Dr Rajiv Desai

MONEY

July 1, 2022 by Dr Rajiv Desai

Money:

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Section-1 

Prologue:  

Somebody once asked the late bank robber named Willie Sutton why he robbed banks. He answered: “That’s where the money is.” Money is something we encounter in every facet of our daily lives. The first thing that springs to mind for most of us when we hear the word “money” is coins and banknotes. We talk about “making money” when we refer to our income. We say that we are “spending money” when we go shopping. For major purchases we sometimes have to “borrow money” by taking out a loan, either from someone we know or from a bank. It is no accident that the term “money” gets used in so many different ways: it is a reflection of the myriad functions that money performs in our economic lives.

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Money is one of the fundamental inventions of mankind. Economists say that the invention of money belongs in the same category as the great inventions of ancient times, such as the wheel and the inclined plane. The creation of money is made possible because human beings have the capacity to accord value to symbols. Money is a symbol that represents the value of goods and services. The acceptance of any object as money – be it wampum, a gold coin, a paper currency note or a digital bank account balance – involves the consent of both the individual user and the community. Thus, all money has a psychological and a social as well as an economic dimension. As human consciousness has evolved, the nature and function of money has evolved too. While a history of money may trace the origin and usage of different forms of money at different times and in different parts of the world, an evolutionary perspective on money traces the social and psychological changes in human attitude and collective behavior that made possible this historical development.

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Money is the commonly accepted medium of exchange. In an economy which consists of only one individual there cannot be any exchange of commodities and hence there is no role for money. Even if there are more than one individual but they do not take part in market transactions, such as a family living on an isolated island, money has no function for them. However, as soon as there are more than one economic agent who engage themselves in transactions through the market, money becomes an important instrument for facilitating these exchanges. Economic exchanges without the mediation of money are referred to as barter exchanges. Humans passed through a stage when money was not in use and goods were exchanged directly for one another. However, they presume the rather improbable double coincidence of wants. Consider, for example, an individual who has a surplus of rice which she wishes to exchange for clothing. If she is not lucky enough she may not be able to find another person who has the diametrically opposite demand for rice with a surplus of clothing to offer in exchange. The search costs may become prohibitive as the number of individuals increases. Thus, to smoothen the transaction, an intermediate good is necessary which is acceptable to both parties. Such a good is called money. The individuals can then sell their produces for money and use this money to purchase the commodities they need. Though facilitation of exchanges is considered to be the principal role of money, it serves other purposes as well like store & measure of value.

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Money has undergone a long process of historical evolution. The inconveniences and drawbacks of barter led to the gradual use of a medium of exchange. If we study history of money, we shall find that all sorts of commodities like seashells, pearls, precious stones, tea, tobacco, cow, leather, cloth, salt, wine, etc. have been used as a medium of exchange. It is called commodity money. Inadequacy of commodity money led to the evolution of metallic money (gold and silver). The problem of uniformity of weight and purity of precious metals led to private and public coinage. This process was finally taken over by the state as one of its essential features and ultimately commodity money gave way to paper money which means currency notes. The process of evolution of some better medium of exchange still continues. As the volume of transactions increased, even paper money started becoming inconvenient because of time involved in its counting and space required for its safe keeping. This led to introduction of bank money (or credit money) in the form of cheques, drafts, bills of exchange, credit cards, etc. We use coins and banknotes but the balances we hold in our bank accounts are now recorded only in the form of bits and bytes. Although we cannot even hold it in our hands, we still accept it as money because we trust in its value. Ultimately, money is whatever is generally accepted as money within a society at a given time. Money is what money does. Money is so important that when no official money exists, people often create it. For example, during World War II, prisoners in prisoner-of-war camps used cigarettes as money. All other goods were priced in terms of cigarettes, and prisoners willingly accepted them as payment for any other good. While cigarettes have value to smokers, once they become money, they gain value in terms of everything they can be exchanged for, whether a person smokes or not. People will always find something to serve as money, even with no government to enforce its legitimacy.

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Money for the sake of money is not an end in itself. You cannot eat dollar bills or wear your bank account. Ultimately, money is only useful because you can exchange it for goods and services. As the American writer and humourist Ambrose Bierce (1842–1914) wrote in 1911, money is a “blessing that is of no advantage to us excepting when we part with it.” Businesses and government use money in similar ways. Both require money to finance their operations. By controlling the amount of money in circulation, the federal government can promote economic growth and stability. For this reason, money has been called the lubricant of the machinery that drives our economic system. Money is indispensable in an economy, whether it is capitalistic or socialistic. Our banking system was developed to ease the handling of money. Money is a necessary component of any democracy: it enables political participation, campaigning and representation. However, if not effectively regulated, it can undermine the integrity of political processes & institutions and jeopardize the quality of democracy. Thus, regulations related to the funding of political parties and election campaigns, commonly known as political finance are a critical way to promote integrity, transparency and accountability in any democracy. In order to appreciate the conveniences that money brings to our lives, think about life without it.

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Money was a clever and convenient invention; it was designed as a means of exchange and a measure of wealth. But somehow that has changed; what was once solely a means to an end has become the end itself, and what was a measure of wealth has become wealth itself. Take for example agriculture, the purpose of which was to produce nutritious food whilst ensuring that the land remained in good heart for all future generations and for the good health of biotic communities. Agriculture was a way of life that gave farmers their dignity, and in turn they cultivated the crops with tender loving care and considered their work intrinsically good. Then came money, which changed everything: agriculture turned into agribusiness and the paramount purpose of it became the making of money. Food became a commodity and yet another means of making large profits. We can cut down the rainforest to make money, we can pollute the rivers and over-fish the oceans for profit, we can destroy the local economy in search of cheaper goods, no matter how much CO2 is emitted in the process. Nothing is forbidden, just as long as it adds to GDP and increases the share value of corporations and companies. Ethics, morals and human dignity are all secondary and subservient to the profit margin. All money tends to corrupt, and absolute money corrupts absolutely. This is an ancient message. You can find it in the Bible (“the love of money is the root of all evil”) and in the writings of ancient Greek philosophers and Renaissance moralists. You can’t buy a friend because if you know you’ve paid someone to be nice to you it ceases to be a “real” friendship. Nonetheless rich people tend to have more “friends” than poor ones. Money creates conflicts within family and between families. Money is the root cause of many crimes. Von Mises remarked: “Money is regarded as the cause of theft and murder, of deception and betrayal.”  I have seen people trying to bribe God with money so that their sins can be pardoned. I have also seen people who believe that money is God no matter means to obtain it.       

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Quotes on money: 

-1. The money which a man possesses is the instrument of freedom.; that which we eagerly pursue is the instrument of slavery.

~ Jean-Jacques Rousseau

-2. Top 15 Things Money Can’t Buy

Time. Happiness. Inner Peace. Integrity. Love. Character. Manners. Health. Respect. Morals. Trust. Patience. Class. Common sense. Dignity.

― Roy T. Bennett, The Light in the Heart

-3. If you want to know what God thinks of money, just look at the people he gave it to.

― Dorothy Parker

-4. Libraries will get you through times of no money better than money will get you through times of no libraries.

― Anne Herbert

-5. The hardest thing in the world to understand is the income tax.

― Albert Einstein

-6. Money may not buy happiness, but I’d rather cry in a Jaguar than on a bus.

― Françoise Sagan

-7. I’ve been rich, and I’ve been poor; believe me, rich is better.

―Mae West 

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Abbreviations and synonyms:

CDBC = central bank digital currencies

M0 = base money

MZM = money zero maturity

TVM = time value of money

UCC = Uniform Commercial Code

EFTS = electronic funds transfer system

FRB = Federal Reserve Board

Fed = Federal Reserve

OMO = open market operations

MMT = Modern Monetary Theory

MMMF = Money Market Mutual Funds

PPP = Purchasing Price Parity

CPI = Consumer Price Index

CRR = cash reserve ratio

IOU = I owe you  

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Some facts about money:

-The U.S. currency paper is composed of 25% linen and 75% cotton. About 4,000 double folds (first forward and then backwards) are required before a note will tear.

-The copper coin production in the Chinese Song Dynasty reached the highest output, once within a period, 10000 tons of copper a year were used, if line up the coins one by one, it is 128333 kilometers, about 3 circles round the earth, this was only one year’s output, no one knows where so much copper were collected.

-Records shows China had ways to avoid counterfeited paper money nearly 1000 years ago, and laws for that were also published then, even printed on the paper money.

-The United States Secret Service was originated in 1865 to combat counterfeit money. At the time, as much as one third of all the money in the United States was estimated to be counterfeit. Currently, about $250,000 in counterfeit money appears each day.

-As of mid-July 2017, there was more than $1.56 trillion in U.S. currency in circulation, with $40 billion in coins.

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Terminology:  

Key term	Definition
money	any asset that can serve the three functions of money; 1) medium of exchange, 2) a store of value, and 3) a unit of account.
a medium of exchange	the ability for something be used to purchase something else, such as “I can use this 5 dollar bill to buy a grilled cheese and peanut butter sandwich”
a store of value	the ability to delay using money as a medium of exchange until later, such as “I am going to keep this $5 bill in my wallet so I can buy a grilled cheese and peanut butter sandwich tomorrow”
a unit of account	the ability to represent the value of an item, such as “this grilled cheese and peanut butter sandwich costs $ 5”
currency in circulation	money outside of banks, such as money in your wallet or your cupboard; the money in your pocket is currency in circulation, but the money in your bank account is outside of circulation.
currency in vaults	(Also called reserves) money that banks keep within the bank, outside of circulation
required reserves	the fraction of money a bank is required to put aside and not use for loans or any other purpose, usually required by banking regulations; this fraction is based on the amount of money that has been deposited into the bank, such as 10 percent of all deposits.
demand deposits	deposits placed into banks that a bank must return to the account holder on demand; checking accounts are examples of demand deposits because the bank must allow you to withdraw it or use it at any time.
the transactions motive	when people hold money for the purpose of buying things
M1	assets that can be directly used to carry out the transactions motive of money; M1 is sometimes called “narrow money” because this is the narrowest definition of the money supply.
M2	financial assets that aren’t directly used for a medium of exchange, but can be converted into cash or a checking account; M2 is sometimes called “near money” because it is nearly as liquid as M1, but not quite as liquid.
money supply	the total amount of money in an economy that can carry out the transactions motive; in most countries, the money supply is either the monetary aggregate M1 or M2
monetary aggregates	an overall measure of the money supply that includes different forms of money which are categorized based on liquidity; the most commonly used monetary aggregates are M1 and M2
monetary base M0	(Also called high powered money) the sum of currency in circulation and bank reserves held in vaults; only part of the monetary base (currency in circulation) is counted in the money supply.
commodity money	money that has intrinsic value in other uses; a tangible asset that circulates as money. Examples of commodity money include gold, silver, tobacco, grain, platinum, etc. Gold has historically been the most popular and efficient commodity money used throughout history.
fiat money	money which is declared to be legal tender but has no intrinsic value and is not backed by (not legally defined by convertibility into) any tangible commodity such as gold, silver, etc. Fiat money is money by decree or proclamation. It derives its value from the perceived authority and creditworthiness of the issuer (national government – central bank of the respective country); paper money is fiat money because its value for its use as a currency is far higher than the intrinsic value of a small scrap of paper.
commodity backed money	money that has no inherent value, but it has a value guaranteed by a promise that it can be converted into something of value like gold
central bank	a banking organization that is usually independent of government, responsible for implementing a country monetary policy and for the function of issuing currency.
currency	notes and coins issued by the central bank or government serving as legal tender for trade.
fiscal policy	the deliberate use of the government’s revenue – raising (taxation) and spending activities in an effort to influence the behaviour of certain macroeconomic variables such as total employment.
monetary policy	an attempt to influence the economy by operating on such monetary variables as the quantity of money and the rate of interest. The nation’s central bank is usually involved with monetary policy.
seigniorage	seigniorage revenue is the net revenue derived for governments from the issuing of coins and bank notes. It is the difference between interest earned on the issuance of money and the costs associated with the producing and distributing bank notes & coins. Unlike the seigniorage for coins, bank note seigniorage is collected in instalments over a period of years due to paper money’s short life span (i.e., damaged notes) and the future liability to government of redeeming the currency.
Bank rate (discount rate)	Bank rate, also known as discount rate, is the rate of interest which a central bank charges on its loans and advances to a commercial bank.
Funds rate	The interest rates at which banks lend to each other overnight in order to maintain reserve requirements is known as funds rate.

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Various Words about Money:    

Many of the words we associate with money today come from ancient uses of currency. Examining where these words came from helps us understand how currency systems developed.

Buck – Early settlers in North America relied heavily on the skin of the deer for trade. Each skin was referred to as a buck.

Pecuniary – This modern word means, “relating to money.” It comes from the Latin word pecus, which means cattle.

Fee – This word comes from the German word for cattle, vieh.

Shell out – The use of shells as currency among Native Americans, and, later, the European colonists, led to the phrase “shell out,” meaning “to pay.”

Salary – This is another money-related word we got from the Romans. At one point, Roman soldiers were paid part of their wages in salt. The Latin word salarium means “of salt.”

Dollar – A count in a Czechoslovakian town called Jachymov started minting silver coins in 1519. The coins were known as talergroschen, which was eventually shortened to talers. They spread throughout Europe, and today, many nations have currency named for some variation of the word taler, including the American “dollar.”

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Slang terms for money:

Slang terms for money often derive from the appearance and features of banknotes or coins, their values, historical associations or the units of currency concerned. Within a language community, some of the slang terms vary in social, ethnic, economic, and geographic strata but others have become the dominant way of referring to the currency and are regarded as mainstream, acceptable language (for example, “buck” for a dollar or similar currency in various nations including Australia, Canada, New Zealand, South Africa, Nigeria and the United States).

India:

In India slang names for coins are more common than the currency notes. For 5 paisa (100 paisa is equal to 1 Indian rupee) it is panji. A 10 paisa coin is called dassi and for 20 paisa it is bissi. A 25 paisa coin is called chavanni (equal to 4 annas) and 50 paisa is athanni (8 annas). However, in recent years, due to inflation, the use of these small value coins has declined, and so has the use of these slang terms. The more prevalent terms now (particularly in Mumbai and in Bollywood movies) are peti for a Lakh (Rs. 100,000) and khokha for a Crore (Rs. 10,000,000) and tijori for 100 crores (Rs. 1,000,000,000). Peti also means “suitcase”, which is the volume needed to carry a Lakh of currency notes. Tijori means a large safe or a cupboard, which would be the approximate space required to store that money in cash form. Because of the real estate boom in recent times, businessmen also use the terms ‘2CR’ or ‘3CR’ referring to two crores and three crores respectively.

United States:

General terms include:

• bread
• bucks
• cheddar
• dough
• greens
• jello
• loot
• moolah
• paper
• samolians or simoleons
• smackers
• smackeroonies
• stash
• rack
• guap

U.S. coinage nicknames reflect their value, composition and tradition:

• The one-cent coin ($0.01 or 1¢) is commonly called a penny due to historical comparison with the British penny. Older U.S. pennies, prior to 1982, are sometimes called “coppers” due to being made of 95% copper. Pennies dated 1909–1958, displaying wheat stalks on the reverse, are sometimes called “wheaties” or “wheat-backs”, while 1943 steel wheat cents are sometimes nicknamed “steelies”.
• The five-cent coin ($0.05 or 5¢) is commonly called a nickel due to being made of 25% nickel since 1866. Nickels minted between 1942 and 1945 are nicknamed ‘war nickels’ owing to their different metal content, removing the nickel for a mixture of silver, copper and manganese.
• The dime coin ($0.10 or 10¢) is worth ten cents.
• The quarter coin ($0.25 or 25¢) is worth twenty-five cents. A quarter used to be called two-bits (see below), but this is falling out of use.
• The half ($0.50 or 50¢) is worth fifty cents.

Dimes and quarters used to be sometimes collectively referred to as “silver” due to their historic composition of 90% silver prior to 1965.

A bit is an antiquated term equal to one eighth of a dollar or 12+1⁄2 cents, after the Spanish 8-Real “piece of eight” coin on which the U.S. dollar was initially based. So “two bits” is twenty-five cents; similarly, “four bits” is fifty cents. Rarer are “six bits” (75 cents) and “eight bits” meaning a dollar. These are commonly referred to as two-bit, four-bit, six-bit and eight-bit.

Actually, money is so important that people came up with dozens of ways to talk about it throughout the ages. Emerging in the US, the UK or elsewhere, slang words for money became a huge part of the language we use.

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Section-2

Introduction to money:  

Money is one of the fundamental inventions of mankind. It has become so important that the modern economy is described as the money economy. The modern economy cannot work without money. Even in the early stages of economic development, the need for exchange arose. At first, the family or village was a self-sufficient unit. But later on, with the development of agriculture and application of the division of labor—that is, the division of the society into agriculturists, carpenters, merchants, and so on—the need for exchange arose. Exchange took place first in the form of barter. Barter is the direct exchange of goods for goods. Barter is a system of trading without the use of money. At first, when the wants of men were few and simple, the barter system worked well. But as days passed by, it was found to be unsuitable. It has many difficulties.

Difficulties of Barter:

The barter economy presents many difficulties:

-1. Absence of double coincidence of wants:

Barter requires a double coincidence of wants. That is, one must have what the other man wants, and vice versa. This is not always possible. For example, say I want a cow. You must have it. If you want a horse in return, I must have it. But if I do not have it, exchange cannot take place. So, I should go to a person who has a horse, and I must have what he wants. All of this means a lot of inconvenience. But money overcomes these difficulties. If I have an object, I can sell it for some price. I get the price in money. With that, I can buy whatever I want.

-2. No standard of measurement:

A barter market theoretically requires a value being known of every commodity, which is both impractical to arrange and impractical to maintain. If all exchanges go ‘through’ an intermediate medium, such as money, then goods can be priced in terms of that one medium. The medium of exchange allows the relative values of items in the marketplace to be set and adjusted with ease. This is a dimension of the modern fiat money system referred to as a unit of account or measure of value. Barter provides no standard of measurement. In other words, it provides no measure of value.

-3. Absence of subdivision:

Sometimes it will be difficult to split up commodities into parts. They will lose their value if they are subdivided. For example, say a man wants to sell his house and buy some land, some cows, and some cloth. In this case, it is almost impossible for him to divide his house and barter it for all the above things. Again, suppose a man has diamonds. If he divides them, he will make a great loss. A barter transaction requires that both objects being bartered be of equivalent value. A medium of exchange is able to be subdivided into small enough units to approximate the value of any good or service.

-4. Difficulty of storage:

Money serves as a store of value. In the absence of money, a person has to store his wealth in the form of commodities, and they cannot be stored for a long period. Some commodities are perishable, and some will lose their value.

-5. No transactions over time:

A barter transaction typically happens on the spot or over a short period of time. It is impossible to make payments in instalments and difficult to make payments at a later point in time.

All the difficulties of barter were overcome with the introduction of money. Despite the long list of limitations, the barter system has some advantages. It can replace money as the method of exchange in times of monetary crisis, such as when the currency is either unstable (e.g., hyperinflation or deflationary spiral) or simply unavailable for conducting commerce. It can also be useful when there is little information about the credit worthiness of trade partners or when there is a lack of trust.

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Medium of exchange:

In economics, a medium of exchange is any item that is widely acceptable in exchange for goods and services. In modern economies, the most commonly used medium of exchange is currency. The origin of “mediums of exchange” in human societies is assumed to have arisen in antiquity as awareness grew of the limitations of barter. The form of the “medium of exchange” follows that of a token, which has been further refined as money. A “medium of exchange” is considered one of the functions of money. The exchange acts as an intermediary instrument as the use can be to acquire any good or service and avoids the limitations of barter; where what one wants has to be matched with what the other has to offer. Most forms of money are categorised as mediums of exchange, including commodity money, representative money, cryptocurrency, and most commonly fiat money. Representative and fiat money most widely exist in digital form as well as physical tokens, for example coins and notes.

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Examples of Mediums of Exchange:

The Island of Yap:

In 1903, an American anthropologist by the name of William Henry Furness III visited the island. He found the islanders used a currency that was large, solid, thick, stone wheels, ranging in diameter from a foot to twelve feet, having in the centre a hole varying in size with the diameter of the stone, wherein a pole may be inserted sufficiently large and strong to bear the weight and facilitate transportation.  An interesting aspect of the stones was that they were made from limestone found on an island some 400 miles distant. They were originally quarried and shaped on that island and brought to Yap by venturesome native navigators, in canoes and on raft. Also interesting was that it was not necessary for owners to physically possess the stones. After concluding bargains that involved too many stones to be conveniently moved, its new owners were quite content to accept the bare acknowledgment of ownership and without so much as a mark to indicate the exchange, the coin remains undisturbed on the former owner’s premises.

Cigarettes as a Currency in Prisoner of War Camps:

R.A. Radford was a British prisoner of war in a German camp during World War 2. His article “The Economic Organisation of a P.O.W. Camp” describes the use of cigarettes as a currency in these camps. Radford describes how all prisoners would receive equal supplies of all rations including cigarettes. Everyone receives a roughly equal share of essentials; it is by trade that individual preferences are given expression and comfort increased. All at some time, and most people regularly, make exchanges of one sort or another.   “Cigarettes rose from the status of a normal commodity to that of currency … Although cigarettes as currency exhibited certain peculiarities, they performed all the functions of a metallic currency as a unit of account, as a measure of value and as a store of value, and shared most of its characteristics. They were homogeneous, reasonably durable, and of convenient size for the smallest or, in packets, for the largest transactions.” 

Precious Metals as Mediums of Exchange:

While large stones and cigarettes make entertaining examples of items that can be used as a medium of exchange, coins made of precious metals such as gold and silver have been the dominant format for money for most of its history. Precious metals were adopted as mediums of exchange because they contained many of the features that made such mediums work well.

-1. Coins made of precious metals were portable and easy to use.

-2. The precious metal content of coins could be standardised and checked.

-3. The metals generally had their own separate value for use as jewellery or ornaments, so the coins could still have a value even if they ceased to be accepted purely as a medium of exchange.

-4. The fact that metals were difficult to extract meant that the supply of such metals was usually stable. Large fluctuations in the supply of a medium of exchange will limit its usefulness.

Despite these advantages, many different decisions had to be taken before precious metals could be used as a workable currency system.

