlling its own issues and the mandatory minimum reserve ratio. The reserve ratio is to prevent banks from having a shortage of cash when large deposits are withdrawn.

The multiplier is stated as follows:

MM = D /r

where D is the initial deposit and r is the reserve requirement. Therefore, in the above example, to determine what will be the final cumulative increase in money supply resulting from the initial increase in deposits, we have M = 1,000,000/.10 = $10,000,000.

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