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Government Money:

Because of the inefficiency of barter, mediums of exchange sometimes emerged as an evolutionary process in which people decided that the use of some agreed “token” to facilitate transactions would be an improvement. However, a number of questions have to be resolved before a monetary system can be put in place.

-1. Who decides which tokens will be used as money?

-2. Who controls the supply of money?

-3. Who prevents counterfeit of money?

In practice, most of the monetary systems that have existed have been controlled by governments as opposed to emerging spontaneously from private markets.  Charles Goodhart’s 1998 paper “Two Concepts of Money” provides evidence that the relationship of the state, the governing body, to currency in all its roles has almost always been close and direct. He explains the key roles governments have played in introducing money, in enforcing its use as legal tender and in generating demand for it via requiring payment of taxes in money. The introduction of currency also made it much more convenient for governments to collect taxation. Kings traditionally required resources to fund their armies, justice systems, palaces and so on. Prior to the existence of currency, kings could request, for example, 10 percent of everyone’s output and then use barter to exchange stuff they didn’t need for stuff they did need. But this kind of system creates lots of complications. At what point in the year does the king collect his share and where does he store it all? How would the king collect ten percent of the output of a barber or a playwright? The introduction of currency thus made it much easier to finance government operations. Requiring that taxation be paid in the legal tender created an important source of demand for the currency and also restricted its supply: A government running a balanced budget would receive as much currency as it created so it was not increasing the total supply of currency.

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The term money refers to an object that is accepted as a mode for the transaction of goods and services in general and repayment of debts in a particular country or socio-economic framework. Traditionally, economists considered four main functions of money, which are a medium of exchange, a measure of value, a standard of deferred payment, and a store of value. Money can be in various forms, such as notes, coins, credit and debit cards, and bank checks.

There are two important things to note about money. First, Money has been defined in terms of functions it performs. That is, money is anything which performs the functions of money. Second, any essential requirement of any kind of money is that it must be generally acceptable to every member of the society. Money has a value for ‘A’ only when he thinks that ‘B’ will accept it in exchange for goods. And money is useful for ‘B’ only when he confident that ‘C’ will accept it in exchange for goods or for settlement of debts. General acceptability is not a physical quality possessed by a good. General acceptability is a social phenomenon and is conferred upon a good when the society by law or convection adopts it as a medium of exchange. Since general acceptability is the fundamental characteristic of money, in simple words, money may be defined as anything which is generally acceptable by the people in exchange of goods and services or in repayment of debts. The status of a particular form of money always depends on the status ascribed to it by humans and by society. For instance, gold may be seen as valuable in one society but not in another or that a bank note is merely a piece of paper until it is agreed that it has monetary value.  

Money is a concept which we all understand but which is difficult to define in exact terms. This is because it fulfills many functions and comes in many forms each of them providing a criterion of moneyness. For this reason, Prof. Walker defines money as ‘‘Money is what money does’’. By this, he refers to the functions of money. Money performs many functions in a modern economy. One of the traditional definitions of Money calls it “a unit of account, a means of payment and a store of value”.

Professor Coulborn defines money as “the means of valuation and of payment; as both the unit of account and the generally acceptable medium of exchange.” These are the functional definitions of money because they define money in terms of the functions. Some economists define money in legal terms saying that “anything which the state declares as money is money.”

Professor D.H. Robertson defines money as “anything which is widely accepted in payment for goods or in discharge of other forms of business obligations.”

According to Hawtrey, “Money is one of those concepts which like a teaspoon or an umbrella, but unlike an earthquake or buttercup are definable primarily by the use or purpose which they serve.”

According to Crowther, “Money can be defined as anything that’s generally acceptable as a means of exchange and that at the same time acts as a measure and a store of value.” An important point about this definition is that it regards anything that is generally acceptable as money. Thus, money includes coins, currency notes, cheques, Bills of Exchange, and so on.

According to Dr Alfred Marshall, “Money constitutes all those things which are at any time and place generally accepted without doubt or specially enquiry as a means of purchasing commodities and services and of defraying expenses”.

According to Prof G D H Cole, “Money is anything that is habitually and widely used as a means of payment and is generally acceptable in the settlement of debt.” 

It is not always easy to define money.

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Money goes back a dizzyingly long way in Indo-European civilization. Well before the invention of minted coins in the Lydian cities of the Aegean in the 7th century BCE, writings from the Sumerian civilization at Ur in the 3rd millennium BCE refer to documents mentioning silver struck with the head of Ishtar. The mother-goddess and symbol of fertility, Ishtar was also the goddess of death. So from the very outset, money’s ambivalence reflects the ambiguity of its social function: an instrument of cohesion and pacification in the community, it is also at the center of power struggles and a source of violence. Money towers over the market economy as we know it from so high and so far that its shadow throws suspicion on the prevailing economic wisdom, which incidentally also creates unease within the profession itself. After all, did not Hahn assert that the perplexing difficulty of the theory of value lay in the inability to account for the universality and durability of money? Economists cannot therefore regard the history of money as a sort of “natural” history which should immediately make sense. The OECD views money as a force driving economic and social change. This position is incompatible with the neutrality of money, which is the theoretical cladding for its supposed unimportance in coordinating economic actions as money is the primary standard of exchange, the fundamental institution of the market economy. This is the paradox of money in economics.

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We are destined to fail if we try to define ‘money’ from the viewpoint of materials or forms. Money is sometimes considered to be some commodity such as gold or silver, and it is sometimes considered to be the paper on which some numbers and figures are printed. Furthermore, it is often considered to be the only abstract number recorded in the computers used by the banks. Money changed its materials and its forms in the course of the development of economic society. As Hicks (1967) pointed out correctly, therefore, we must define ‘money’ from the viewpoint of its function. Usually, the economists define ‘money’ as the ‘generally accepted means of payments’, and as a result it is said that ‘money’ must have the following three functions.

-1. Means of payments (or means of exchange)

-2. Measure of value (or unit of calculation)

-3. Means of store of value

This is the conventional definition of ‘money’ in Economics. As Hicks (1967) noted, this definition has somewhat paradoxical nature, because it means that ‘money’ is what is considered to be money by a lot of people in a society. It may be worth noting that the first function is primary, and other two functions are derived from the first function. That is to say, money is used as the measure of value and the means of store of value because it is generally accepted as the means of payments or exchange. Money to be used as a medium of exchange must be universally acceptable. All people must accept a thing as money. Or the government should give it legal sanction. And to be used as a store of value, money should have stability of value. In other words, the value of money should not change often. Since ancient times, the enigmatic properties of money have fascinated philosophers, and the philosophical and metaphysical speculations on money abound.

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In standard economic theory, the necessity of money is usually explained by using figure below, which is an illustration of the so called ‘Wicksell’s problem’.  

Suppose that there are three economic agents, D(Denmark) who has the commodity w(wheat), S (Sweden) who has the commodity t (timber), and N (Norway) who has the commodity f (fishes). Suppose, furthermore, that D wants t, S wants f, and N wants w. In this case, any exchange in barter is impossible because there is no double coincidence of the wants. However, the indirect exchanges become possible if one of the commodities, for example, w, is used as a ‘generally accepted means of payments’, that is, money. In this case, S receives w from D in exchange for t, and then S receives f from N in exchange for w. In this example, a commodity w became the ‘commodity money’. But, what kind of commodity is likely to become commodity money? Menger (1892) considered this problem, and his answer was as follows. “The commodity with the highest saleability or marketability will be accepted as money by the society.” Historically such a commodity was gold or silver. This is a semi theoretical/semi historical consideration of the origin of money. Needless to say, in modern society money is not commodity money but paper money and/or credit money. But it is true that they are still the commodities with the highest saleability/marketability in modern society.

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Definition of Money:

There is much difference in opinions of scholars regarding the ‘definition of money’. Someone has based the definition of money on the universal acceptance; whereas someone else has taken its function as the central issue in the definition. The definitions of money can be classified as follows:

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Definitions on the basis of nature of money can be classified into following three groups:

-1. Descriptive or Functional Definitions:

This category includes definitions of those scholars who stated functions of money in their definitions.

Some important definitions of this category are given below:

(1) According to Crowther, “Money is anything that is commonly used and generally accepted as means of exchange and at the same time acts as measure and store of value.”

(2) According to Prof. Thomas, “It is a means to an end not for its own sake but as a means of obtaining-other’s articles or commanding the service of others”.

(3) According to Coulborn, “Money may be defined as the means of valuation and payment.”

(4) According to Nogaro, “Money is a commodity which serves as an intermediary in exchange and as a common measure of value.”

(5) According to Hartle Withers, “Money is what money does.”

(6) According to Whitelesy, “If a particular unit is commonly employed to state values, exchange goods and services or perform other money functions, than it is money whatever its legal or physical characteristics.”

Although the above definitions are practical, they describe money in place of defining it. There is radical difference in ‘description’ and ‘definition’. These definitions don’t claim any universal acceptance or recognition of governments. So even if these definitions are accepted in practice, they can’t be given recognition.

-2. Definitions Based on Common Acceptance:

It is an essential characteristic of money that it is commonly accepted by the common people in return for the goods and services. So, some scholars have defined money on the basis of acceptance.

Some important definitions of this category are given here:

(1) According to Marshal, “Money includes all those things which are at given time or place generally current without doubt or special enquiry as a means of purchasing commodities or services and of defraying expenses.”

(2) According to Robertson, “Money is anything which is widely acceptable in discharge of obligation.”

(3) According to Seligman, “Money is one thing that possesses general acceptability.”

(4) According to Ely, “Anything that passes freely from hand to hand as a medium of exchange and is generally received in final discharge of debts.”

(5) According to Prof. Keynes, “Money itself is that by delivery of which debt contracts and price contracts are discharged and in the shape of which a store of general purchasing power is held.”

(6) According to G.D.H. Cole, “Money is simply purchasing power— something which buys things, it is anything which is habitually and widely used as a means of payment and is generally acceptable in the settlement of debts.”

(7) According to R.P. Kent. “Money is anything which is commonly used and generally accepted as a medium of exchange or as a standard value.”

(8) According to (roger miller) “Anything which is generally accepted in payment for the goods and services or the repayment of debts is money”

It is evident from all above definitions that a common acceptance is a chief characteristic of money. But just describing qualities can’t be a complete definition. On the basis of the above definitions credit instruments can’t be considered as money since they are not accepted everywhere.

-3. Legal Definitions:

Definitions based on state principles have been kept under this category. According to this principle only such a thing can be money which has been declared legally by the government. This category includes ideas of Prof. Knapp from Germany and British Economist Hartle.

(1) According to Knapp, “Anything which is declared money by state becomes money.”

(2) Hartle has also initially accepted the definitions given by Knapp, but he has amended this definition saying, “Money should not be defined only in terms of recognition by the government, but also as a unit of settlement of transactions.”

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Definitions given on the Basis of Expansion:

There are three views regarding the meaning of money on the basis of expansion:

-1. Definitions with Narrow Points of View:

The definition given by Robertson is kept in this category. Robertson and his associates held that “A commodity which is used to denote anything which is widely accepted in payment of goods or in discharge of other business obligations.”

If this definition is analysed, gold is the only thing which is acceptable to all countries for replacement. In this condition, money formed from gold or silver alone can be included in the definition of money. So, most of the economists held, the definition given by Robertson to be narrow.

-2. Definitions with Broad Points of View:

Definition given by Hartle Withers can be included in this category! According to him, “Money is what money does.”

This definition is descriptive as well as universal. This definition can be termed as ‘everything in something’. According to this definition not only metals or currencies but also cheques, bill of exchanges, hundies and other credit instruments are included in money. But some economists consider that this definition is far more universal (broad) than what is needed. According to this definition credit instruments are also money, but nobody can be compelled to accept it for repayment.

-3. Proper Definition:

On making a careful study of various definitions, it is found that some economists have centered their attention on the acceptance of money, while some others have based their definitions on functions what it does. To know the form of money, it can be defined as follows:

“Money is something which is accepted freely and widely as a medium of exchange; measuring value; final repayment of loans and accumulating values.”

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Definitions Based on Viewpoints of Economists:

Harry G. Johnson has presented four viewpoints regarding the definition of money.

These include:

(1) Traditional Approach:

According to this viewpoint money is considered according to its function. So, all those things which act as money can be called money. On this basis, currencies and demand deposits are included in money. In this category Hartle Withers, Keynes, Kent, Crowther etc. get place for their definitions.

(2) Chicago Approach:

Economist of Chicago University has made the definition of money universal by accepting the traditional approach and at the same time including fixed term deposits and savings accounts deposits of commercial banks.

According to this approach:

Money = Currency + Demand Deposits + Fixed Deposits + Saving Bank Deposit.

(3) Gurley and Shaw Approach:

This approach includes savings deposits with non-banking financial institutions, debenture and bonds to Chicago approach.

So, according to this approach:

Money = Currency + Demand Deposits + Fixed Deposits + Saving Bank Deposits + Saving Deposits with Non-banking Financial Institutions, shares, debentures and bonds.

(4) Central Bank Approach:

According to this approach all kinds of credits are included in money. That is why; in the monetary policies of the Central Bank the amount of gross credit is considered.

Redcliff has also said, “Money means credits forwarded by various sources.”

Considering all these approaches it is evident that ‘Proper Definition’ which has already been defined is the best.

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Locality:

The definition of money says it is money only “in a particular country or socio-economic context”. In general, communities only use a single measure of value, which can be identified in the prices of goods listed for sale. There might be multiple media of exchange, which can be observed by what is given to purchase goods (“medium of exchange”), etc. In most countries, the government acts to encourage a particular form of money, such as requiring it for taxes and punishing fraud.

Some places do maintain two or currencies, particularly in border towns or high-travel areas. Shops in these locations might list prices and accept payment in multiple currencies. Otherwise, foreign currency is treated as a financial asset in the local market. Foreign currency is commonly bought or sold on foreign exchange markets by travellers and traders.

Communities can change the money they use, which is known as currency substitution. This can happen intentionally, when a government issues a new currency. For example, when Brazil moved from the Brazilian cruzeiro to the Brazilian real. It can also happen spontaneously, when the people refuse to accept a currency experiencing hyperinflation (even if its use is encouraged by the government).

The money used by a community can change on a smaller scale. This can come through innovation, such as the adoption of cheques (checks). Gresham’s law says that “bad money drives out good”. That is, when buying a good, a person is more likely to pass on less-desirable items that qualify as “money” and hold on to more valuable ones. For example, coins with less silver in them (but which are still valid coins) are more likely to circulate in the community. This may effectively change the money used by a community.

The money used by a community does not have to be a currency issued by a government. A famous example of community adopting a new form of money is prisoners-of-war using cigarettes to trade.

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Various money types:

-1. Fiat Money

Examples: Banknotes (paper money) and coins

Fiat money (fiat currency) is money whose value is not based on its inherent value but is based on an authoritative decision (fiat) by the governing body. The government declares it as legal tender and it must then be accepted as a form of payment everywhere. Due to not having an intrinsic value, a partially destroyed bill can be replaced by the Federal Reserve Bank. On the other hand, commodity money cannot be.

-2. Commodity Money

Examples: Precious metals (i.e., gold), salt, beads, alcohol

Unlike fiat currency, the value of commodity money is intrinsic; its value comes from the commodity it is made from. If the money is destroyed, it cannot be replaced. It is also probably the earliest form of money. These commodities are used as a medium of exchange and gain their value from the scarcity of the items. The use of this type of money is like using the barter system where goods and services are exchanged for the like. Unlike the barter system, using commodity money functions as a unit of account that allows you to compare the worth of goods and services.

-3. Representative Money

Examples: Certificates, token coins

Representative money, like fiat money, has no value of its own. Unlike fiat money, it is backed by a commodity. As a commodity-back money, it could be exchanged for precious metals (like gold) held within a bank vault. It was easier to carry a certificate around rather than a chest full of gold.

-4. Fiduciary Money

Examples: Checks, bank drafts

Deriving from the Latin word fiducia, to trust, fiduciary money works on the promise and trust that it will be exchanged for fiat or commodity money by the issuer (bank). People are not required to take it as a form of payment because it is not a government-ordered legal tender. People can use fiduciary money just like regular fiat or commodity money as long as they are confident that the promise will not be broken.

-5. Commercial Bank Money

Example: Funds in a checking account

Commercial money (also known as demand deposits) is a claim against a bank for the purchase of goods and services (through the means of withdrawing in person, check, ATMs, or online banking). It is a debt-created currency by the bank. They create more money through a process called fractional-reserve banking. In this, only a certain percentage of money the bank “has” is held within it. The other percent is given to others in the form of loans, in doing so, the bank makes back more money from the interest and fees charged to customers. In short, the bank is loaning out the money you deposit to give others debt and create more money from the interest placed on it.

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Leper colony money:

Leper colony money was special money (scrip or vouchers) which circulated only in leper colonies (sanatoriums for people with leprosy) due to the fear that money could carry leprosy and infect other people. The original reason for leper colony money was the prevention of leprosy in healthy persons. However, leprosy is not easily transmitted by casual contact or objects; actual transmission only happens through long-term, constant, intimate contact with leprosy sufferers and not through contact with everyday objects used by sufferers. Special leper colony money was used between 1901 and around 1955. In 1938, Dr. Gordon Alexander Ryrie in Malaysia proved that the paper money was not contaminated with leprosy bacteria, and all the leper colony banknotes were burned in that country.

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Inside and Outside Money: 

Money is an asset that serves as a medium of exchange. 

Outside money is money that is either of a fiat nature (unbacked) or backed by some asset that is not in zero net supply within the private sector of the economy. Thus, outside money is a net asset for the private sector. The qualifier outside is short for (coming from) outside the private sector. 

Inside money is an asset representing, or backed by, any form of private credit that circulates as a medium of exchange. Since it is one private agent’s liability and at the same time some other agent’s asset, inside money is in zero net supply within the private sector. The qualifier inside is short for (backed by debt from) inside the private sector. 

Money which is an asset to the person or firm holding it, but is also a liability for somebody else in the economy. As an easy way to remember whether money is “inside” or “outside” money ask first where the liability resides. If the liability resides inside the private sector then the money is inside money. If the liability resides outside the private sector then the money is outside money. For instance, a bank deposit is a liability of the private bank that issues it. One of the most common examples of inside money is the deposits that customers make at banks. These deposits form the basis for the bank being able to respond to the needs of others in the community who are in need of loans for cars, mortgages, and other loan. Inside money is contrasted with outside money, where the asset of the holder is not balanced by a liability for some other party. Bank balances, for example, are clearly inside money, while gold coinage is outside money. A rise in the real value of inside money does not increase the aggregate wealth of the economy, but redistributes it between the issuers and the holders of money.  

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Understanding Money:

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 can be: market-determined, officially issued legal tender or fiat moneys, money substitutes and fiduciary media, and electronic cryptocurrencies.

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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.

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Money is a medium of exchange, a measure of value, a store of value, and a standard of deferred payments.

-1. Medium of exchange: 

The most important function of money is that it acts as a medium of exchange. When money is used to intermediate the exchange of goods and services, it is performing the function of a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the dependence on the occurrence of a coincidence of wants. To be widely acceptable, a medium of exchange should have stable purchasing power. It should therefore possess the following characteristics:

Valuation of common assets

Constant utility

Low cost of preservation

Transportability

Divisibility

High market value in relation to volume and weight

Recognizability

Resistance to counterfeiting

Gold was long popular as a medium of exchange and store of value because it was inert and was convenient to move because even small amounts of it had considerable value. Gold also had a constant value due to its special physical and chemical properties, which made it cherished by men.

-2. Measure of value:

Money acts as a common measure of value. It is a unit of account and a standard of measurement. Whenever, we buy a good in the market, we pay a price for it in money. And price is nothing but value expressed in terms of money. So we can measure the value of a good by the money we pay for it. Just as we use yards and meters for measuring length, and pounds for measuring weights, we use money for measuring the value of goods. It makes economic calculations easy. To function as a measure of value and unit of account, whatever is being used as money must meet these characteristics:

-It must be divisible into smaller units without loss of value. For example, precious metals can be coined from bars, or melted down into bars again.

-It must be fungible. In other words, one unit or piece must be perceived as equivalent to any other. One dollar note is equivalent to any one dollar note. This is why diamonds, works of art, or real estate are not suitable as money.

-It must be countable. A unit of account is countable and subject to mathematical operations. You can easily add, subtract, divide, and multiply units. This allows people to account for profits, losses, income, expenses, debt, and wealth. It must have a specific weight, measure, or size in order to be verifiably countable. For instance, coins are often milled with a reeded edge, so that any removal of material from the coin (lowering its commodity value) will be easy to detect.

-3. Store of value:

A man who wants to store his wealth in some convenient form will find money admirably suitable for the purpose. It acts as a store of value. Suppose the wealth of a man consists of a thousand cattle. He cannot preserve his wealth in the form of cattle. But if there is money, he can sell his cattle, get money for that and can store his wealth in the form of money. To act as a store of value, money must be able to be reliably saved, stored, and retrieved. Moreover, it must be predictably usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time. Put simply, money acting as a store of value allows its owner to transfer real purchasing power from the present to the future. Some have argued that inflation, by reducing the value of money, diminishes its ability to function as a store of value.

-4. Standard of deferred payments:

Money is used as a standard for future (deferred) payments. It forms the basis for credit transactions. Business in modern times is based on credit to a large extent. This is facilitated by the existence of money. In credit, since payment is made at a future date, there must be some medium which will have as far as possible the same exchange power in the future as at present. If credit transactions were to be carried on the basis of commodities, there would be a lot of difficulties and it will affect trade. Money can function as a “standard of deferred payment”, which means that its status as legal tender allows it to function for the discharge of debts. Debt is the money you owe, while credit is money you can borrow. You create debt by using credit to borrow money.

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Money is one of the most fundamental inventions of mankind. Every branch of knowledge has its fundamental discovery. In mechanics, it is the wheel; in science fire; in politics the vote. Similarly, in economics, in the whole commercial side of man’s social existence, money is the essential invention on which all the rest is based. Money is indispensable in an economy, whether it is capitalistic or socialistic. Price mechanism plays a vital role in capitalism. Production, distribution, and consumption are influenced to a great extent by prices, and prices are measured in money. Even a socialist economy, where the price system does not play so important a role as under capitalism, cannot do without money. For a while, the socialists talked of ending money, i.e., abolishing money itself, because they considered money as an invention of the capitalists to suppress the working class. But later on they found that even under a system of planning, economic accounting would be impossible without the help of money.

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In the early stages of civilization, different people used different things as money. Cattle, tobacco, shells, wheat, tea, salt, knives, leather, animals such as sheep, horses and oxen, and metals like iron, lead, tin, and copper have been used as money. Gradually, precious metals such as gold and silver replaced other metals such as iron, copper, and bronze as money. Now paper is used as money. Almost all countries in the world today have paper money. We may describe one more form of money; that is, bank deposits that goes from person to person by means of cheques.

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Although money can take an extraordinary variety of forms, there are really only two types of money: money that has intrinsic value and money that does not have intrinsic value.

Commodity money is money that has value apart from its use as money. Mackerel in federal prisons is an example of commodity money. Mackerel could be used to buy services from other prisoners; they could also be eaten. Gold and silver are the most widely used forms of commodity money. Gold and silver can be used as jewellery and for some industrial and medicinal purposes, so they have value apart from their use as money. The first known use of gold and silver coins was in the Greek city-state of Lydia in the beginning of the seventh century B.C. The coins were fashioned from electrum, a natural mixture of gold and silver.

One disadvantage of commodity money is that its quantity can fluctuate erratically. Gold, for example, was one form of money in the United States in the 19th century. Gold discoveries in California and later in Alaska sent the quantity of money soaring. Some of this nation’s worst bouts of inflation were set off by increases in the quantity of gold in circulation during the 19th century. A much greater problem exists with commodity money that can be produced. In the southern part of colonial America, for example, tobacco served as money. There was a continuing problem of farmers increasing the quantity of money by growing more tobacco. The problem was sufficiently serious that vigilante squads were organized. They roamed the countryside burning tobacco fields in an effort to keep the quantity of tobacco, hence money, under control. (Remarkably, these squads sought to control the money supply by burning tobacco grown by other farmers.)

Another problem is that commodity money may vary in quality. Given that variability, there is a tendency for lower-quality commodities to drive higher-quality commodities out of circulation. Horses, for example, served as money in colonial New England. It was common for loan obligations to be stated in terms of a quantity of horses to be paid back. Given such obligations, there was a tendency to use lower-quality horses to pay back debts; higher-quality horses were kept out of circulation for other uses. Laws were passed forbidding the use of lame horses in the payment of debts. This is an example of Gresham’s law: the tendency for a lower-quality commodity (bad money) to drive a higher-quality commodity (good money) out of circulation. Unless a means can be found to control the quality of commodity money, the tendency for that quality to decline can threaten its acceptability as a medium of exchange.

But something need not have intrinsic value to serve as money. Fiat money is money that some authority, generally a government, has ordered to be accepted as a medium of exchange. The currency—paper money and coins—used today is fiat money; it has no value other than its use as money. You will notice that statement printed on each bill: “This note is legal tender for all debts, public and private.” Legal tender money is issued by the monetary authority of a country. It has legal sanction of the Government. Every individual is bound to accept legal tender money in exchange for goods and services, and in the discharge of debts.

Checkable deposits, which are balances in checking accounts, and traveler’s checks are other forms of money that have no intrinsic value. They can be converted to currency, but generally they are not; they simply serve as a medium of exchange. If you want to buy something, you can often pay with a check or a debit card. A check is a written order to a bank to transfer ownership of a checkable deposit. A debit card is the electronic equivalent of a check. Suppose, for example, that you have $100 in your checking account and you write a check to your campus bookstore for $30 or instruct the clerk to swipe your debit card and “charge” it $30. In either case, $30 will be transferred from your checking account to the bookstore’s checking account. Notice that it is the checkable deposit, not the check or debit card, that is money. The check or debit card just tells a bank to transfer money, in this case checkable deposits, from one account to another.

A negotiable instrument is a signed document that promises a sum of payment to a specified person or the assignee. Negotiable instruments are transferable in nature, allowing the holder to take the funds as cash or use them in a manner appropriate for the transaction or according to their preference. Common examples of negotiable instruments include checks, money orders, and promissory notes. Negotiable instruments do not include money. Negotiable instruments exist as an alternative to cash in instances where someone wants to promise or order the payment of a specific amount of money. Check is a negotiable instrument but not money.

What makes something money is really found in its acceptability, not in whether or not it has intrinsic value or whether or not a government has declared it as such. For example, fiat money tends to be accepted so long as too much of it is not printed too quickly. When that happens, as it did in Russia in the 1990s, people tend to look for other items to serve as money. In the case of Russia, the U.S. dollar became a popular form of money, even though the Russian government still declared the rouble to be its fiat money.

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Qualities (properties) of good money:  

With the ongoing fraudulent issues associated with counterfeit money, it is important to be familiar with the qualities of good money. To be able to perform the functions of money well, the money material must possess the following qualities:

-1. Acceptability – Good money is accepted by all because it serves as a medium of exchange. The material of which money is made should be acceptable to all without any hesitation. In this connection, metallic money – gold and silver are considered as good money material because they are readily acceptable to the general public due to its utility and value. The holder can use it as money or metal. He does not lose value in both.ie Apart from being used as money, these metals can also be put to other uses (e.g., making ornaments.) The essential quality of good money is that it should be acceptable to all, without any hesitation in the exchange for goods and services. Also it should have a long history of acceptance, which is why we don’t use molybdenum or rhodium.

-2. Durability – Money must be durable/long lasting. It should not lose its value with passage of time. This simply refers to the physical wear and use of money over a period of time. If some money is easily destroyed or damaged it is likely that it is fraudulent and therefore cannot be trusted. Money material must last for a long time without losing its value. Ice and fruits cannot become good money because they lose their value with the passage of time. Ice melts and fruits, wheat, corn, rice etc perish. Metals are most durable compared to other forms of money. Gold and silver do not wear out quickly, in case of money made from a paper source some wear and tear must be expected. However they can be treated as durable due to replacement by the bank.

-3. Portability – The commodity chosen as money should be easily transportable without any depreciation. Good money must be portable easily. It should have more value in small quantity. On this ground, various animals cannot be used as money. The commodity chosen as money should be easily transportable without any depreciation. i.e. should be easily transferable from one place to another for doing business and making payment. The paper money is easier to carry because it has less weight than metallic money, people can carry it around with them on a daily basis. This also allows for the ease of transaction.

-4. Scarcity – The scarcity is the quality of good money material. Good money is always scarce. Money must be limited in supply as compare to demand for it. It should be scarce enough to be valuable/ to retain its worth. The more money that is in circulation the less it is valued by the economy. Which is why we don’t use aluminium or iron or common goods such as sand or pebbles on a beach. This quality induces the people to have more and more money for meeting their basic necessities of life.

-5. Divisibility – Good money is that which could be easily sub-divided for the purchase of smaller units of the commodities, without losing any value. People will only need as much money as is necessary for their purchases, therefore it is necessary for money to be easily broken down for different types of transactions. Cow, for example, cannot function as good money because it cannot be divided without losing its value; a fraction of cow is quite different entity than a whole cow. The metallic money and paper money is divisible and therefore has public confidence

-6. Cognizability – Good money is easily recognized either by sound, sight or touch. If it is not easily recognizable, it would be difficult for the individuals to determine whether they are dealing with money or some inferior asset.  Money is subject to the type of currency that is in circulation within a specific place, so if it is easily recognized it is likely to be genuine. The printing of notes is secret. The imitation is not possible, because the process of colouring and the quality of paper are always in the hands of central bank. The general public is familiar with the various kinds of notes and recognise it easily.

-7. Malleability – A good money material must be malleable i.e. capable of being melted and put to different forms/new money. A metal is melted and then coins are minted. Gold, silver, copper, etc., have this quality they can be moulded and stamped and proper designs are made on it. The money material, which can be melted, is fit for making coins. The malleable materials have impression on its face and back for recognition.

-8. Homogeneity / Uniformity – Good money must be of standardized/identical nature. The quality and quantity of its material should not undergo great change. Money should be homogeneous. Its units should be identical; they should be of equal quality and physically indistinguishable. The unit of money of the same denomination of currency must have the same purchasing power otherwise there will be confusion in buying and selling of goods and services. The colour and size of money material help the people to deal in the market and also allows for money to be counted and measured accurately. If money is not homogeneous, the individuals will not be certain of what they are receiving when they make transactions.

-9. Elasticity -The good material has the quality of elasticity. The business needs change from season to season. The supply money should be elastic. If demand of money increases its supply may be increased easily. Paper money possesses the quality of elasticity.

-10. Stability of value – The value of money should remain stable and should not change for a long period of time. If the value of money is not stable, it will not be able to function as a measure of value, as a store of value and as a standard of deferred payment. A change in its value brings change in the prices of goods and services. The public confidence is developed if value of money is stable. The money having ever-changing value is not liked by the people

-11. Storability – A good money material is that which can be store able without any depreciation. If money material is perishable then it cannot serve as a good money material as it will lose its value. A good money material is storable for meeting the future demand. The minimum space and lowest storing expenses are necessary for keeping the money material. Paper money and metallic coins have this quality of storability.

-12.  Economical – It is important quality of good money that it should be made economically, unnecessary expenditure may not be wasted on its preparation. If there is heavy cost on issuing more money that is not good money. Good money is that has low cost and more supply. The cost of printing currency notes and minting coins must be lower. Paper money has this quality of economy.

-13. Effective Supervision – The good money is one that can be effectively supervised by a central monetary authority. It is of such a nature that central authority is able to keep records of the amount of money in circulation and the pattern of its distribution.

-14. Government Support: The good money material must be supported by the government. The people accept even fiat money (money issued without keeping any metallic reserves) due to the government support. The government’s backing to money creates a sense of confidence.

-15. Fungibility: It must be fungible. In other words, one unit or piece must be perceived as equivalent to any other. One dollar note is equivalent to any one dollar note. This is why diamonds, works of art, or real estate are not suitable as money.

-16. Countable: It must be countable. A unit of account is countable and subject to mathematical operations. You can easily add, subtract, divide, and multiply units. This allows people to account for profits, losses, income, expenses, debt, and wealth. It must have a specific weight, measure, or size in order to be verifiably countable. For instance, coins are often milled with a reeded edge, so that any removal of material from the coin (lowering its commodity value) will be easy to detect.

-17. Noncounterfeitability:  This characteristic means that money cannot be easily duplicated. A given item cannot function as a medium of exchange if everyone is able to “print up,” “whip up,” or “make up” a batch of money any time that they want. Why would anyone accept money in exchange for a good, if they can make their own? Money that is easily duplicated ceases to be the medium of exchange.

Preventing the unrestricted duplication of money is a task that has long been relegated to government. In fact, this task is one of the prime reasons why governments exist. An economy needs government to regulate the total quantity of money in circulation. By controlling money duplication, governments are also able to control the total quantity in circulation, and this control is what gives money value in exchange. 

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So far not a single commodity has been discovered which possess all the attributes given above in their entirety. The precious metals, gold and silver by and large, possess the above mentioned qualities of good money material. It is because of this reason, that these metals have been used as money for a considerably long period of time. These have been discarded in the past in favour of paper currency and bank money. Now the notion of money has changed. The modern governments go through trial and error procedures before adopting a common medium of exchange. The main considerations for selecting a money material are general acceptability and cost of producing money. We can say that anything which command confidence of the people and is accepted as a medium of exchange is called money.

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Technological progress has historically enabled the development of new forms of money with novel and enhanced properties. The introduction of coins and paper money, for instance, improved portability and cognizability relative to commodity money. Private bank money offered the possibility to earn interest and (eventually) transact digitally. Cryptocurrencies, such as Bitcoin, provided censorship resistance. Central bank digital currencies, which are under research and development at an increasing number of central banks, promise to restore public money, but in a digital form. And quantum money, which has been theoretically studied but is not yet technically feasible, could reproduce the properties of cash, but with improved unforgeability guarantees and the ability to transact digitally.

While digital forms of money are now the preferred medium of exchange in many countries, the terminology used to describe money is still largely derived from foundational texts on physical currency, such as Jevons and Menger. Furthermore, the academic discussion of money’s functions that followed these texts appears to have peaked prior to the development of digital currencies. Consequently, many concepts that are routinely used in the modern literature on money were crystallized prior to the digital era.

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Properties of money are depicted in table below:

The table categorizes instantiations of broad categories of money according to the extent to which they exhibit different properties. Each row contains a property of money, categorized by the primary function to which it corresponds. Each column refers to a broad category of money, along with a representative example, given in parentheses, and is used to determine which properties apply.

A † indicates that a property or function appeared in the original Jevons-Menger framework. A Ë indicates that a form of money has a property, a − indicates that the property is present but weaker than in the best available implementations, an é indicates that it is not present or not satisfactory, and A ? indicates that we are uncertain whether the property will hold. The ` symbol represents a volatile transaction cost.  For the purpose of this table, quantum money is apparently issued as a CBDC and, thus, has the properties of public money. It is also, of course, possible that it could be issued privately.

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Attributes of money:

Currently, fiat money is generally centralized, traceable and unconstrained, but this is a relatively recent phenomenon (starting in 1971). However, historically, money was open, decentralized, anonymous and supply constrained and there is clearly important utility to this combination of attributes.

Gold is the most ubiquitous commodity money and is fully anonymous, decentralized, open, supply constrained and physical. While gold is still used as money, its primary function is store of value. Historically used as money, it has been hampered in recent times from its physical nature which creates serious limitations in a global and digital world. Importantly, gold is only currently supplied constrained—it grows by the amount mined on Earth each year (~2%). However, gold is only scarce on the surface of the Earth. Whereas it is far more common in the solar system and in the foreseeable future mankind may access these broader supplies of gold. For example, one small asteroid could easily contain a very meaningful percentage of the existing gold stock which would be problematic in maintaining a supply constrained ledger as a store of value.

Cryptocurrency (e.g., Bitcoin) is pseudo-anonymous, decentralized, open, supply constrained and natively digital. Bitcoin is the first cryptocurrency and the best proxy to use as it ranks highest in nearly every important metric including market cap, transaction volume and developer engagement. Its invention created a money ledger very similar to gold with two crucial differences: Firstly, and most importantly, it is natively digital and therefore created an open, decentralized ledger that did not have to exist in physical form. Secondly, it is verifiably supply constrained with a programmatic cap at 21 million Bitcoin, subject to a majority of the network changing the rules. This is inherently deflationary and has no prior antecedent in a successful money ledger and many other cryptocurrencies have opted for some form of a programmatic perpetual inflation.

Below is a chart that compares the various attributes and examples.

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Intrinsic and Extrinsic Attributes of Money: 

The properties of money are not solely determined on the basis of the object or artefact used as money but in terms of the combined intrinsic attributes (those inherent to the object or artefact), and extrinsic attributes (those realised or provided within a domain). Intrinsic and extrinsic attributes in turn give rise to the differing capabilities of a particular manifestation of money to fulfil the functions of money in a particular domain.

Table below presents many of the important intrinsic attributes of money. Intrinsic attributes are characteristics that are inherent in the given form of money and do not change with domain of use but may differ in their manifestation e.g., Digital Fiat vs currency notes and coins. Jevons (1875) suggested that perfect money should have among other things the following characteristics: divisibility, be fungible or homogeneous, and portable which are all intrinsic attributes in our framework.

Intrinsic Attributes of Money:

Attribute	Description
Divisible	The value of the artefact is divisible in a measurable way and available in fractional form e.g., such as coins and notes.
Fungible	Consistency between individual units with the same value, namely they can be substituted as alternatives.
Identifiable	Easily identifiable as money by formation and/or characteristic identifiers on the artefact.
Securable	Low cost to secure and protect from theft, loss or damage.
Seigniorage cost	The artefact has a relatively low cost of enabling it as money relative to its value in usage. Cost of production and in-use is low.
Uniqueness	Reasonably unique, not easily duplicable and able to be authenticated in some visible way to prevent counterfeiting.
Anonymous	The artefact is not traceable to the last holder and is independent – ownership rests with the bearer.
Digital/Programmable	Exists in cybernetic or electronic form only.
Durable	The degree an artefact reasonably survives repeated use i.e., does not diminish in value in any significant way.
Physical	An artefact that can be physically held or touched.
Portable	Ability to transport or send.

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Extrinsic attributes are defined in the context of an existing artefact adopted as money as these attributes are augmentations to physical or virtual artefacts. For example, the ability to transact directly without intermediaries is dependent on a platform or network to facilitate the transaction even though a digital currency has an intrinsic attribute that allows it to be transferred electronically. Extrinsic attributes usually, depending on implementation, require institutional arrangements to facilitate that capability by providing connectivity between platforms. Other forms of money such as account-based money require additional capabilities to allow exchanges across domains to enable them to be used for settlement. Table below presents many of the important extrinsic attributes of money.

Extrinsic Attributes of Money:      

Attribute	Description
Disintermediated	Transactions are not gross-settled but can be settled directly.
Finite supply	Quantity available is finite and limited.
Fiat authority	Legally acceptable form of money within a particular domain(s).
Usage/utilisation	Degree to which the money has wide adoption – dynamic.
Institutional recognition	Formal institutions are willing to accept and transact the money.
Asset backed	Value backed by external asset reserves.
Private	Private money controlled by non-government sources vs. public money by sovereign government.
Transfer mechanism	Network externalities and platform.
Transfer protocol	Operationally supported with records to manage the source and destination of transfer in the payment system.
Socially recognised	It is an artefact that can articulate value in society and is socially recognised as money.

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To enable interoperability of money across domains requires transfer protocols and platforms to complete transactions e.g., SWIFT in foreign exchange. Some attributes can be autoaugmented. For example, when a form of money has wider adoption due to network effects of usage, it becomes better accepted (i.e., the extrinsic attribute of high usage/utilisation) and this enhances its capability as money. Thus, attributes are properties that are not only observable or measurable by existence but also by intangible aspects such as social recognition and utilisation performance.

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Relating Capabilities to Functions:  

Table below outlines the capabilities essential to support each triad function. For example, the medium of exchange function of money has often been cited as the predominant motivator for the use of money (e.g., Menger, 1907) and is supported by capabilities such as acceptability, convenience and low cost of use, relative to the value being exchanged and is easily transferable.

Functions and Related Capabilities of Money: 

Function                Capability		Description
Medium of Exchange
	Acceptability	Acceptance in transactions.
	Convenience	Convenient personal handling, storage, transportation and safe keeping with minimal cost or eroding value.
	Cost of operating	The transactions can be completed at a low cost and includes the cost of creating the money.
	Transferability	The ability of money to conclude transfers rapidly.
Store of Value
	Liquidity	Conversion to other forms of money or assets by frictionless exchange is relatively easy.
	Ownership	Able to be attached to the owner of that money by a record of account or provable possession (e.g. account money).
	Payment	Money is capable of settling a transaction to finality.
	Stable value	Does not intrinsically fluctuate in value with usage.
Unit of Account
	Deferred payment	Allow users to acquire goods or services where payments are postponed to the future. Usually only used where debt is likely to be recovered.
	Macro money	Money needs to support the overall macro economy in terms of its scale and scope to reflect the real activity in the economy whilst maintaining the purchasing power of the money (Friedman, 2002).
	Standard of value	Used to measure the value of goods or services and be compared in relative terms to other forms of money.
	Scalable	The money can be expanded if more money is required in the economy.

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The store of value function of money allows value to be transferred in time for future trading or deferred consumption. The holding of money through time was highlighted by Keynes (1936), who suggests that individuals will forego consumption with no gain in wealth over time due to uncertainty around the future, lack of synchronization of cash flows, and costs of transacting. In relation to alternative physical stores of value, money may be more durable in nature and hence stable in value (Hoover, 1996). Also, money should be durable, valuable, and able to be stored or hidden with little loss of value and secure against loss of value (Latzer and Schmitz, 2002). 

The store of value function is supported by capabilities such as whether the money is liquid or easily convertible, can have ownership readily attributable, be used for payment, and to have a stable value. Convertibility was initially considered around whether the State would purchase or back money (Knapp, 1924). If money is illiquid, it will have reduced acceptability and a reduced capacity to maintain a stable value. A user of money asserts ownership by way of their rights over the money so that they can use it, often by possession. If there is concern that money has been illegally obtained, then the money may be confiscated by authorities effectively removing the store of value from the holder of the money. Money is held to ‘lubricate the action of exchange’ (Jevons, 1875) enabling payments or to settle liabilities for both current and future transactions.  Therefore, store of value functions requires money to have the capability of a stable value to encourage transactions to be undertaken and not change due to different usage situations or domains. In other words, the artefact should be a consistent measure of value across different types of exchanges in its domain(s) of use and not tied to a particular form of transaction or vary with type of transaction. Furthermore, it should be able to be compared in relative and stable terms with other forms of money to enable easy exchange (Ingham, 2013). 

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The unit of account function of money, or standard of value (Hicks, 1989) can be considered analogous to the gain that comes from other common measurements such as height and weight (Brunner and Meltzer, 1971). Unit of account allows for expanded trade given an agreed upon means to measure to value goods or services. This function also helps to determine amounts to transact in the intertemporal allocation of resources including deferred payments, borrowing, credit and the expansion of payment systems (Brunner and Meltzer, 1971). Also, money can be used as ‘macro money’ when it has fractional reserve capabilities that also support the unit of account function. But there is concern that money will lose its macro abilities with further improvements in technology (such as cryptocurrency) whereby payments can be made outside the banking system (e.g., Brunnermeier, James and Landau, 2019), so that central banks lose their ability to influence the short-term interest rate (Friedman, 2002). 

Standard of value is an important capability of money according to Ingham (2013) as it can be used to measure the value of two artefacts that do not need to be directly traded or compared. In other words, it supports the ability of money to put a number or ‘numeraire’ on a good or service and therefore to be representative of a clearing price at an auction (Bell, 2001). The unit of account function of money is also supported when money is scalable. For instance, when the economy grows, the amount of money available needs to grow too. The unit of account function also relies on money having a stable value which is also required for money to be useful as a measure of value. Jevons (1875) suggests that money lent needs to be paid back in the future and ‘that the value of future payments needs to be regulated’ so that the money recouped can be exchanged with other commodities in nearly unchanged ratios in the future (i.e., to maintain purchasing power). It would be difficult for a contract or good to be measured in value using a lesser-known form of money that does not have a stable value. This has been the major argument against the use of Bitcoin as money given the volatility of its price and hence its function as a stable value is weak (e.g. Yermack, 2017). However a plethora of cryptocurrencies have emerged in the form of ‘stablecoins’, with the objective of limiting the fluctuation of price (relative to the US dollar) such as Tether and new proposals such as Diem from Facebook that will offer Fiat pegged stablecoins, such as Euro-Diem and so on. They all plan to use additional or augmented methods and procedures to stabilise their value that are not intrinsic to the cryptocurrency. 

Thus, it can be seen that there are many forms of money emerging, notably cryptocurrencies and CBDC, that will vary in their capabilities to fulfil triad functions depending on domain. From this analysis, it is evident that the ability of existing forms of money to perform the triad functions is constantly changing in terms of particular capabilities, which are due not only to the intrinsic attributes but importantly also due to the extrinsic attributes often provided by institutions and users within the domain.  

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Functions of Money:

Just like the definition, the functions of money have also drawn the economists into confusion. Prof. Kinley has divided the functions of money into three categories where­as Prof. Chandler has considered the main function of money to ease transactions of goods and services. On the other hand, there is an English poem in vogue about the function of money, “Money is a matter of four functions a medium, a measure, a standard, a store.” But in practice, the functions of money are wide ranging. Considering the convenience of study, functions of money can be classified as follows: 

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(A) Primary Functions:

The essential and fundamental functions that money should perform is every economy are regarded as primary functions of money. Primary functions of money are those functions which are applicable in any country in every time and circumstances.

Following two functions come in this category:

-1. Medium of Exchange:

Money serves as a medium of exchange. This is the main and most important function of money. Money carries the capacity to purchase goods and services which people want. Money is normally accepted as a medium through which all the sales and purchases takes place. As the money is accepted as a common medium of exchange, it has eliminated the difficulties of barter system. It has avoided the wastage of time and resources and has eliminated the need for double coincidence of wants involved in the barter.

-2. Measure of Value:

Money is accepted as a common measure of value. Under the barter system, the value of a commodity used to be expressed in terms of other commodity. The value of rice used to be expressed in terms of a piece of cloth but after the evolution of money, value of any commodity can be expressed in terms of money. When we express the value of a commodity in terms of money, it is known as price. Thus, money provides a language of economic communication. Money will be a useful unit of value only as long as its own value or purchasing power remains constant. But it is also important to note that value of money changes from time to time. Consequently, gross measurement of money is still troublesome. Cloth is measured in meter and the length of meter is fixed and rice is measured in kilogram and kilogram is a fixed quantity. But the value of money is not still and it keeps changing. This creates difficulties in the economy of a country.

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(B) Secondary Functions:

These categories of functions are those, which are derived from the primary functions.

Secondary functions of money are as follows:

-1. Standard of Deferred Payment:

Money acts as a standard of deferred payment. In other words, money can be used in the settlement of debts. It means payment to be made in future can be assessed and expressed in terms of money. This function of money has been derived from medium of exchange function of money. The present era is the era of credit. Credit plays an important role in the progress of any business. Credit is a system in which goods and services are exchanged or money is borrowed on the promise of future payments. The use of money has made the credit system quite easy.

Under barter system, credit transactions were not possible because the seller was not sure of getting the same kinds of good after a certain time period. This problem has been removed completely with the introduction of money. In modern economy, many transactions involve the deferred payment.

It is possible to accept money as a standard of deferred payment because money has a general acceptability and it can be expressed in definite and standardized units. For example, A lends Rs. 1000 to B for a year. He knows well what he will receive after a year. On the other hand, A lends 1 kg rice to B for a year, it is not definite that he will receive back the rice of same quality as he lends out.

Money is a more successful functional unit of the standard of deferred payments, because:

(i) It’s value is relatively more stable.

(ii) The element of durability is higher.

(iii) There is a quality of general acceptability.

-2. Transfer of Value:

Money also acts as a means to transfer of value. This function of money has derived from the general acceptability of money as a medium of exchange. Value can be transferred from one person to another with the help of money. When we pay the price of any commodity to its owner, we transfer the value to the owner. Similarly, money is a quick and efficient means of transferring value from one place to another. The price of any commodity can be paid in terms of money from one city to another or from one state to another or even from one country to another country.

-3. Store of Value:

Money acts as a store of value. It means people can store their wealth in the form of money. Before the evolution of money, it was not always possible to store the wealth. As the perishable commodities, i.e., wheat, rice, vegetables which were not needed at a time, could not be stored for a long time.

Money has facilitated the store of value. Though there are some other things which can be stored as store of money like gold, bond, shares, debentures, etc. But money is considered a better storage of value particularly in one respect. Money is a perfectly liquid asset, i.e., it is a readily and generally acceptable means of payment. It gives the immediate purchasing power which other goods do not give. Thus, in the form of money, purchasing power can be stored and can be used at any time as and when needed.

The invention of money has eased the process of storing money or wealth. Banking system also operates using this characteristic of moneys. This feature of money promotes the tendency of saving which leads to capital formation and activates the economic development of a country.

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(C) Contingent Functions:

The contingent functions of money were not the contemplated functions. Rather they emerged or evolved with the expanded scope of facilitating functions of money. Money can be used in assisting various economic entities such as consumers, producers, etc., in arriving at economic decisions relating to consumption, production, etc. These are the contingent functions of money. The main contingent functions are as below:

-1. Maximization of Utility:

As we know a rational consumer wants to maximize his utility (or satisfaction) while purchasing various goods and services. A consumer will be able to maximize his satisfaction, if the ratios of marginal utilities of different commodities is equal to the ratio of price between different goods. For equalizing the marginal utilities, money plays an important role because prices of all commodities are expressed in terms of money.

-2. Employment of Factor Inputs:

Money helps the producer in deciding how many units of different factors of production should be employed. Every producer wants profit maximization while employing various factors of production. A producer with maximum profit objective will equate marginal productivity (expressed in value terms) of a factor with its price or rate of remuneration and remuneration is expressed in terms of money. Thus, money is helpful in taking decisions regarding employment of units of factors of production.

-3. Basis of Credit:

Credit instruments are increasingly being used these days. Cheques, bank drafts, bill of exchange, hundi etc. are commonly used for payments. But money is hidden in these credit instruments. Banks issue drafts or allow the use of cheques against liquid money only. Thus, money does the work of credit.

-4. Distribution of Income:

The work of production has become wide and complex in the present era. Various sources contribute in the work of production. Sources of production are paid for their contribution after selling the produced goods and getting money. The job of production is possible only due to this role of money. Thus, money is the basis of social distribution of income.

-5. Maximum Satisfaction:

Every consumer wants to get maximum satisfaction. To achieve maximum satisfaction, he wants to spend his income to meet various needs in such a way that he can get equal marginal utility from every commodity. This is possible only through the use of money. 

-6. Productivity of Capital:

Money increases the productivity of capital as it is the most liquid asset and can be put to any use. Due to liquidity of money, capital can be easily transferred from less productive uses to more productive uses.

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(D) Other Functions:

Besides the functions started above, money does some other functions as well.

A few of these are:

-1. Guarantor of Solvency:

Every person or firm keeps sufficient money in reserve to maintain the ability of solvency. If they don’t have sufficient money for repayment of loans, they lose their ability of solvency and they are declared to be insolvent. Thus, money works as an indicator of guarantee of ability of solvency. 

-2. Helps to maintain Repayment Capacity:

Money characterizes the virtue of general acceptability. Therefore, to maintain its capacity to pay, every individual and firm has to keep some amount of liquid money in its assets. By so doing, the firm protects its repayment capacity. Similarly, banks, insurance companies and even governments keep some money in the liquid form so that they are able to maintain their repayment capacity.

-3. Money represents Generalized Purchasing Power:

Money represents the purchase power. This purchasing power stored in terms of money can be put to any use. It is not necessary that money should be utilized for the same purpose for which it has been saved. For example, if a person has saved now to construct a house sometime in future, it is not necessary that he should utilize that saving only for constructing the house. The saver may prefer to spend it on some other more important uses such as education of his children. Objectives for which saving has been made may change overtime. If the objective of the saver changes, he faces no difficulty because money represents generalized power that can be put to any use saver likes. This gives money bearer options.

-4. Liquidity:

Money is the most liquid of all assets. Money can be put to any use readily. “Market liquidity” describes how easily an item can be traded for another item, or into the common currency within an economy. Money is the most liquid asset because it is universally recognized and accepted as a common currency. In this way, money gives consumers the freedom to trade goods and services easily without having to barter. Liquid financial instruments are easily tradable and have low transaction costs. There should be no (or minimal) spread between the prices to buy and sell the instrument being used as money.  

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Static and Dynamic Functions:

Paul Einzing has classified the functions of money into two broad categories, i.e., static and dynamic functions:

-1. Static Functions:

In the static functions, money acts as a passive or technical tool to ensure a smooth working of the economic system. It does not have a causative influence on the economic activities. The traditional functions of money, i.e., medium of exchange, measure of value, standard of deferred payments and store of value, all are the static or technical functions of money.

Paul Einzing adds one more technical function, i.e., money as a medium of price mechanism. Prices are the value of goods and services, expressed in money terms. Money is a medium through which the price mechanism operates in order to establish a balance between demand and supply in the market, and, thereby, to reconcile the interests of the producers and consumers.

-2. Dynamic Functions:

The dynamic functions are those by which money actively influences the economic system through its impact on price level, interest rates, volume of production, distribution of wealth and income etc. In its dynamic role, money tends to influence the economic trends.

Important dynamic functions of money are described below:

(i) Effect on Price Level:

Money has great influence on the economic activity through a rise or fall in the price level (or a fall or rise in the value of money.) According to one explanation, inflation or a general rise in price level is caused by an increase in the amount of money in circulation; and deflation or a general fall in price level is due to decrease in money supply.

(ii) Effect on Interest Rate:

Money has great influence on the economic system by changing interest rates. Change in the money supply is partially responsible for the fluctuations in the interest rates. Interest rate falls with an increase in money supply and rises with a decrease in money supply.

(iii) Effect on Utilisation of Resources:

Proper application of monetary system can bring about an efficient and full utilisation of natural and human resources of the country and of its technological process. This, in turn, increases the national product and improves the standard of living of the people.

(iv) Effect on Government Expenditure:

The monetary system has also influenced the expenditure of the modern governments. Through deficit financing, the present governments are able to spend much more than what they receive by way of taxation or other sources of revenue. This enables the government to undertake a number of economic, social and defence activities in the country.

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The Domains of Money: 

The domain of money is defined as comprising the users who adopt it, and the locale or context of use, money in one domain, even if intrinsically the same, may not be money in another.

Figure below illustrates the concept of a domain, defined as the confluence of the community adopting it (who) and the physical context of usage (where). This determines the adoption of particular forms of money based on the needs of users in that domain of use.  Users that transact money can be classified as consumers (individuals and households), businesses or government. The physical context of use or spatial aspects can be classified as proximal (or local), national or regional, or international. 

The shaded concentric circles indicate the spatial aspects of the domain, the dot filled ovals represent the user domain and the white area outside the circles indicate the virtual domain.

One insight that emerges from figure above is that consumers tend to have historically transacted mostly in narrower or proximal domains, as social development of institutions emerged and as mobility and technology improved, they have widened their domain by transacting more widely and virtually respectively, regardless of physical location. For example, today many users of money can access a virtual domain (via the internet) and transact anywhere to the extent determined by platforms or computer networks and services that are provided by the business or government institutions, enhancing the ability to utilise of that money. Therefore, the capability of any artefact identified as money to serve the domain requires an assessment of its functional capability in a domain, determined by both its intrinsic and domain augmented extrinsic attributes.

The adoption of a form of money in a particular domain does not require it to be absolutely intrinsically superior in capability to another form. For example, prisoners use cigarettes as a (commodity) currency to buy and sell ‘services’ in prison and their value as currency (due to scarcity and acceptance) far exceeds their value as cigarettes outside of a prison domain where they are just cigarettes. A more sophisticated historical example are bills of exchange, which were predominantly used by merchants and financial institutions, relying on their relationships and information about the banks issuing and accepting the bills; knowledge which was not widely known beyond the narrow domain of merchant exchange.

A contemporary example is cryptocurrency. In some circumstances, users may prefer money that is anonymous and easily transferable without intermediation i.e., they would prefer to avoid digital bank account money with greater capability but to instead use paper fiat currency or even diamonds, gold or Bitcoin which have the attribute of anonymity. Rejecting Bitcoin as money because it may fail to fulfil all triad functions, due to its limited payment capabilities due to limited acceptance or price volatility relative to the U.S. dollar, is a flawed argument because it may still function as money in some domains and by its increasing usage may alter its acceptability and volatility.  

Money is a construct, used in societies to store, measure and transfer value. New digital forms of money are motivating a reconsideration of what can function as money. What constitutes money has been considered by many including Smith (1779) and later Mill (1885) and (Jevons, 1875) who assesses the type of objects that can be money. This has been encapsulated in the traditional and widely accepted triad of monetary functions, usually applied in simple binary ways. Namely: an object is money because it supports the triad of functions (unit of account, store of value and medium of exchange), alternatively, the object cannot be considered as money if it fails on at least one of the triad functions (Brunner and Meltzer, 1971). Jevons (1875) warned that the consideration of the ‘union of functions’ was not always desirable, although this practice has persisted. With new digital forms of money supported by innovations and technological change, the binary contrast is becoming blurred. For instance, some consider Bitcoin to be money while others do not (e.g., Yermack, 2017).

The evaluation of new money proposals such as Bitcoin, Diem (formerly Libra), DeFi tokens or central bank digital currencies (CBDCs) is not effective using a triad-based analysis, without this deeper contextualisation of their domain of use. For example, the use of CBDCs is being considered carefully in the context of domain (e.g., retail vs. wholesale settings) and as a consequence its functionality as money will vary. This domain context is helpful in debate about whether new digital forms of currencies such as cryptocurrencies or CBDCs are or can act as a form of money and in considering the impact of cryptocurrencies and private stablecoins on established monetary systems. Domain is important for considering the implications for the sovereignty of government, fiscal policy and for financial institutions that enhance the capabilities of money.

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Uses of money:

Below is a pie chart of uses of money as well as the ideal ranges for each category.  

Simply put, every dollar you earn can go to one of five places: 

Live – These dollars are your lifestyle expenses, the provisions you make for yourself and your family. This is your base standard of living.

Give – These are the monies that you give away. Giving generously and unconditionally breaks the power money can have on you.

Owe (Debt) – Debt payments include your mortgage, auto loans, school loans or any sort of debt you owe.

Owe (Taxes) – This is the part of your contribution to society as a whole. If we can take the perspective that it is part of our obligation then we can more easily embrace it.

Grow – Saving and growing your monies is the only way to achieve long-term goals. These are your excess funds that you allocate to any sort of investment strategy.

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Demand for Money:

The demand for money is different from demand for a commodity. Demand for money refers to the amount of money to be held by individuals and businesses. On the other hand, demand for a commodity is the demand for the continuous flow of goods and services. Therefore, the difference between the demand for money and demand for commodity is that the former focuses on the holding, while later focuses on the flow. Earlier, the demand for money was defined as the amount of money required for making business transactions.

In simple terms, the demand for money was dependent on the number of transactions done in an economy. As a result, there was a rapid rise in the demand for money in the boom period, whereas the demand for money fell at the time of depression. On the other hand, modern view on demand of money given by Keynes says, demand for money is the demand for money to hold. In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or checkable bank deposits rather than investments. Money is the most liquid of all assets in the sense that it is universally acceptable and hence can be exchanged for other commodities very easily. On the other hand, it has an opportunity cost. If, instead of holding on to a certain cash balance, you put the money in a fixed deposits in some bank you can earn interest on that money. While deciding on how much money to hold at a certain point of time one has to consider the trade-off between the advantage of liquidity and the disadvantage of the foregone interest.

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Keynes postulated that there are three motives describing what induces people to hold money (Mishkin, 1992, pp.530-533).  The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for holding money: the transactions, the precautionary, and the speculative motives:

(1) The transactions motive: 

People hold money because it is a medium of exchange that can be used to carry out everyday transactions. Individuals require money to fulfill their current requirements, which is termed as income motive. On the other hand, businesses need money for carrying out their business activities, which is known as business motive. Contrary to other assets, e.g., land, there are no transaction costs involved. For example, if a piece of land has to be sold in order to get cash quickly, one might have to settle for a lower price. The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises.

(2) The precautionary motive: 

Precautionary motive refers to the longing of individuals to hold money for various contingencies that may take place in future. These contingencies can include unemployment, sickness, and accidents. The amount of money needed to be held for the precautionary motive depends on the nature of a person and his/her living conditions.

(3) The speculative motive:

Money, like other stores of value, 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 depreciate in value due to inflation. The opportunity cost of holding money is the interest rate that can be earned by lending or investing one’s money holdings. 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.

For example, if a stock market crash seemed imminent, the speculative motive for demanding money would come into play; those expecting the market to crash would sell their stocks and hold the proceeds as money. The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation. If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. Keynes believed that interest rates also play an important role. As interest rates rise, the demand for money falls. This means with rising interest rates people want to hold bonds rather than money. People are more likely to expect a higher return from holding a bond than from holding money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money.

The precautionary and speculative motive acts as the store of value with different purposes.  

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Supply of Money:

As discussed above, the demand for money is demand for money to hold. Similarly, supply of money refers to the supply of money to hold. Money needs to be held by individuals; else it does not exist. Supply of money refers to the total amount of money (in any form) that is held by a community in a given period of time. In earlier times, the metallic money was the most common form of money that constituted the major part of money in an economy. In modern times, metallic money has been replaced by currency notes and checkable bank deposits.

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In economics, money is any financial instrument that can fulfill the functions of money. These financial instruments together are collectively referred to as the money supply of an economy. In other words, the money supply is the number of financial instruments within a specific economy available for purchasing goods or services. Since the money supply consists of various financial instruments (usually currency, demand deposits, and various other types of deposits), the amount of money in an economy is measured by adding together these financial instruments creating a monetary aggregate.

Modern monetary theory distinguishes among different ways to measure the stock of money or money supply, reflected in different types of monetary aggregates, using a categorization system that focuses on the liquidity of the financial instrument used as money. The most commonly used monetary aggregates (or types of money) are conventionally designated M1, M2, and M3. These are successively larger aggregate categories: M1 is currency (coins and bills) plus demand deposits (such as checking accounts); M2 is M1 plus savings accounts and time deposits under $100,000; M3 is M2 plus larger time deposits and similar institutional accounts. M1 includes only the most liquid financial instruments, and M3 relatively illiquid instruments. The precise definition of M1, M2, etc. may be different in different countries.

Another measure of money M0 is also used. M0 is base money, or the amount of money actually issued by the central bank of a country. It is measured as currency in circulation plus reserves of banks and other institutions at the central bank. Reserves are not part of money supply.  

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The total quantity of money in the economy at any one time is called the money supply. Economists measure the money supply because it affects economic activity. What should be included in the money supply? We want to include as part of the money supply those things that serve as media of exchange. However, the items that provide this function have varied over time. Before 1980, the basic money supply was measured as the sum of currency in circulation, traveler’s checks, and checkable deposits. Currency serves the medium-of-exchange function very nicely but denies people any interest earnings. (Checking accounts did not earn interest before 1980.)

Over the last few decades, especially as a result of high interest rates and high inflation in the late 1970s, people sought and found ways of holding their financial assets in ways that earn interest and that can easily be converted to money. For example, it is now possible to transfer money from your savings account to your checking account using an automated teller machine (ATM), and then to withdraw cash from your checking account. Thus, many types of savings accounts are easily converted into currency.

Economists refer to the ease with which an asset can be converted into currency as the asset’s liquidity. Currency itself is perfectly liquid; you can always change two $5 bills for a $10 bill. Checkable deposits are almost perfectly liquid; you can easily cash a check or visit an ATM. An office building, however, is highly illiquid. It can be converted to money only by selling it, a time-consuming and costly process.

As financial assets other than checkable deposits have become more liquid, economists have had to develop broader measures of money that would correspond to economic activity. In the United States, the final arbiter of what is and what is not measured as money is the Federal Reserve System. Because it is difficult to determine what (and what not) to measure as money, the Fed reports several different measures of money, including M1 and M2.

M1 is the narrowest of the Fed’s money supply definitions. It includes currency in circulation, checkable deposits, and traveler’s checks. M2 is a broader measure of the money supply than M1. It includes M1 and other deposits such as small savings accounts (less than $100,000), as well as accounts such as money market mutual funds (MMMFs) that place limits on the number or the amounts of the checks that can be written in a certain period.

M2 is sometimes called the broadly defined money supply, while M1 is the narrowly defined money supply. The assets in M1 may be regarded as perfectly liquid; the assets in M2 are highly liquid, but somewhat less liquid than the assets in M1. Even broader measures of the money supply include large time-deposits, money market mutual funds held by institutions, and other assets that are somewhat less liquid than those in M2.

“The Two Ms: October 2010” shows the composition of M1 and M2 in October 2010.

M1, the narrowest definition of the money supply, includes assets that are perfectly liquid. M2 provides a broader measure of the money supply and includes somewhat less liquid assets. Amounts represent money supply data in billions of dollars for October 2010, seasonally adjusted.

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Figure bellow should help in visualizing the relationship between M1 and M2. Note that M1 is included in the M2 calculation. The figure shows that the components of M1 money supply are part of the M2 money supply. M1 equals coins and currency in circulation plus checkable (demand) deposit plus traveler’s checks. M2 equals M1 plus savings deposits, money market funds, certificates of deposit, and other time deposits.

Figure above shows the relationship between M1 and M2 Money.

M1 and M2 money have several definitions, ranging from narrow to broad.

M1 = coins and currency in circulation + checkable (demand) deposit + traveler’s checks.

M2 = M1 + savings deposits + money market funds + certificates of deposit + other time deposits.

The Federal Reserve System is responsible for tracking the amounts of M1 and M2 and prepares a weekly release of information about the money supply. To provide an idea of what these amounts sound like, according to the Federal Reserve Bank’s measure of the U.S. money stock, at year-end 2012, M1 in the United States was $2.4 trillion, while M2 was $10.4 trillion. For comparison, the size of the U.S. GDP in 2012 was $16.3 trillion. A breakdown of the portion of each type of money that comprised M1 and M2 in 2012, as provided by the Federal Reserve Bank, is provided in Table below.

Components of M1 in the United States in 2012	$ billions
Currency	$1,090.0
Traveler’s checks	$3.8
Demand deposits and other checking accounts	$1,351.1
Total M1	$2,444.9 (or $2.4 trillion)
Components of M2 in the United States in 2012	$ billions
M1 money supply	$2,444.9
Savings accounts	$6,692.0
Time deposits	$631.0
Individual money market mutual fund balances	$640.1
Total M2	$10,408.7 billion (or $10.4 trillion)

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M3 – The broadest class of money, M3 combines all money found in the M2 definition and adds to it all large time deposits, institutional money market funds, short-term repurchase agreements, along with other larger liquid assets.

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Monetary supply aggregates are the formal breakdown and measurement of money supply in the economy based on liquidity. M0 is the most liquid category, as it represents all the physical coinage and paper money in circulation plus bank reserves but bank reserves are not included in money supply. As per the diagram below, as the circles broaden, each grouping encompasses increasingly illiquid assets, with M3 encompassing large deposits over $100,000, money market funds, and Eurodollar deposits.

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The four concepts of money supply as used by Reserve Bank of India is depicted in the following figure:

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Elucidation of Money Supply (M1) vis-à-vis Monetary Base (M0):

Base Money (M0) is also called the monetary base. As mentioned earlier, it denotes the money of central bank. M0 includes Currency in Circulation and Bank’s Reserves. M1 includes Currency in Circulation and Checkable Bank’s Deposits.

Active Money:  

The M1 category includes what’s known as active money—the total value of coins and paper currency in circulation. The amount of active money fluctuates seasonally, monthly, weekly, and daily. In the United States, Federal Reserve Banks distribute new currency for the U.S. Treasury Department. Banks lend money out to customers, which becomes active money once it is actively circulated.

The variable demand for cash equates to a constantly fluctuating active money total. For example, people typically cash paychecks or withdraw from ATMs over the weekend, so there is more active cash on a Monday than on a Friday. The public demand for cash declines at certain times—following the December holiday season, for example. 

Remember, the precise definition of M1, M2, M3 etc. may be different in different countries.

Disuse of M3:

The U.S. Fed has stopped stop reporting M3. M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the federal reserve board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits. Since 2006, M3 is no longer tracked by the U.S. central bank, the Federal Reserve. The Fed did not use M3 in its monetary policy decisions even before 2006. The additional less liquid components of M3 didn’t appear to convey more economic information than was already captured by the more liquid components of M2.

M3 has since been eclipsed by money zero maturity (MZM) as a preferred measure of the money supply. MZM is seen as a better measure of the readily available money in the economy and as a clearer illustration of the expansion and contraction of that supply. Money zero maturity (MZM) is a measure of liquid money in an economy. MZM includes the M2 measure less the time deposits, plus all money market funds. MZM has become one of the preferred measures of money supply because it better represents money readily available within an economy for spending and consumption. 

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What is excluded from money supply?  

(1) ​The stock of monetary gold held in reserves as a backing to paper currency​ is not included in money supply. This is so because it is not permitted to circulate within the country.

(2) ​The cash held by commercial banks as reserves ​is not included in money supply. 

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Plastic money?

Where does “plastic money” like debit cards, credit cards, and smart money fit into this picture?

A debit card, like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller. It is important to note that in our definition of money, it is checkable deposits that are money, not the paper check or the debit card. Although you can make a purchase with a credit card, it is not considered money but rather a short term loan from the credit card company to you. When you make a purchase with a credit card, the credit card company immediately transfers money from its checking account to the seller, and at the end of the month, the credit card company sends you a bill for what you have charged that month. Until you pay the credit card bill, you have effectively borrowed money from the credit card company. With a smart card, you can store a certain value of money on the card and then use the card to make purchases. Some “smart cards” used for specific purposes, like long-distance phone calls or making purchases at a campus bookstore and cafeteria, are not really all that smart, because they can only be used for certain purchases or in certain places. In short, credit cards, debit cards, and smart cards are different ways to move money when a purchase is made. But having more credit cards or debit cards does not change the quantity of money in the economy, any more than having more checks printed increases the amount of money in your checking account.

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Understanding Money Supply:

Economists analyze the money supply and develop policies revolving around it through controlling interest rates and increasing or decreasing the amount of money flowing in the economy. Public and private sector analysis is performed because of the money supply’s possible impacts on price levels, inflation, and the business cycle. In the United States, the Federal Reserve policy is the most important deciding factor in the money supply. The money supply is also known as the money stock.

A central bank regulates the level of money supply within a country. Through monetary policy, a central bank can undertake actions that follow an expansionary or contractionary policy. Expansionary policies involve the increase in money supply through measures such as open market operations, where the central bank purchases short-term Treasuries with newly created money, thus injecting money into circulation. Conversely, a contractionary policy would involve the selling of Treasuries, removing money from circulating in the economy. When the Fed limits the money supply via contractionary or hawkish monetary policy, interest rates rise and the cost of borrowing increases. This can dampen inflationary pressures, but also risk slowing down economic growth.

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Effect of Money Supply on the Economy:

An increase in the supply of money typically lowers interest rates, which in turn, generates more investment and puts more money in the hands of consumers, thereby stimulating spending. Businesses respond by ordering more raw materials and increasing production. The increased business activity raises the demand for labor. The opposite can occur if the money supply falls or when its growth rate declines. Change in the money supply has long been considered to be a key factor in driving macroeconomic performance and business cycles. Macroeconomic schools of thought that focus heavily on the role of money supply include Irving Fisher’s Quantity Theory of Money, Monetarism, and Austrian Business Cycle Theory.

Historically, measuring the money supply has shown that relationships exist between it and inflation and price levels. However, since 2000, these relationships have become unstable, reducing their reliability as a guide for monetary policy. Although money supply measures are still widely used, they are one of a wide array of economic data that economists and the Federal Reserve collect and review.

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Money supply data is published monthly and is one of the many important macroeconomic variables that are tracked by economists and investors alike. The variables can be used to determine the timing of the business cycle and future expectations. They are often intertwined and therefore must be understood together to draw conclusions.

Different assets and attributes outperform at different stages in the business cycle. By understanding where we are in the current business cycle as seen in the figure below, investors can strategically shift their portfolios to maximize their returns. 

Business cycles are comprised of concerted cyclical upswings and downswings in the broad measures of economic activity—output, employment, income, and sales. The alternating phases of the business cycle are expansions and contractions. Change in the money supply has long been considered to be a key factor in driving macroeconomic performance and business cycles.

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Because money is used in virtually all economic transactions, it has a powerful effect on economic activity. An increase in the supply of money works both through lowering interest rates, which spurs investment, and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock market prices rise and firms issue equity and debt. If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans. Opposite effects occur when the supply of money falls or when its rate of growth declines. Economic activity declines and either disinflation (reduced inflation) or deflation (falling prices) results.

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Deficit financing is practice in which a government spends more money than it receives as revenue, the difference being made up by borrowing or minting new funds. A mild inflation arising out of the creation of money by deficit financing may stimulate investment by raising profit expectations and extracting forced savings. But a runaway inflation is highly detrimental to economic growth. The developing economies have to face the problem of inadequacy of resources in initial stages of development and it can make up this deficiency by deficit financing. But it has to be kept strictly within safe limits. Thus, increase in money supply affects vitally the rate of economic growth. In fact, it is now regarded as a legitimate instrument of economic growth. Kept within proper limits it can accelerate economic growth but exceeding of the limits will retard it. Thus, management of money supply is essential in the interest of steady economic growth.

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Over the course of U.S. history, the money supply expanded and contracted along with the economy. For that reason, several economists like Milton Friedman pointed to the money supply as a useful indicator of the state of the national economy.

Over recent decades, however, that perception of the money supply has changed. In the 1990s, people began to take money out of their low-interest bearing savings accounts and invest it in the booming stock market. As a result, M2 fell, even as the economy grew. Alan Greenspan, the Federal Reserve Chairman at the time, questioned the usefulness of the money supply measurement and concluded that if the economy were dependent on M2 for growth, it would be in a recession. The Federal Reserve no longer sets target ranges for money supply growth.

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The central bank can influence and manipulate the money supply: 

If the central bank wants to increase the amount of money in circulation, perhaps to boost economic activity, the central bank can, of course, print it. However, the physical bills are only a small part of the money supply.

Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market. When the central bank buys these government securities, it puts money into the marketplace, and effectively into the hands of the public. How does a central bank pay for this? As strange as it sounds, the central bank simply creates the money and transfers it to those selling the securities. Alternatively, the central bank can lower interest rates allowing banks to extend low-cost loans or credit—a phenomenon known as cheap money—and encouraging businesses and individuals to borrow and spend.

To shrink the money supply, perhaps to reduce inflation, the central bank does the opposite and sells government securities. The money with which the buyer pays the central bank is essentially taken out of circulation. Keep in mind that we are generalizing in this example to keep things simple.

A central bank cannot print money without end. If too much money is issued, the value of that currency will drop consistent with the law of supply and demand.

Remember, as long as people have faith in the currency, a central bank can issue more of it. But if the central bank issues too much money, the value will go down, as with anything that has a higher supply than demand. Therefore, the central bank cannot simply print money as it wants.

Money is debt:

While each euro, pound, crown, rouble, dollar and yen of course is somebody’s asset, at the same time it is also somebody’s debt. Consumers carrying banknotes in their wallets hardly think of themselves as creditors; nonetheless, banknotes represent the central bank’s debt to banknote holders. Similarly, a bank deposit represents the bank’s debt to the customer.

Money is created when a loan is extended:

How is money created? Some is created by the state, but usually in a financial emergency. For instance, the crash gave rise to quantitative easing – money pumped directly into the economy by the government. The vast majority of money (80%) comes into being when a commercial bank extends a loan. When a borrower approaches a bank for a loan today, the bank creates a deposit account for the borrower with the loan amount already credited to it. Interestingly, this loan does not come from cash in the bank’s vault but is simply electronic money that the bank created out of nothing. Money is first and foremost created when someone gets a loan. When a bank grants a loan, both its assets and liabilities increase. The lending bank asks the customer to sign a promissory note and adds the resulting receivable to its assets. However, the loan is withdrawn only when the customer’s account is credited with the equivalent amount, so that the bank’s debts also increase.  The customer becomes aware of an increase in his account balance and notices that he has more money than a moment earlier. When the loan is repaid, the customer must arrange for the required sum to be available in the account. At repayment of the loan, both the bank’s debts and receivables are wiped off the bank’s accounts. In practice, the amount of bank debt deducted from the customer’s account is slightly more than the sum originally borrowed, as the bank collects interest on the loan and makes some other charges.

We have learnt that new money was created when the loan was extended and that the money ceased to exist when the loan was repaid in full. In fact, owing to the interest charged on the loan, the sum of money ceasing to exist was even somewhat larger than the sum of money created when the loan was extended.

Despite being charged with managing the money supply, the modern central bank does not simply run new paper bills off of a machine. Of course, real currency printing does occur but the vast majority of money supply is digitally debited and credited to commercial banks. Moreover, real money creation takes place after the banks loan out those new balances to the broader economy.  Although the bulk of money is created in ordinary deposit banks, to settle their debts to their depositors, banks have no options but to pay in cash, which is currently issued only by central banks. Central bank money comprises banknotes in circulation and banks’ deposits (reserves) with the central bank. An ordinary household will not have to deal with central bank deposits, but these deposits are important for banks.  

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Money creation in brief:   

In modern economies the money supply is determined by the government. The government puts money in circulation every time it buys goods or assets from the private sector and takes it out of circulation by levying taxes on the private sector and selling assets to private institutions and individuals. When the government exchanges money for goods or securities the stock of money in private hands necessarily goes up. And when it sells assets to the private sector or levies taxes, the money it receives goes out of circulation.

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We must distinguish between two branches of government—the treasury and the central bank. The job of the treasury is to budget the government’s expenditures and finance them either by levying taxes or borrowing. Since every dollar it spends must be raised through taxes or borrowing, the treasury’s actions do not change the money supply.

It is the central bank’s job to manage the money supply. It puts money in circulation by purchasing bonds from the private sector and takes it out of circulation by selling bonds to the private sector. These actions are called open market operations. The central bank also manages the government’s deposit accounts on which cheques are written to pay the government’s expenditures—these deposits typically are in part with the commercial banks and in part with the central bank itself.

The treasury normally issues bonds to finance some portion of the government’s expenditures. The central bank then buys in the open market an amount of these sufficient to put in circulation the appropriate quantity of money. In some cases the central bank may buy bonds directly from the Treasury, who puts the funds in circulation when it makes government expenditures with them.

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Things are more complicated than this, however, because part of the money supply consists of deposits in the commercial banks—quite apart from the amount of cash in circulation, any change in the amount of these deposits will also change the money supply. Commercial banks are profit-making firms who borrow funds from depositors and lend them out to households and businesses at rates of interest that are above the interest rates paid on the deposits. The excess of interest received over interest paid minus the costs of managing their loans and deposits represents the banks’ profits. Banks create money by issuing a loan to a borrower; they record the loan as an asset, and the money they deposit in the borrower’s account as a liability. This, in one way, is no different to the way the Federal Reserve creates money. Money is simply a third party’s promise to pay which we accept as full payment in exchange for goods. The two main third parties whose promises we accept are the government and the banks.

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In current economic systems, money is created by three procedures:

-1. Legal tender is the cash created by a Central Bank by minting coins and printing banknotes.

-2. Bank money, or broad money (M1/M2) is the money created by private banks through the recording of loans as deposits of borrowing clients, with partial support indicated by the cash ratio. Currently, bank money is created as electronic (digital) money. In most countries, the majority of money is mostly created as M1/M2 by commercial banks making loans. Contrary to some popular misconceptions, banks do not act simply as intermediaries, lending out deposits that savers place with them, and do not depend on central bank money (M0) to create new loans and deposits.

-3. Central bank can create new money (digital/electronic money) by process of debt monetization, open market operations and quantitative easing.

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Money presentation:    

The medium of exchange and measure of value. Whatever fills these functions, however crudely, is money. Of all the substances which have been used as money, gold and silver take the first place, and the discussion of money usually has these in view. It is well to remember, however, that some of the humbler functions of money are today performed by nickel and copper, and that in times past not only other metals, tin, lead, iron, and platinum, have been used as money, but also, especially among primitive peoples, a wide variety of other objects. Jevons enumerates among other things, furs, skins, leather, sheep, cattle, wampum, cowries, grains, olive oil, tobacco, and salt, as being in use at one time or another for this purpose. Primitive as these may be, the enumeration seems to emphasize the fact that it is not a substance per se that we designate as money, but a substance invested with a certain utility.

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So important is this function in modern life that we cannot readily conceive of a society without some mechanism to perform it. And indeed from the earliest days of recorded history we find references to money, and there are few among the primitive peoples of our own time which do not possess it in rudimentary form. The difference between the highly civilized nations of modern Europe and America and their early progenitors or the savage tribes of Africa does not consist so much in the fact that we use money and they do not, as in the extent to which it is used. Even though money is recorded as known among the most primitive peoples, it is then of only occasional use, it does not penetrate into every relation of social life. Peoples whose social organization is based upon slavery and patriarchal conditions have little need for money, nor is the need great among a pastoral or agricultural people when there is little differentiation of occupation. On the other hand, among highly organized industrial peoples where nearly all produce not for individual needs, but for sale in the market, money is in constant and universal demand. 

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The primary function of money is that of a medium of exchange; and, if in the theory of money today this characteristic receives scant notice, it is not because it is not fundamentally important, but rather because it is comprehended with comparative ease. Other functions are all derived from the primary function, medium of exchange.

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Whatever the substance used as money maybe it becomes an object of universal desire. In primitive society the most widely desired object came to be used as money. The fact that an object is universally desired fits it in the first instance for use as money, but after it acquires that function it is desired not chiefly for its own sake, but for its command over other things. At an early date the desire for personal adornment singled out the precious metals as money par excellence, but at the present time it is not because gold is beautiful that we desire it, but because as money it procures for us whatever we may desire.

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In the second place, money is the measure of value. The acts of buying and selling fix upon the objects bought and sold relative values, and it was only a slight step to extend the conception of value to things not sold or bought, or which are not intended for sale. All things capable of sale can be valued in terms of money. All credit operations depend upon this fact. Since the value of the money in use in any society is insignificant as compared with its total wealth valued in terms of money, it has been argued that the function of money as a measure of value is far more important than its function as a medium of exchange. And in fact the further we get away from primitive conditions of trading, the more important does this derivative function become. When all wealth is valued in terms of money barter of a higher order becomes possible. In the new form of barter, however, the exchange of commodities is indirect. Modern commerce is largely based upon it, and while it is most apparent in international trade, where balances only are settled by the transfer of money, it is no less widespread and fundamental in domestic trade.

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From the function of a measure of value is derived a subordinate function of the greatest practical importance, namely the function of money as a standard of value. A standard of value is simply a measure by which values at different periods are compared. The measure of value contemplates the estimation of commodities at the same time; the standard of value, their estimation at different times. The standard of value is often called the standard of deferred payments. Credit organization involves future payments. These payments are expressed in money and present goods are transferred for a promise to pay money in the future. In the ordinary transactions of mercantile life the futurity contemplated is not far distant, but in many operations, both public and private, a lapse of years is contemplated. In such contracts stability in the value of money is of the highest importance; and were it not that money has been subject to certain variations, it is quite possible that it would not have been found necessary to differentiate this function from that of a measure of value.

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The substances which at various times in the world’s history have fulfilled these several functions have not performed the office equally well, and gradually all except gold, silver, certain minor metals, and paper have been eliminated among advanced nations. The selection of the precious metals for this purpose is due in part to certain physical characteristics and in part to economic conditions. In the first place, they are durable, and while it is true that there is always some loss through abrasion, the process is a remarkably slow one. Secondly, they are homogeneous and divisible. If a given quantity be divided into parts, those parts will be absolutely alike, and the sum of the parts will equal the whole. Finally, they are portable, since relatively to their weight they are of high value. Other objects such as precious stones excel the metals in portability, but they do not present the other necessary qualities of divisibility and homogeneity. Furthermore, it should be remarked that the metals are relatively stable in value, a result of their durability, since the existing stock is always so much greater than the annual output that violent fluctuations in supply are avoided. Some writers have insisted that the money substance should itself possess value, and have gone so far as to speak of the necessity of ‘intrinsic’ or inherent value. The use of the word ‘intrinsic’ evidently indicates a confusion of thought. These writers mean that the money substance should possess a ‘utility’ apart from that which it gains by virtue of its money function. It may be true that no substance without utility could have become established as money, but this initial primary utility is insignificant after it has acquired the greater utility which attaches to it as a medium of exchange and measure of value.

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It has already been noted that besides the precious metals which possess in a high degree the qualities named, other substances, minor metals and paper, are used as money among advanced peoples. The role of the former is quite subordinate. For use in minor exchanges they are sufficiently portable and they possess the other physical qualities named. Since their quantity is limited, and provision is usually made for convertibility into money made of the precious metals, their value is not less stable than that of gold and silver. The problems of paper money are more complicated, since it is used in far greater quantities and for large payments. In portability it excels the metals, and, while it is not literally indestructible or divisible, the case of replacement of old notes by new, or one denomination by another, is a substitute for these qualities. Its ‘intrinsic value,’ i.e., its utility for non-monetary uses, is of course a negligible quantity. Far more important is the question of the stability of its value. This question we can answer only after an investigation of the laws which govern the value of money.

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There are two explanations of the value of money, one that it is fixed by the law of supply and demand, the other that it is fixed by the costs of production. These are the general explanations of value and are complementary rather than antagonistic. The first is the law of market value, the second of normal value. In the case of freely reproducible goods, while market value may at a given moment vary from normal value, it cannot maintain such variation for any length of time. Money is in a less degree freely reproduced than most of the other goods with which it can be compared. We should, therefore, without neglecting the influence of the cost of production, expect to find that in the fixation of the value of money supply and demand are the dominant factors.

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Before discussing what the supply of money and the demand for it are, it may be well to call attention to the way in which the value of money is expressed. The values of all commodities are expressed in money as prices. Conversely, the prices of commodities express the value of money. We speak of prices as high or low, but we might as well speak of money as cheap or dear. Money is cheap when prices are high, and is dear when prices are low. When wheat rises from 50 cents a bushel to $1 a bushel, we say it has risen in value, but we might also say that the wheat price of money has fallen, because in the first instance it required two bushels of wheat to secure a dollar in exchange and in the second instance only one bushel. Wheat in our illustration stands for commodities in general, and, while the rise in price of one commodity does not mean that money has fallen in value, yet if all commodities rise in price we cannot escape the conclusion that it has so fallen. Prices and the value of money are therefore reciprocals.

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The supply of money is the amount of money in existence. This has led some writers to say that the value of money depends upon its quantity. Other things being equal, this is true; but it does not in itself furnish an adequate explanation of the value of money. Assuming that no other influences are at work, it must be admitted that any increase in the quantity of money will lower its value and that any decrease will enhance it. There is a certain money work to be performed, a certain volume of exchanges to be transacted. If the units of money are numerous, each transaction will call for a larger number of units than when the money units are relatively few. Every increase in the world’s money supply has been followed by a rising in prices or a fall in the value of money. If the fall is not commensurate with the increase in amount, it is because the quantity of money is not the exclusive factor in fixing the value of money. Monetary legislation endeavours to adjust supply to demand by providing an automatic regulation of the quantity of money. Under a metallic currency system we usually find provisions for the free coinage of the standard money metal. Should money increase in value, i.e., should prices fall and thus reveal an inadequate supply, free coinage will in a measure correct this by attracting to monetary use such supplies of the metal as are available for this purpose. So far as nations using the same standard are concerned there is a natural flow of the metals from one country to another which prevents any undue deficit or redundancy in any one of the countries involved. This adjustment takes place automatically through the course of trade. When currency is redundant in any country, prices will be high in that country and imports will be large relatively to exports. The settlement of the resulting unfavorable balances will diminish the currency of the country where it was formerly redundant and so diminish prices. If money is scarce in any country, prices will be low, exports large relatively to imports, and the resulting favorable balances will bring gold into the country. It is obvious, therefore, that international trade speedily corrects any local excess or deficit. A general excess or deficit in the money supply carries with it a certain correction also, but the operation is slower. If prices rise, showing a fall in the value of money, mining enterprises become less profitable, and the additions to the volume of money will tend to grow less. On the other hand, if prices fall, showing a rise in the value of money, mining enterprises become correspondingly profitable and capital will seek employment in them. This is likely to increase the production of the metals and by increasing the supply to check the rise in value. These effects will not be immediate, as capital has great inertia, and its withdrawal from one line of activity and transfer to another cannot be instantaneous.

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The value of money, as of any other commodity, is immediately dependent upon supply and demand. The demand for money is a derived demand. It is dependent on the demand for commodities which it buys in the economy. The supply of money admits of easy definition; but the demand for money cannot be so precisely stated. It has been paraphrased as the amount of money work to be done, but this money work cannot be expressed in statistical statements. The elements which enter into it can, however, be stated. The most important and the positive element in the case is the volume of exchanges to be accomplished. Whatever increases the volume of exchanges increases the demand for money; whatever diminishes the volume diminishes the demand. Division of labor and the evolution of a money economy are the most important factors in this increase of the money demand. Without a commensurate increase of supply, prices under such conditions must fall. A diminution in the world’s demand for money is not likely, but a diminution in the local demand, effecting a temporary rise of prices before the correcting influence of international trade is felt, may and does occur.

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But the volume of the exchanges is only one of several elements in determining the demand for money. The first of these is the rapidity of monetary circulation, the second the use of credit, both of which economize the use of money. It is obvious that all simultaneous cash transactions require the use of different pieces of money. But the transactions of a day or a year are not simultaneous and the same piece of money may fill its functions as a medium of exchange many times. When the circulation is sluggish the demand for money for a given volume of exchanges is far greater than when it is rapid. Savings banks, for example, serve to increase the rapidity of circulation. They gather up the savings of the poor which would otherwise be locked up, and restore this money to circulation. In countries where savings take the form of private hoards, as is largely the case in France, more money is required per capita than in Great Britain or the United States.

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Far more important in its effect upon the money demand is the use of credit, balances only being paid in money. The country storekeeper who takes from the farmer butter and eggs on account, paying in supplies as his customer’s needs arise, furnishes a homely illustration of the way in which credit minimizes the demand for money. In the larger business world the trade relations are rarely of such great simplicity, but by the mechanism of centres of credit or banks the transactions of a town or of even larger areas are reduced to a mutual exchange of goods and debts are cancelled without the intervention of money. Banks and clearing-houses are the agencies by which credit is organized.

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Supply and demand as affecting the value of money are not wholly unrelated phenomena, and the explanation of monetary changes cannot he found in one element without the other. An excess of supply stimulates demand, and prevents prices from rising as high as they otherwise would. A diminution of supply slackens demand and prevents prices from falling as much as they otherwise would. This interaction of supply and demand prevents changes in the money supply from producing effects in the increase or decrease of prices commensurate with the changes in the volume of money. It modifies but does not obliterate the significance of such changes.

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Having considered what fixes the value of metallic money, we are now ready for the question what determines the value of paper money. Despite differences of detail, there are for the purpose of this discussion but two classes of paper money—convertible and inconvertible. The first is secondary money, representing metallic money, and deriving its value from the latter; the second is itself primary money, and, like all primary or standard money, derives its value from the relation of supply and demand.

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Paper money in the first instance was purely secondary or representative money. It was practically a storage receipt for gold and silver. Such receipts calling for metallic money on demand could and did serve in lieu of the latter in making exchanges. Such money offers no theoretical difficulties. Its circulation is that of metallic money in another form. The advantage of such money is that it forms a convenient mode of avoiding the cumbersomeness of metallic money. This is the function of the gold and silver certificates issued by the United States Government, each of which represents a corresponding quantity of metal in the United States Treasury, and whose presence in the monetary circulation does not in the slightest degree affect its volume.

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But such certificates are not the only form of representative paper money, nor the most important. The history of banking shows that the depositaries of metallic money soon learned that under normal conditions coin would not be demanded at any one time for the full amount of the outstanding notes or certificates, and that a considerably larger sum could be kept in circulation than the metallic reserve. They began, therefore, to issue notes in excess of the reserve without infringing upon the characteristics of convertibility in coin on demand. Such money is called by the economists bank money, and it is immaterial whether it is issued by banks or by the Government. Such money derives its value from the metallic currency upon which it is based, but, unlike the certificates already described, it enlarges the volume of the monetary circulation. The issue of such money economizes the use of the metals, and in so far as it substitutes an inexpensive for an expensive substance as money is a saving of wealth to the community.

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If the principle of convertibility is not maintained, bank money becomes paper money pure and simple. It has usually been by the failure of banks or of governments to maintain the promise of redemption that such money has arisen. When this takes place paper money falls in value, or, as it is usually expressed, coin is at a premium. This would not of itself cause a disappearance of coin, but it usually happens that paper money is so multiplied in volume that coin disappears and paper becomes the sole standard. This substitution takes place by virtue of Gresham’s law. Such changes from a metallic to a paper currency are not effected without violent convulsions and much suffering; but there can be no doubt that, however ill it does the work, paper money under such circumstances performs all the functions of a medium of exchange, a measure of value, and a standard of deferred payments. Its value, like that of other money, depends upon its quantity in relation to the demand for money. As its quantity is likely to be increased without reference to the demands of trade in response to the fiscal necessities of the Government, its value is unstable and uncertain. But this is not inherent in the nature of paper money; and there may be conditions, as in Austria during the greater part of the nineteenth century, under which paper money maintains a relative stability in value. Today we have fiat money, a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies. Fiat money gives central banks greater control over the economy because they can control how much money is printed. One danger of fiat money is that governments can print too much of it, resulting in hyperinflation. Another danger is counterfeiting.  

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Cautions while using the term money:  

In ordinary language, we use the term “money” very loosely. But in economics, we have to be very careful to define our terms, and to use them with care. This is because many items which are loosely referred to as “money” actually have different roles in the economy and enter the macroeconomy in different ways.

• Money is not “income.” We have been very careful to define aggregate income as the value of total goods and services produced in an economy. An individual’s income is the value of their total earnings in input markets, received in exchange for the sale of labor, capital, land and entrepreneurship in a given period. Income is a flow, while money is a stock.
• Money is not “savings.” Savings is the amount of income not consumed. It is not the “amount of money a person has.” We have been very careful to define savings in terms of income and consumption, and not in terms of “money.” Savings is a flow, while money is a stock.
• Money is not wealth. A person can be wealthy but that is not the same thing as “holding money,” or “having money.” A wealthy person, for example, may have many stocks and bonds and own much property, but may not hold much money. While both wealth and money are stocks (both are calculated as a total volume at a point in time), not all wealth is acceptable as a medium of exchange.
• Money is not capital as economists define capital because it is not a productive resource. While money can be used to buy capital, it is the capital good (things such as machinery and tools) that is used to produce goods and services. Money is not considered a capital resource in economics because it cannot produce a good or service. Capital comprises the physical and non-physical assets (such as education and skills) used in making goods and services. Money is primarily a means of exchanging one good for another. Capital is measured in monetary terms, and since money (cash) buys physical assets (for example, buys a factory), capital is often thought of as money. But strictly speaking, they are different concepts. Said another way, capital involves risk and creates jobs. Accumulating money on the balance sheets of large corporations does not.

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Money vs. Finance vs. Funds:

Money is a part of finance, but finance includes several other things as well. Money acts as a medium of exchange, store of value, a unit of account, and sometimes it can also act as a standard for deferred payments.

Finance is the study of money and involves planning to use it. It involves the acquisition of money from different sources and then finding out the best way to invest or use that money. Finance is divided into three areas namely, personal finance, public finance, and corporate finance. The main focus of finance involves money management, i.e., to manage the money/assets that an organization has in the best possible manner.

Funds means the money we keep aside for a particular goal. It involves financial planning as well as real money. There are several funds such as retirement funds, pension funds, education funds, emergency funds, etc.

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Cash vs. Profits vs. Revenue:

The problem with cash in business is that we tend to take it for granted. We think in profits, but we spend cash. The issue is, profits and cash are different.

Profits are calculated by subtracting expenses from sales. It doesn’t matter if your customer has actually paid you or if you’ve actually paid your bills. Sales are accounted for when you send out your invoice. Expenses work the same way — you can have an expense on your books even though you haven’t paid the bill yet.

Revenue is money coming into the business. For most accounting and financial analysis purposes, it’s the same as sales. But technically, revenue can also include sales of assets and money coming in as loans and investments. Revenue is not profit and profit is not cash in hand or in bank accounts. 

Cash, on the other hand, is what it takes to pay your bills—the actual money you have in hand, in your bank account.

The underlying issue with understanding the difference between cash and profits is basic financial and accounting standards. Throughout the world, we live with a business practice rooted in the profit and loss statement, also called an income statement. It shows the performance of the business over a specific period of time, usually a month, a quarter (three months), or a year.

Sales on credit: How waiting to get paid impacts profits and cash:

A business delivers the goods or services to a business customer or client along with an invoice. The check comes later. That’s extremely common in business-to-business sales, and what it means is that the amount of that invoice is included in the month’s sales, and is booked as sales—but it isn’t actually cash in the bank. Instead, that amount sits in a bookkeeping category called accounts receivable until the check arrives and it’s deposited into the bank. The average time between delivering the invoice and receiving the money is called collection days, or collection period. The problem businesses face is that all the money in accounts receivable shows up in profits as sales, but is not in your bank account. You can’t spend it. Profitable businesses can go under simply because they have too much money in accounts receivable, and not enough in the bank—they have trouble getting their invoices paid on time. The money showed up in sales but never made it to the bank. Ultimately, being profitable didn’t prevent business failure.

Inventory: Buying things before you sell them:

Most product businesses, such as stores, have to buy the things they sell ahead of time before they sell them. Manufacturers and assemblers have to buy components and materials before they create and sell finished goods, and that creates a lot of potential cash flow problems. It’s called inventory: products for resale, materials for manufacturing, components for assembly. Money spent on inventory doesn’t show up in profits until they ultimately sell—but it’s gone, out of the bank, when it’s spent. For businesses that depend on inventory, inventory management can be critical for cash flow. It’s too easy to have money tied up in inventory that sits on the shelves too long, or never gets sold. That money is gone from the bank account but doesn’t show up in the profit and loss statement. 

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Importance of money: 

People use the money to buy things every day. You use the money to pay your bills, you use the money to buy foods, and you use the money to buy a house or to pay the rent in order to put a roof over your head. So money is truly important. Without money, people cannot survive comfortably. Money dictates the flow of human living, especially in this modern world. When you don’t have any money, life will often be painful and difficult. Money creates the freedom to you. If you have seen people who are in serious debt and are chasing for money to make ends meet, you will understand that money is important. Money is a non-negotiable and an indispensable commodity in every person’s life.

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Money can buy security and safety for you and your loved ones. Human beings need money to pay for all the things that make your life possible, such as shelter, food, healthcare bills, and a good education. You don’t necessarily need to be a billionaire, but you will need some money until the day you die. Because money is necessary for obtaining the goods and services you need to survive, an understanding of personal finance is essential. You need to be responsible with the money you earn and save enough for the future to ensure you will still have enough leftover when you can no longer trade your labor for money. The sooner you start saving your money, the more likely it is that you’ll never face a lack of money or financial stress. In fact, if you save enough and invest wisely, you could even become financially free — which happens when you have enough money to live on for the rest of your life.

Benefits of Money:

The existence of money allows you to trade your labor for things that you value. There are many major benefits of money including the following:

-Money gives you freedom. You have the freedom to choose what to eat, what to buy, which house to stay, and what car to drive. Without money, your choice will be limited. If you don’t have money, you cannot spend on luxury items, hence, your freedom is limited. When you have enough money, you can live where you want, take care of your needs, and indulge in your hobbies. If you are able to become financially independent and have the financial resources necessary to live on without working, you’ll enjoy even more freedom since you will be able to do what you want with your time.

-Money gives you the power to pursue your dreams. Having money makes it possible for you to start a business, build a dream home, pay the costs associated with having a family, or accomplish other goals you believe will help you live a better life.

-Money can buy you Health. Yes, this is true, money can buy you health. You can maintain your health even though you cannot rule your health. With modern healthcare to increase human longevity, money can help you improve your health and live a healthy lifestyle. For example, you can spend money on a proper and healthy diet, you can buy nutrition and supplements, you can work out in the gym, and when you are sick, you can get proper medication.

-Money gives you Education. Another important reason why money is important is that money builds your school and money sends you there for education. People who are in poverty do not have a better chance to get into a better school or access to higher education. Furthermore, when you have excess money to spend, you can buy books, attend additional classes like a seminar or a workshop, pay to learn how to cook, how to invest, or how to do things better.

-Money gives you security. When you have enough money in the bank, you’ll never need to worry about having a roof over your head or about having enough to eat or about being able to see a doctor when you’re sick. This doesn’t mean you’ll be able to afford everything you want, but you’ll be able to enjoy a stable middle-class life.

-Money makes your life Comfortable. With money, you can often buy whatever things you want in your life. In other words, money makes your life comfortable. When you have enough money, you can spend money on necessities like food and groceries. And when you have more money, you can then spend them on luxury items like a bigger house and sports car.

-Power and respect. When you have enough money, you don’t have to be concerned about others pushing you around. And, because you worked hard at earning and saving your money, you’ll be respected by others.

That’s why it’s so important to work hard, earn money, and learn how to save and invest it. When you start to invest your money, it starts to work for you and help you produce more — and eventually, you should have enough that you can retire.

-Money can help others. Money can help others and make the world a better place. In 2010, the world’s richest men, Bill Gates and Warren Buffett announced a campaign to encourage wealthy people to contribute a majority of their wealth to philanthropic causes, and they called their campaign, The Giving Pledge. As of 2017, there are 158 wealthy people have signed the pledge including the Facebook creator Mark Zuckerberg, and their pledges total to over $365 billion. And this act of kindness has created values, help, and saves a lot of lives around the world. Thus, money can help others. Not only that money is important in enriching your life, but it can enrich other people’s lives too.

Downsides of Money:

Of course, there are some definite disadvantages of money too, including:

-Obsession with money, or a love of money, can create a host of problems. Trying to acquire money at all costs, or constantly trying to acquire as much money as you can, could lead you to unethical or even criminal behavior, such as theft or scamming others. It could also cause you and your family problems if you focus too much on money or material things at the expense of other people and things in your life. If all you have is money, but you have no one to share your life with and nothing to enjoy, you’re unlikely to be happy.

-Money can lead to disagreements: When you and your partner or family members don’t agree on what should be done with money, this can cause substantial friction in your life. Did you know that ⅓ of married couples fight over cash each month? In fact, money is one of the leading causes of divorce for couples.

Most of these cons relate not to money itself, but to the way people interact with money and the attitudes people have about money. You can take a responsible approach towards acquiring and saving money without allowing it to cause you problems in your life.

While the quest to earn money could be corrupting if you take it too far, having enough money can be quite liberating because it gives you the freedom to buy what you need and do what you like. Just remember, it’s up to you to save so you can use money to shape your future.

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Role of Money in Economic Life:  

Money plays very important role in the economic life. In today’s world everything whether production, consumption, distribution, saving, investment, employment is influenced by money. According to Prof. Marshall, “Money is a centre around which economic science clusters.” In fact, whether you are an owner or a labourer; a teacher or a student; money is important for everybody and everywhere. Considering the importance of money, Crowther has said, “Money is a basic invention among all the inventions by human beings.”  Similarly, P. B. Trescott has said, “If money is not the heart of our economic system, it can certainly be considered as its blood stream.”

Money has the following importance in various aspects of Economics:

(1) In the Field of Consumption:

Consumption has the highest place among all economic activities. If there is no consumption the activities of production, demand, supply etc. would come to an end. People use goods and services to fulfill their various needs. Consumers seek maximum satisfaction from their consumption. For this they want to spend their income in various commodities so that they can able to get marginal utility. The concept of Law of Equi-Marginal utility given by Gossen is based on this hypothesis. Money is the basis of the whole activity of consumption. Income is the basis of consumption and it is indicated in money only. Again the quantity of consumption of a certain goods is determined in money only. Thus money is important with respect to consumption.

(2) In the Field of Production:

Land, capital, labour and organisation are sources of production. These sources can be achieved only with the help of money. The cost of production and selling price are determined in money only. Money encourages savings and savings create capital formation. The faster process of capital formation in the country is the cause for the higher rate of production because capital plays an important role in setting up of industries. Money is a liquid asset, so it can be made active and hence more productive. The modern division of labour and specialisation are based on money itself. All the factors of production are paid in money only.

(3) In the Field of Exchange:

The production of a commodity is relevant only when it can be sold. The selling price of a commodity depends on its cost of production. In determining the cost of production, some direct expenditure as well as indirect like depreciation, insurance etc., are included. These expenditures are measured in money only and on the basis of these expenditures the selling price of the commodity is determined. Thus, money plays an important role in the field of exchange. It also promotes international trade. Money is also the basis of credit.

(4) In the Field of Distribution:

Once the production is completed, rent to the landowner, interest to the capital provider, wages for labourer, profit to the entrepreneur etc. have to be distributed i.e., paid in money. The returns for all these are not possible without money. Thus money has a special place in the just distribution of the required national income.

(5) In the Field of Public Finance:

The government plays an important role in the nation’s progress. The government meets the expenditures in the interest of public with public income. The area of public expenditure is very large in any country. Its prediction and expenditure both can be fulfilled by money only. The collections of various kinds of taxes levied by the government are not possible without money. Thus, money has an important place in the field of finance as well.

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Money management:

Money management refers to the processes of budgeting, saving, investing, spending, or otherwise overseeing the capital usage of an individual or group. The term can also refer more narrowly to investment management and portfolio management.  Money management is a strategic technique to deliver the highest interest-output value for any amount spent on making money. It is a natural human tendency to spend money to fulfil the cravings regardless of whether they can be justifiably included in a budget. The idea of money management techniques was developed to reduce the amount that individuals, firms, and institutions spend on items that do not add any significant value to their standard of living, long-term portfolios, and assets. Financial advisors and personal finance platforms such as mobile apps are increasingly common in helping individuals manage their money better. Poor money management can lead to cycles of debt and financial strain.

You can improve your money management by regularly evaluating what you’re doing with money and making changes that make sense for you. For example, if you don’t have a budget, you could start by developing one. If you have a budget, you could track your spending and see how it lines up with your budget. Once you have an idea of your income and spending, you could choose to increase your savings, pay off debt, or start investing based on your financial goals.

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Money in the world:

Money is the medium of exchange for goods and services. It doesn’t literally make the world go around, but the economies of countries rely on the exchange of money for products and services. Money supply data is usually analyzed and published by the government or the central bank of the country. Since it is present in various forms (virtual and physical) in different currencies, it’s extremely difficult to determine the exact total amount.

Typically, different types of money are classified as “M”s. They range from M0 (narrowest) to M3 (broadest), depending on the policy formulation of the country’s central bank. The Federal Reserve System — central bank of the United States of America — for instance, publishes data on these monetary.

As of March 31, 2021, there was nearly US $2.1 trillion in circulation, including Federal Reserve notes, coins, and currency no longer issued. A comparable tally of currency in circulation from all over the world, tracked by the Bank for International Settlements, totals about $5 trillion. If you are looking for all the physical money (notes and coins) and the money deposited in savings and checking accounts worldwide, you could expect to find approximately $40 trillion. This figure represents only ‘narrow money.’ However, if you add the ‘broad money,’ the amount rises to over $90.4 trillion. This amount further increases when bitcoins and other cryptocurrencies are included. Money in the form of investments, derivatives, and cryptocurrencies exceeds $1.3 quadrillion. This is what it looks like written out: $1,300,000,000,000,000.

The value of all cryptocurrencies in circulation (over $2 trillion) and investment in commercial real estate ($30 trillion) also represent a small portion of the total money in the world. Bitcoin, for example, accounts for less than 1% of the world’s money.

In the 2021 list of the world’s billionaires, Forbes included 2,755 billionaires with a total net wealth of $13.1 trillion. Surprisingly, the top 26 billionaires own as much as the poorest 3.8 billion.

The world is wealthier than ever. According to McKinsey’s report, global assets grew from $440 trillion (approximately 13 times GDP) in 2000 to $1,540 trillion in 2020, while net worth increased from $160 trillion to over $510 trillion. This figure includes real estate prices, equity market prices, exchange rates, natural resources, human resources, as well as capital and technological advancements that may create new assets or render others worthless in the coming years.

The total quantity of money in circulation will increase in the future as more investments flow-in, and developing countries stabilize their economies. The use of physical money is reducing year-by-year and transactions are becoming more digital. As digital payments gain more popularity, the amount of physical money is likely to fall even further. In Sweden, for instance, only 20% of all transactions are now made in cash. Sweden’s national bank estimates that the amount of physical money circulating in the country will be reduced by 50% by 2050.

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Value of money:

The yard measures distance. But what measures the yard? Well, distance itself’.

Similarly, money measures “goods”. But what measures money? “Goods” is the reply.

Value, as we know, is the ratio of exchange between two goods, and money measures that value through price. Money is an object of desire. Efforts are made to obtain it not for its own sake but for the goods it can purchase. The value of money, then, is the quantity of goods in general that will be exchanged for one unit of money. The value of money is its purchasing power, i.e., the quantity of goods and services it can purchase. What money can buy depends on the level of prices. When the price level rises, a unit of money can purchase less goods than before. Money is then said to have depreciated. Conversely, a fall in prices signifies that a unit of money can buy more than before. Money is then said to appreciate. The “general level of prices” and the value of money are thus the same thing from two opposite angles. When the prices rise the value of money falls and vice versa. In other words, the value of money and the general price level are inversely proportional to each other. Violent changes in the value of money (or the price level) disturb economic life and do great harm. We must, therefore, carefully study the factors which’ determine the value of money. 

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The value of money means all is related with its exchange value. Apart from exchange value of money it has no other independent value. In other words, the money is always related with its exchange value. As we know the eye whether of human person or animal does not have its own light, similarly the eye can see only with either by artificial or natural light. In the same way, the value of money can be judged or perceived only when it is related with its power of purchase.

In the words of Crowther “The value of money is what is will buy.” In other words the value of money depends on its purchasing power. In this connection the other definition of Robertson may also be referred. As per this definition— “The value of money means the amount or things in general which will be given in exchange for a unit of money.”

In this way the value of the money depends on its purchasing power either of a commodity or other services. It is also evident that the value of money and value of commodity has opposite relationship. This means when there is an increase in the value of commodity, the value of money will decrease.

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Suppose we have found by measurement that a room is four metres long. Measuring it again next day we are surprised to see that the same room is five metres in length. How could the room stretch itself by a metre overnight? Was some partition knocked out or an extension added during the night? Or is it that our metre measure has grown shorter by 20 centimeters? Which out of these is the correct answer? In the same way, if a rupee can buy one kg of wheat today but purchases only half a kg tomorrow, we are greatly perplexed. We feel disgusted with our food-measure, the rupee, which has shrunk to half its length. We want to know what has happened. We are told “the value of money has changed.” Exactly this is what has happened in India. There are many times more rupee notes circulating in the country now than previously, while the number of goods has not increased to that extent. Hence a rupee buys less. In 1913, money was worth a lot more. A dollar then could buy what $29.04 could purchase in 2022. The dollar lost value slowly over time.

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Time Value of Money:

Money also has a time value. Money today is worth more than money in the future because today’s money can be invested and grown. To calculate the time value of money (TVM), you must consider the present value, the time frame available, and the rate at which it can grow.

The formula for finding the time value of money is FV = PV x [ 1 + (i / n) ] ^ (n x t), where FV is the future value, PV is the present value, i is the interest rate, n is compounding periods per year, and t is the number of years.

Here is an example of finding the time value of money. If you have $100 in present value, a 5% interest rate, and interest that compounds annually, you would be able to calculate the future value of the money after 5 years.

FV = $100 x [1 + (0.05 / 1)] ^(1 x 5) = $127 after 5 years.

You would have $127 in future value. If you keep the same $100 in cupboard for 5 years, it will remain $100 only. 

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Inflation:   

You may have heard your parents or grandparents talk about how different things were when they were your age. It only cost a nickel to see a movie. Gasoline was 30 cents per gallon. A brand new car might cost about $5,000. In the intervening years, prices have risen, sometimes drastically. Seeing a movie in the theatre now costs about $8; gasoline can cost more than $4 per gallon in some places; and few new cars cost less than $15,000. That’s inflation.

Inflation is when a certain form of currency starts to have less value over time. It is caused mainly by two things: people’s perception of value, and the economic principle of supply and demand.

Perception of Value:

Understanding that the value of money is based on our perception of its worth is easier if we look at how that perception can alter the specific amount of that value. Let’s say that one American dollar is worth 5 French francs. One day, the U.S. government announces that part of its economic policy will be to allow the value of the U.S dollar to decrease slowly to about 3 francs (the U.S. government might do this to encourage foreign investors, among other reasons). The next day, the value of the dollar would likely drop sharply, which it has in similar situations. Why? The government announcement led people to believe that their dollars would be worth less — therefore, they were worth less. The same effect can be seen in today’s stock market, which is another currency system. When a company declares that its profits are down, the value of the company’s shares can drop within minutes.

People’s perceptions of a currency’s value can affect its value. This effect causes inflation by directly affecting the value of the money. When currency was still on a gold standard, inflation often happened when people started to worry that the government or bank wouldn’t be able to redeem their cash for gold. If you had a dollar that was worth an ounce of gold, but people thought the government only had half of the gold required to redeem it, then dollars would start being traded at a value of half an ounce of gold.

Supply and Demand:

Value changes are the result of supply and demand. This is true with fiat currency as well as any other asset that’s subject to market forces. When the supply of money increases or decreases, the relative value of that money rises or falls with those forces. Demand for certain currencies can fluctuate, as well. When it comes to money, those changes in supply and demand typically stem from activity by central banks or forex traders. Throughout history, governments have tried to solve financial problems by simply printing more money. This can drive the value of money drastically downward, especially in modern markets where money is not backed by gold. Twice as many dollars in an economy makes those dollars worth half as much.

After World War I, Germany was forced to pay war reparations of about $33 billion. It was virtually impossibly for the nation to produce that much actual output, so the government’s only choice was to print more and more money, none of which was backed by gold. This resulted in some of the worst inflation ever recorded. By late 1923, it took 42 billion German marks to buy one U.S. cent! It took 726 billion marks to buy something that had cost just one mark in 1919.

The law of supply and demand, briefly, states that when demand is high, prices will rise, and when supply is high, prices will drop. Two examples demonstrate this. If there is a theater with 2,000 seats (a fixed supply), the price of the performances will depend on how many people want tickets. If a very popular play is being performed, and 10,000 people want to see it, the theater can raise prices so that the richest 2,000 can afford to buy tickets. When the demand is much higher than the supply, prices can go through the roof. The second example is more whimsical. Let’s say you live on an island where everyone loves candy. However, there’s a limited supply of candy on the island, so when people trade candy for other items, the price is fairly stable. Over time, you save up 50 pounds of candy, which you can trade for a new car. Then, one day, a ship hits some rocks near the island, and its cargo of candy washes ashore. Suddenly, 30 tons of candy are lying on the beach, and anyone who wants candy can just walk to the beach and get some. Because the candy supply is far greater than the demand, your 50 pounds of candy is all but worthless.

Inflation is when the value of money steadily declines over time. Once people expect that prices will rise, they are more likely to buy now, before prices go higher. That increases demand, which tells producers they can safely pass on more costs. They drive prices up more, and inflation becomes a self-fulfilling prophecy. That’s why the Federal Reserve watches inflation like a hawk. It will reduce the money supply or raise interest rates to curb inflation. The Consumer Price Index is the most common measure of inflation.

Deflation:

Deflation occurs when the general price level across the economy declines. That sounds like a great thing, but it is worse for the economy than inflation. Why? Think about what happened to the housing market from 2007 to 2011. That was massive deflation. Many people could not sell their houses for what they owed on their mortgage. Buyers were afraid that the price would drop right after they purchased it. No one knew when prices would turn back up. True, the value of money increased. You received more house for the dollar in 2011 than in 2006. But families lost homes. Construction workers lost jobs. Builders went bankrupt. That’s what makes deflation so dangerous. It’s a fear-driven downward spiral. Yes, deflation will certainly raise the value of money or its purchasing power. But it’s the fear of rapidly plunging prices that will make people hold on to their money, lessen aggregate demand for goods and services, and cause a serious slowdown in economic activity.

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Value of dollar: 

There are three ways to measure the value of the dollar.

-1. Foreign Exchange Rate

The first way to measure the value of the dollar is by how much the dollar will buy in foreign currencies. That’s what the foreign exchange (forex) rate measures. Forex traders on the foreign exchange market determine exchange rates. They take into account supply and demand, and then they factor in their expectations for the future. For this reason, the value of money fluctuates throughout the trading day.

-2. Treasury Note Values

The second method to measure the value of the dollar is the value of Treasury notes. They can be converted easily into dollars through the secondary market for Treasury. When the demand for Treasury is high, the value of the U.S. dollar rises.

-3. Foreign Exchange Reserves

The third way is through foreign exchange reserves. That is the amount of dollars held by foreign governments. The more they hold, the lower the supply. That makes U.S. money more valuable. If foreign governments were to sell all their dollar and Treasury holdings, the dollar would collapse. U.S. money would be worth a lot less.

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Why the Dollar changes in value

No matter how it’s measured, the dollar’s value declined from 2000 to 2011. That was due to a relatively low federal funds rate, a high federal debt, and a slow-growth economy. Since 2011, the U.S. dollar has risen in value despite these factors.  Why? Most of the economies in the world had even slower growth. That made traders want to invest in the dollar as a safe haven. As a result, the dollar strengthened against the euro.

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The cycle of money and goods:

The central role of money in a modern market economy can be demonstrated using a simple model:

On one side, we have households that supply labour and demand consumer goods. On the other side, we have businesses that offer consumer goods and need workers. This means that there are different flows running between households and enterprises. A money cycle runs counter to the cycle of consumer goods and labour: households receive income from businesses in the form of money for the work that they do. This can then be used to purchase consumer goods. There is a circular flow of money in economy. Money that a consumer uses to purchase goods and services reaches to the producer via mediators. Again, from the producer money goes to the consumers by the medium of wages, salaries, rents, profits etc. This cycle moves on. If a part of wages, salaries, profits etc., goes to the government in the form of taxes, they are spent on the planning of economic welfare. This way money comes back to the consumers. If a part of wages, salaries and profits goes to investment, it will lead to capital formation which in turn leads to goods & services to be consumed by people completing the cycle.  As there is circular flow of money in the economy, an economic balance is maintained but a disturbance in the flow of money system leads to economic imbalance.

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Currency: 

Currency seems like a very simple idea. It’s only money, after all, and that’s just what we use to buy the things we want and need. We get paid by our employers, and we use that money to pay the bills, buy our food, and purchase goods and services. We might put some in a savings account at the bank or invest it in stocks or real estate, but for the most part, currency seems like a fairly straightforward concept.

In fact, the development of currency has shaped human civilization. Currency has stopped wars, and it has started many more. Cities and nations as we know them would not exist without it. It is difficult to overstate the importance of currency in modern life.

A currency is a standardization of money in any form when in use or circulation as a medium of exchange, for example banknotes and coins.  A more general definition is that a currency is a system of money in common use within a specific environment over time, especially for people in a nation state.  Under this definition, U.S. dollars (US$), euros (€), Indian rupee (₹), Japanese yen (¥), and pounds sterling (£) are examples of (government-issued) fiat currencies. The United Nations recognises around 180 currencies as legal tender. Currencies may act as stores of value and be traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are defined by governments, and each type has limited boundaries of acceptance.

One can classify currencies into three monetary systems: fiat money, commodity money, and representative money, depending on what guarantees a currency’s value (the economy at large vs. the government’s physical metal reserves). Some currencies function as legal tender in certain political jurisdictions. Others simply get traded for their economic value.

Digital currency has arisen with the popularity of computers and the Internet. Whether digital notes and coins will be successfully developed remains dubious. Cryptocurrencies are not currencies as they do not have an issuer, are not an instrument of debt or a financial asset and do not have any intrinsic value. Anything that derives value based on make believe, without any underlying, is just speculation. Decentralized digital currencies, such as cryptocurrencies are not legal currency, strictly speaking, since they are not issued by a government monetary authority (although one of them, Bitcoin, has become legal tender in El Salvador). Many warnings issued by various countries note the opportunities that cryptocurrencies create for illegal activities, such as money laundering and terrorism. In 2014 the United States IRS issued a statement explaining that virtual currency is treated as property for Federal income-tax purposes and providing examples of how longstanding tax principles applicable to transactions involving property apply to virtual currency.  

In most cases, a central bank has the exclusive power to issue all forms of currency, including coins and banknotes (fiat money), and to restrain the circulation alternative currencies for its own area of circulation (a country or group of countries); it regulates the production of currency by banks (credit) through monetary policy.

An exchange rate is a price at which two currencies can be exchanged against each other. This is used for trade between the two currency zones. Exchange rates can be classified as either floating or fixed. In the former, day-to-day movements in exchange rates are determined by the market; in the latter, governments intervene in the market to buy or sell their currency to balance supply and demand at a static exchange rate.

In cases where a country has control of its own currency, that control is exercised either by a central bank or by a Ministry of Finance. The institution that has control of monetary policy is referred to as the monetary authority. Monetary authorities have varying degrees of autonomy from the governments that create them. A monetary authority is created and supported by its sponsoring government, so independence can be reduced by the legislative or executive authority that creates it.

Several countries can use the same name for their own separate currencies (for example, a dollar in Australia, Canada, and the United States). By contrast, several countries can also use the same currency (for example, the euro or the CFA franc), or one country can declare the currency of another country to be legal tender. For example, Panama and El Salvador have declared US currency to be legal tender, and from 1791 to 1857, Spanish dollars were legal tender in the United States. At various times countries have either re-stamped foreign coins or used currency boards, issuing one note of currency for each note of a foreign government held, as Ecuador currently does.

Each currency typically has a main currency unit (the dollar, for example, or the euro) and a fractional unit, often defined as 1⁄100 of the main unit: 100 cents = 1 dollar, 100 centimes = 1 franc, 100 pence = 1 pound, although units of 1⁄10 or 1⁄1000 occasionally also occur. Some currencies do not have any smaller units at all, such as the Icelandic króna and the Japanese yen.

Mauritania and Madagascar are the only remaining countries that have theoretical fractional units not based on the decimal system; instead, the Mauritanian ouguiya is in theory divided into 5 khoums, while the Malagasy ariary is theoretically divided into 5 iraimbilanja. In these countries, words like dollar or pound “were simply names for given weights of gold”. Due to inflation khoums and iraimbilanja have in practice fallen into disuse.

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In a nutshell

Currency is the physical money in an economy, comprising the coins and paper notes in circulation. Currency makes up just a small amount of the overall money supply, much of which exists as credit money or electronic entries in financial ledgers. While early currency derived its value from the content of precious metal inside of it, today’s fiat money is backed entirely by social agreement and faith in the issuer. For traders, currencies are the units of account of various nation states, whose exchange rates fluctuate between one another.

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Fiat currency (fiat money):  

Fiat money is a currency that lacks intrinsic value and is established as a legal tender by government regulation. A fiat currency is a national currency that is not pegged to the price of a commodity such as gold or silver.  Traditionally, currencies were backed by physical commodities such as silver and gold, but fiat money is based on the creditworthiness of the issuing government. The value of fiat money depends on supply and demand and was introduced as an alternative to commodity money and representative money. Commodity money is created from precious metals such as gold and silver, while representative money represents a claim on a commodity that can be redeemed. China was the first country to use fiat currency, around 1000 AD, and the currency then spread to other countries in the world. It became popular in the 20th century when U.S. President Richard Nixon introduced a law that canceled, the direct convertibility of the U.S. dollar into gold. Currently, most nations use paper-based fiat currencies that only serve as a mode of payment. Unlike the traditional commodity-backed currencies, fiat currency cannot be converted or redeemed. It is intrinsically valueless and used by government decree. For a fiat currency to be successful, the government must protect it against counterfeiting and manage the money supply responsibly. The value of fiat money is largely based on the public’s faith in the currency’s issuer, which is normally that country’s government or central bank. Historically, commodity money has an intrinsic value that is derived from the materials it is made of, such as gold and silver coins. Fiat money by contrast, has no intrinsic value – it is essentially a promise from a government or central bank that the currency is capable of being exchanged for its value in goods. Well-known examples of fiat currencies include the pound sterling, the euro and the US dollar. In fact, very few world currencies are true commodity currencies and most are, in one way or another, a form of fiat money. The value of fiat money is dependent on how a country’s economy is performing, how the country is governing itself, and the effects of these factors on interest rates. A country experiencing political instability is likely to have a weakened currency and inflated commodity prices, making it hard for people to buy products as they may need.

Pros and cons of a fiat currency:

Pros of a fiat currency:

Since fiat money is not a scarce or fixed resource – like gold – a country’s central bank has greater control over its supply and value. This means that governments can manage the credit supply, liquidity and interest rates more reliably. Unlike commodity currencies, which could be affected by the discovery of a new gold mine, the supply of fiat currencies is regulated and controlled by the respective currency’s government. There is less risk of an unexpected devaluation caused by the supply of fiat currencies, as any increase in supply is a pre-empted decision made by a fiat currency’s government.

Cons of a fiat currency:

Since it is not tied to a tangible asset, the value of fiat money is dependent on responsible fiscal policy and regulation by the government. Irresponsible monetary policy can lead to inflation and even hyperinflation of a fiat currency. Adding to this, there is greater opportunity for bubbles with fiat currency – an economic cycle in which there is a rapid increase in price before an equally rapid decline in price. The increased prevalence of bubbles is because fiat currencies have a virtually unlimited supply, which means that quantitative easing is an option for governments. While possibly providing stimulus to an economy, quantitative easing can also cause greater inflation rates. This could impact anything from housing prices to national debt levels, which in turn could impact the financial markets.

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Why is the U.S. Dollar an internationally accepted money?

Any currency could replace the U.S. Dollar as a global currency. However, for a currency to be accepted internationally, two major factors play a vital role.

Firstly, the credibility of the currency is very important. A country cannot print or circulate currency as it likes. The quantity of money a country circulates purely depends upon how much gold reserve it has. The currency of a nation that does not follow the basic rule of gold reserve loses its credibility naturally. The US Dollar dominates other currencies when it comes to credibility. It does not mean that other countries do not maintain enough gold reserves to strengthen their currencies. However, the global community believes that the United States follows higher standards comparatively. And this belief of the global community is true to some extent.

Secondly, the global community looks at the stability of the political and economic system of a nation to use its currency for important international transactions. The United States has not undergone any major political crisis. Even though the country faced great depression in 1930 and subprime mortgage crisis in 2008, it was able to regain its economic stability magically. Other countries struggle a lot for restoration, if they face such traumatic events. For instance, Euro tried to replace US Dollar as an international currency. However, the currency of the European Union lost its credibility because of Eurozone crisis, and the restoration magic that worked in the US economy has not taken place in the Eurozone till now.

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Why don’t all countries of the world use one currency?

The concept of a single worldwide currency has been suggested since the 16th century and came close to being instituted after World War II — yet the idea remains little more than that.  Advocates, notably Keynes, of a global currency often argue that such a currency would not suffer from inflation, which, in extreme cases, has had disastrous effects for economies. In addition, many argue that a single global currency would make conducting international business more efficient and would encourage foreign direct investment (FDI). If the world adopts one currency, the problem of currency risk will be eradicated completely. Countries, who use currency exchange to make their goods and services cheaper, as China often devalues its currency to gain from international trade, will no longer be able to gain from the single currency model. Also, countries may not be able to implement an independent monetary policy because of the single currency method. There are many different variations of the idea, including a possibility that it would be administered by a global central bank that would define its own monetary standard or that it would be on the gold standard. Supporters often point to the euro as an example of a supranational currency successfully implemented by a union of nations with disparate languages, cultures, and economies.

Some economists argue that a single world currency is unnecessary, because the U.S. dollar is providing many of the benefits of a world currency while avoiding some of the costs. Also, in the present world, nations are not able to work together closely enough to be able to produce and support a common currency. There has to be a high level of trust between different countries before a true world currency could be created. A world currency might even undermine national sovereignty of smaller states.

One of the chief fears among opponents of a universal currency is the creation of a central body formed to oversee the monetary policy for a single world currency. The interest rate set by the central bank indirectly determines the interest rate customers must pay on their bank loans. This interest rate affects the rate of interest among individuals, investments, and countries. Lending to the poor involves more risk than lending to the rich. As a result of the larger differences in wealth in different areas of the world, a central bank’s ability to set interest rates to make the area prosper will be increasingly compromised, since it places wealthiest regions in conflict with the poorest regions in debt. Additionally, some religious adherents who oppose the paying of interest are currently able to use banking facilities in their countries which regulate interest.

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Money vs. currency: 

Money is an intangible concept, which means it cannot be touched, it cannot be smelled; however it can be seen in terms of numbers. These days everything runs online, so if you transfer money from one account to another account, the only difference is in the numbers. You don’t actually see the tangible money or you cannot physically touch the money. That’s what money is! Money does have a few properties such as it must be a medium of exchange; a unit of account; a store of value; and a standard of deferred payment. Any kind of object that fulfills these functions can be considered as money. Although, previously gold was considered to be money as the banks would have gold reserved, based on which they would issue notes or currencies. These were basically promissory notes stating that it would pay you that amount of gold when presented with the currency. However, this has long since changed and one can no longer demand gold/silver or any such commodity upon presenting the cash. Money has now become a complete intangible concept that is represented by numbers in the system.

Currency is a tangible concept that is based on the intangible money. Currency is the promissory note or coin that is presented in form of money. Currency is what brings money to life. It is what is traded in return of goods or services. The term currency is derived from the Middle English word ‘curraunt’, meaning “in circulation”. These are the coins and bank notes that are in circulation. Each country has its own currency, which can be traded against another currency. Throughout history, various different things have been used as currency including silver, shells and even stores of grains. This describes any medium that can be used to purchase another commodity.

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Difference between the currency market and money market:  

-1. The essential difference between the currency market and the money market is that the currency market is a trading network for foreign exchange trading, whereas the money market is a short-term capital lending market with a deadline of one year or less, which is an integral part of the international capital market.

-2. The foreign exchange market and the money market have different compositions of business. The currency market consists of a spot trading market, a forward trading market, and an adjustment trading market. The money market is composed of three parts – short-term credit market, short-term securities market, and discount market.

-3. The types of money used in the foreign exchange market and the money market are different. In the currency market, a foreign exchange transaction invariably deals with two kinds of money. Whereas in the money market, typically a loan business, only involves one kind of money.

-4. Another difference between the currency market and the money market lies in the function of the respective markets. The function of the currency market is to realize the exchange of different types of currencies and prevent the risk of exchange rate fluctuations. The function of the money market is plain to finance the surplus and deficit of short-term funds.

-5. In the currency market, the profits of banks in the foreign exchange business come from the differences in the exchange rates while buying and selling foreign exchange. The part of the selling price that exceeds the buying price is the bank’s profit. In the money market, the profit of a bank’s short-term capital deposit and loan business comes from the difference between the deposit and the loan interest rate. The part of the loan interest rate higher than the deposit interest rate is the bank’s profit.

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Cash:

• In economics, cash is money in the physical form of currency, such as banknotes and coins.
• In bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately (as in the case of money market accounts). Cash is seen either as a reserve for payments, in case of a structural or incidental negative cash flow or as a way to avoid a downturn on financial markets.
• In finance and accounting, cash refers to money (currency) that is readily available for use. It may be kept in physical form, digital form, or invested in a short-term money market product. In economics, cash refers only to money that is in the physical form.

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Cash is legal tender—currency or coins—that can be used to exchange goods, debt, or services. Cash is also known as money, in physical form. Although cash typically refers to money in hand, the term can also be used to indicate money in banking accounts, checks, or any other form of currency that is easily accessible and can be quickly turned into physical cash.  Cash, in a corporate setting, usually includes bank accounts and marketable securities, such as government bonds and banker’s acceptances.

Cash in its physical form is the simplest, most broadly accepted and reliable form of payment, which is why many businesses only accept cash. Checks can bounce and credit cards can be declined, but cash in hand requires no extra processing. However, it’s become less common for people to carry cash with them, due to the increasing dependability and convenience of electronic banking and payment systems.

In finance and banking, cash indicates the company’s current assets, or any assets that can be turned into cash within one year. A business’s cash flow shows the net amount of cash a company has, after factoring in both incoming and outgoing cash and assets, and can be a good resource for potential investors. A company’s cash flow statement shows all incoming cash, such as net income, and outgoing cash used to pay expenses such as equipment and investments.

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Historical Forms of Cash:

Cash has been used as long as goods and services have been traded, and its form depends on the culture in which it operates. Many civilizations over the last 4,000 years used coins struck from precious metals including copper, bronze (an alloy of copper and tin), silver, and gold, though other early civilizations used seashells or commodities of weight, including salt and sugar. In modern times cash has consisted of coins, whose metallic value is negligible, or paper. This modern form of cash is fiat currency. Paper money is a more recent form of cash, dating back to around the 18th century, and its value is set by its users’ faith in the government backing the currency. This ability to determine price has extensive effects on an economy. It can affect inflation, or the rate at which prices rise for goods and services.

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The role of cash:

The economy requires a certain amount of available cash to function. Cash is the dominant means of payment as the clear majority of our daily payments are made using banknotes or coins. Cash is also essential for the inclusion of socially vulnerable citizens, such as the elderly or lower-income groups.

But cash offers other important functions and benefits:

-It ensures your freedom and autonomy. Banknotes and coins are the only form of money that people can keep without involving a third party. You don’t need access to equipment, the internet or electricity to pay with cash, meaning it can be used when the power is down or if you lose your card.

-It’s legal tender. Creditors, such as shops and restaurants, cannot refuse cash, unless both they and the customer have agreed on another means of payment in advance.

-It ensures your privacy. Cash transactions respect our fundamental right to have our privacy, data and identity protected in financial matters.

-It’s inclusive. Cash provides payment and savings options for people with limited or no access to digital money, making it crucial for the inclusion of socially vulnerable citizens such as the elderly or lower-income groups.

-It helps you keep track of your expenses. Cash allows you to keep closer control of your spending, for example by preventing you from overspending.

-It’s fast. Banknotes and coins settle a payment instantly.

-It’s secure. Cash has proven to be secure in terms of cybercrime and fraud. And, as its central bank money, it doesn’t entail financial risks for either the payer or the payee.

-It’s a store of value. Cash is more than just a payment instrument. It allows people to hold money for saving purposes without default risk. It is useful for small person-to-person gifts and payments. For example, parents can entrust small amounts of cash to their children for small purchases, or a person can give a friend or acquaintance cash to purchase something on their behalf. Cash also contributes to the financial literacy of children.

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Cash vs. credit:    

A cash transaction is a transaction where payment is settled immediately and that transaction is recorded in your nominal ledger. The payment for a credit transaction is settled at a later date. Try not to think about cash and credit transactions in terms of how they were paid, but rather when they were paid.  The key difference between cash and credit is that one is your money (cash) and one is the bank’s (or someone else’s) money (credit). When you pay with cash, you hand over the money, take your goods and you are done. Which is great, as long as you have the money. When you pay with credit, you borrow money from someone else to pay. Usually this money does not come for free. Yes, you need to pay back the money you borrowed, but there is also usually an additional amount you have to pay back – this is called interest. The interest rate you pay can vary depending on the type of credit you choose and the lender you borrow from. The higher the interest rate, the more money you will pay in interest over time. The lower the interest rate, the less money you will pay in interest over time. It can take some time to save up enough money for a big purchase, like a car. One of the benefits of using credit is that you can buy the thing you want now, even if you don’t have the cash saved up yet.

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Which is better, cash or credit?

Depending on who you ask, you will likely get a variety of responses. There are significant pros and cons for using both cash and credit. In some cases, the merchant will indicate which payment they prefer. But a huge percentage of the time, the method you choose comes down to which option works best for you. It is important to consider your spending habits before choosing a payment method. Paying attention to how and when you spend money can help inform which option may be best for you. Do you know when you are most likely to overspend? Do you find it easier to make a purchase on credit or lose track of where your cash was spent? If you are carrying a large credit balance or struggling to stay on top of payments, sticking to cash whenever possible may help you pay down debt. Dave Ramsey popularized the envelope method encouraging people to use cash whenever possible. Many people use credit cards regularly and rarely carry a balance. If you stay on top of your payments and pay your card in full, a credit card is probably a great option for you.

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Is it illegal to keep large amounts of cash at home?

It is legal for you to store large amounts of cash at home so long that the source of the money has been declared on your tax returns. There is no limit to the amount of cash, silver and gold a person can keep in their home, the important thing is properly securing it.

Should you keep most of your money in the bank accounts?

Keeping money in bank accounts is convenient for many reasons. When you have to make a large purchase of any kind, it’s more secure to swipe your credit/debit card rather than paying cash. It’s nerve-wrecking to be in possession of thousands of dollars in cash because of the fear of theft. Also, we very much depend on a good credit score to purchase a house, a car, among other things. A good or bad credit score can only be measured if you use a credit card which will most likely be paid through your bank account.

On the other hand, no bank can fully guarantee to give us complete access of your money at any given moment. Most banks have a withdrawal limit and debit card payment limit. In other words you could have thousands of dollars in account but only have access to a small percentage of it today. There are many reasons for this, but consider that most banks don’t keep a lot of paper currency on hand to begin with. If a handful of people were allowed to empty out their accounts today, the bank would run out of cash quickly.

Over the last decade, we have seen the collapse of many banks and while things seem steady at the moment, who knows what the future will hold. In 2008, the United States suffered a financial crisis where some of the most important banks filed, or were close to filing, for bankruptcy. In a more extreme example, we can look at the great economic collapse of Argentina which occurred in 2002. Argentina witnessed a collapse that had been steadily declining since 1998 where most people lost complete control over their accounts.

There are many people who have chosen to keep cash and valuables in a safe deposit box at their bank. This can be a great idea as well, under the right circumstances. The valuables you keep at the bank are completely undisclosed, even to the bank. If anything were to be destroyed or stolen there is no chance of recovery because those items are not insured by the institution nor the government. Before experiencing a terrorist attack or natural disaster emergency, consider how accessible your money and valuables are going to be. Ask the bank what emergency operating procedures they have in place involving customers having access to their safety deposit boxes prior to and during an emergency.

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Cashless payments:

A cashless society can be defined as one in which all financial transactions are handled through “digital” forms (debit and credit cards) in preference to cash (physical banknotes and coins). Cashless societies have been a part of history from the very beginning of human existence. Barter and other methods of exchange were used to conduct a wide variety of trade transactions during this time period.

Since the 1980s, the use of banknotes has increasingly been displaced by credit and debit cards, electronic money transfers and mobile payments, but much slower than expected. The cashless society has been predicted for more than forty years, but cash remains the most widely used payment instrument in the world and on all continents. In 17 out of 24 studied countries, cash represents more than 50% of all payment transactions, with Austria at 85%, Germany at 80%, France at 68%. The United Kingdom at 42%, Australia at 37%, United States at 32%, Sweden at 20%, and South Korea at 14% are among the countries with lower cash usage. By the 2010s, cash was no longer the preferred method of payment in the United States.  In 2016, the United States User Consumer Survey Study reported that three out of four of the participants preferred a debit or credit card payment instead of cash.  Some nations have contributed to this trend, by regulating what type of transactions can be conducted with cash and setting limits on the amount of cash that can be used in a single transaction.

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Cash is still the primary means of payment (and store of value) for unbanked people with a low income and helps avoiding debt traps due to uncontrolled spending of money. It supports anonymity and avoids tracking for economic or political reasons. In addition, cash is the only means for contingency planning in order to mitigate risks in case of natural disasters or failures of the technical infrastructure like a large-scale power blackout or shutdown of the communication network. Therefore, central banks and governments are increasingly driving the sufficient availability of cash. The US Federal Reserve has provided guidelines for the continuity of cash services, and the Swedish government is concerned about the consequences in abandoning cash and is considering to pass a law requiring all banks to handle cash.

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Digital and virtual currencies:

Digital currency is a generic term for various approaches to support secure transactions of the public using a distributed ledger, like blockchain, as a new technology for decentralized asset management. It considers establishing an electronic version of the national currency which is backed by the central bank as the issuer. Virtual currency is a digital representation of value that is neither issued by a central bank or a public authority, such as Bitcoin.  Facebook’s concept for the diem is based on a token to be backed by financial assets such as a basket of national currencies.

In 2012, Bank of Canada was considering introducing digital currency.  Meanwhile, it rates digital currency a fairly complicated decision and is analyzing the pros and cons and working to determine under which conditions it may make sense to, one day, issue a digital currency. As a threat, a central bank digital currency could increase the risk of a run on the banking system.

Also in 2012, Sveriges Riksbank, the central bank of Sweden, was reported to analyze technological advances with regard to electronic money and payment methods for digital currency as an alternative to cash.  In 2019, it is investigating whether Swedish krona need to be made available in electronic form, the so-called e-krona, and if so, how it would affect Swedish legislation and the Riksbank’s task. It has started procuring a technical supplier to develop and test solutions for a potential future e-krona. No decisions have yet been taken on issuing an e-krona.

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Inconsistent Definitions of Money and Currency in Financial Legislation as a Threat to Innovation and Sustainability, a 2021 paper:

External shocks, like the climate catastrophe or the COVID-19 pandemic, as well as intrinsic fallacies like the securitization of bad debt leading up to the financial crisis in 2008, point to the need for updating our monetary and financial systems. Ensuring their adequacy and resilience is an important factor for sustainability at large. This paper examines the definitions of “money” and “currency” in financial legislation as a foundational factor in achieving systemic resilience by allowing or hampering monetary innovation and diversity. From the unencumbered vantage point that the practice of complementary currencies offers, definitions of the terms “money” and “currency” are here traced through the laws and regulations of the United States of America, from the beginnings of modern banking to the recent rulings on crypto-currencies. They are both found to be used and defined in contradictory ways that are inapt even in regard to conventional modern banking practices, let alone when applied to novelty in payment, issuance and valuation. Consequently, this paper argues that basic legal definitions need to be reviewed and consolidated to enable the innovation and diversification in monetary systems needed for long term macro-economic stability. With this in mind, a terminology that is consistent with monetary practice—current, past and future—as well as the procedural difficulties of reforming laws and regulations is proposed.

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Legal professionals do not claim the final word on establishing “what money is” and refer to economists for having a broader and practically more relevant vision of money. Yet, when economists are probed to define money beyond descriptions of its use and functionality, they are quick to admit, even at the Bank of England, that “there is no universal agreement on what money actually is” (McLeay et al. 2014a)—and they refer back to the legal disciplines for concise answers (e.g., in Bholat et al. 2015).

A standard textbook, consulted by law students trying to comprehend the financial law of the US, uses the two terms “money” and “currency” in a way that suggests them being legally synonymous. The authors posit that “money”, in a narrow statutory sense, equals “cash”—and all other payment instruments are only “money substitutes” (Gillette et al. 2007, p. 1). In support of this equation, they draw on the often-cited definition of “money” in the US Uniform Commercial Code (UCC), which reads: “a medium of exchange authorized or adopted by a domestic or foreign government” (U.C.C. § 1–201(24), see Uniform Commercial Code 2017). “Cash” is here equal to the term “currency” in as much as it is defined in another central statute of the US, the Code of Federal Regulation (CFR). There, “currency” is: “The coin and paper money of the United States or of any other country that is designated as legal tender and that circulates and is customarily used and accepted as a medium of exchange” (CFR § 1010.100 (m), see Code of Federal Regulations 2017).

Taken together, the two definitions lead to the textbook equation of “money” and “currency”. This, of course, contradicts both the everyday experience as well as the economists’ take on the matter. Both would agree that most “money” in circulation today comes not in the form of cash, but as electronic balances issued by commercial banks (McLeay et al. 2014b; Yang 2007, p. 201; Huber 2016, 2017). However, those bank balances are explicitly excluded from the legal definition of currency here cited. It seems tempting to dismiss the relevance of this finding as a quirk attributed to legalistic language so often joked about being unintelligible and disjunct from common parlance. Moreover, obviously, it cannot have severe consequences in the real world; because otherwise, our economies would be left with hardly any “money” at all. As much as this complacency towards the letter of the law may seem justified while everything is running smoothly, it is here argued that such inconsistencies between theory and practice will become untenable in times of change, whether induced by crises or pre-emptive design.

The critical reading of US legislation presented in this paper has shown that the definitions of the terms “money” and “currency” are not only antiquated but inconsistent in their use even in modern statutes. The transdisciplinary approach here taken found answers to the question of “what is the legal definition of money” that revealed a level of contradictions in the statutes of the United States that cannot be explained or excused with the preconception that legal language is always difficult to understand. Complex language is only merited where it leads to more coherence, not less. Otherwise, it is simply jargon. Specifically, the term “currency” cannot, as it was found in the statutes examined here, be consistently defined as cash issued by national governments, while it is simultaneously used to talk about the opposite: units transacted electronically and issued by private institutions, whether banks or FinTech-challengers. The term money was found to be even more ambiguous: being at times used synonymously with currency and at other times encompassing anything of value that can be transacted. This equates to a haphazard appropriation of a term which is easily regarded as too general and idealistic to allow the law or state any exclusive right over it.

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The definitions here proposed are:

Money = the abstract concept of transferable units that facilitate collaboration

Currency = the actual instantiations of the concept “money”: unit-systems that are intentionally or implicitly designed for a specific group of agents to transact for a specific purpose, in specific ways and contexts.

For the assignment of the term currency/currencies to any instantiation of the concept of money, it does here not matter in which particular way a currency system is designed and implemented or how transactions are executed: Be it by handing-over physical representations of those units made from whatever material, or by the reassignment of electromagnetic representations, in distributed or centralized databases.

Depicting the two terms as sets (see figure below) still allows for terms like “cryptocurrencies”, “community currencies”, “loyalty points,” or “time banks” to be coherently positioned in relation to each other and alongside conventional national currencies. They would simply become subsets or subcategories within or under the wider term currency. Only the term “complementary currencies” thus becomes somewhat redundant because without the theoretic and linguistic hegemony of conventional “money,” all currencies would equally complement all other currencies. However, in current practice and parlance, the term “complementary currencies” would adhere to the whole space/set of “currencies” apart from the subspace here labeled “conventional”.

Figure above shows proposed definitions of “money” and “currencies” as a set diagram. 

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How long will your Money last?

Have you ever wondered how quickly money wears out from being handled or damaged? Not surprisingly, smaller denominations have a shorter life span.

$1 bill	5.8 years
$5 bill	5.5 years
$10 bill	4.5 years
$20 bill	7.9 years
$50 bill	8.5 years
$100 bill	15.0 years

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Section-3

Origin, history and evolution of money:     

There is no evidence about the first emergence of money; particularly the time and place concerned. People had very few wants in the beginning of human civilization. There was no need of money as they could meet their needs themselves. As the civilization prospered; people’s needs multiplied, and consequently interdependence for goods and services increased.

Hence, the barter system came into existence to fulfill the initial needs of exchange. But a number of difficulties were observed in this system by the passage of time; for instance— lack of double coincidence of wants, lack of common measure of value, lack of divisibility of commodities, lack of store of value, difficulty in deferred payment, lack of transfer of value etc. In a civilized society, a need was felt that there should be such a system that could save all from these difficulties. Money came into existence in these circumstances.  

The word money derives from the Latin word moneta with the meaning “coin” via French monnaie.  It is said that “Moneta” is the other name of Goddess Juno. In the ancient Italy this Goddess was called “The Goddess of Heaven”. Metallic money was coined in the temple of this goddess. As this money was produced in the temple of “The Goddess of Heaven”, one who got it felt the joy of Heaven. So, it is considered that the term ‘Money’ is derived from the term “Moneta”. On the other hand, some scholars consider the term ‘Pecunia’ as the root of the term ‘Money’. The term ‘Pecunia’ has originated from the term ‘Pecus’ which literally means ‘Live-stock’. This can be held logical as in ancient days livestock and goods were used as money.

Whatsoever have been the ways of origin of money, it is an ultimate truth that ‘money’ is one of the three greatest inventions of the world. It is worth mentioning here that ‘fire’, ‘wheel’ and ‘money’ are considered to be the three greatest inventions of the world.

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There are three major theories regarding the origin of money: –

-1. Money was created for trading purposes;

-2. Money was created for social purposes;

-3. Money was created for religious purposes.

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-1. Money was created for trading purposes

Most economists assume that money developed for trading purposes, because it was more flexible than bartering. This meant that money was a valuable commodity in itself, such as cattle in ancient civilizations, later gold and silver by weight, and finally coinage – gold and silver coins.

-2. Money was created for social purposes

The second theory is that money was created for social purposes, such as establishing the price of a bride or as blood-money for somebody killed or injured by another tribe.

-3. Money was created for religious purposes

The third theory is that money was developed for religious purposes. Bernhard Laum in his book Heiliges Geld (Holy Money) states that money’s origin was in the Eastern temples as the prescribed sacrifice to the gods and payment to the priests. Gold would have been the easiest metal for ancient man to mine from rocks in river beds, with copper the next easiest and silver requiring the most developed technology to mine. This goes against all our instinctive ideas that gold is valuable because it is so difficult to obtain. Rather gold became valuable precisely because it was relatively easy to obtain, and looked nice. Gold and silver were presented to the temples in the East as dues to the priests and offerings for the gods, as well as other commodities such as barley and wheat. Over time the temples would have acquired a large proportion of the existing gold and silver. This theory is supported by the vast amounts of gold and silver seized by Alexander the Great from Eastern temples in 330 BC.

The monetization of gold:

Between 1500 BC and 1000 BC, the medium of exchange shifted from a cattle standard to a gold by weight standard.  The temples played a major role in transforming gold into money. Over the centuries gold and silver accumulated in the temples. Only so much was required for decorative purposes. The fact that the temples were accumulating so much gold would have been a major factor behind the decision to transform it into money, or monetize it. The theory is that the priests must have decided to use up some of this surplus gold by monetizing it: They could have for example determined that 130 grams of gold was worth 1 cow. Overtime the priests would have charged for their services, such as advice on when to plant crops, and would have come up with a standard charge for these services. The theory that the priests determined the value of gold by arbitrary decision, contradicts the trading origin of money, which assumes that the value of gold was determined by the effort involved in mining it and shaping it into a standard unit of money.

Money is a creature of the law:

Applying logic to these three theories one can understand how a cow was a standard unit of currency in ancient Ireland and Greece with one slave-girl worth 3-4 cows in both these two ancient civilizations. It is easy to value a cow; how old the cow is; how many calves the cow is likely to have; how much milk the cow is likely to produce; the value of its hide and meat, its fertilizer, its pedigree…

But how do you value say 130 grams of gold, which seems to have been the standard weight of a gold monetary unit in ancient times? The priests had the authority among the general public; they had an abundant supply of gold; they determined the price for their services; and when they decided to monetize gold, they could determine its value in relation to the price of the standard unit of account of money then in existence, which was a cow.

The theory of the origin of money in modern civilization that makes most sense is that money was created for religious purposes. Money was assigned a value by decree by the priests in the temples. Therefore money, in the form of gold or silver by weight, was the first fiat currency. It had a value both as a means of payment and also as a commodity. Therefore gold by weight money is a creature of the law, and has nothing to do with the supply and demand of gold, the perceived difficulty of mining gold, and the trading theory of the origin of money.

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History of money:  

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Prehistory: Non-monetary exchange:

Gift economy: 

In a gift economy, valuable goods and services are regularly given without any explicit agreement for immediate or future rewards (i.e., there is no formal quid pro quo).  Ideally, simultaneous or recurring giving serves to circulate and redistribute valuables within the community. There are various social theories concerning gift economies. Some consider the gifts to be a form of reciprocal altruism, where relationships are created through this type of exchange.  Another interpretation is that implicit “I owe you” debt and social status are awarded in return for the “gifts”.  Consider for example, the sharing of food in some hunter-gatherer societies, where food-sharing is a safeguard against the failure of any individual’s daily foraging. This custom may reflect altruism, it may be a form of informal insurance, or may bring with it social status or other benefits.

Barter:

There is no evidence, historical or contemporary, of a society in which barter is the main mode of exchange; instead, non-monetary societies operated largely along the principles of gift economy and debt. When barter did in fact occur, it was usually between either complete strangers or potential enemies.

With barter, an individual possessing any surplus of value, such as a measure of grain or a quantity of livestock, could directly exchange it for something perceived to have similar or greater value or utility, such as a clay pot or a tool, however, the capacity to carry out barter transactions is limited in that it depends on a coincidence of wants. For example, a farmer has to find someone who not only wants the grain he produced but who could also offer something in return that the farmer wants.

In Politics Book 1:9[36] (c. 350 BC) the Greek philosopher Aristotle contemplated the nature of money. He considered that every object has two uses: the original purpose for which the object was designed, and as an item to sell or barter. The assignment of monetary value to an otherwise insignificant object such as a coin or promissory note arises as people acquired a psychological capacity to place trust in each other and in external authority within barter exchange. Finding people to barter with is a time-consuming process; Austrian economist Carl Menger hypothesised that this reason was a driving force in the creation of monetary systems – people seeking a way to stop wasting their time looking for someone to barter with.

In his book Debt: The First 5,000 Years, anthropologist David Graeber argues against the suggestion that money was invented to replace barter. The problem with this version of history, he suggests, is the lack of any supporting evidence. His research indicates that gift economies were common, at least at the beginnings of the first agrarian societies, when humans used elaborate credit systems. Graeber proposes that money as a unit of account was invented the moment when the unquantifiable obligation “I owe you one” transformed into the quantifiable notion of “I owe you one unit of something”. In this view, money emerged first as credit and only later acquired the functions of a medium of exchange and a store of value. Graeber’s criticism partly relies on and follows that made by A. Mitchell Innes in his 1913 article “What is money?”. Innes refutes the barter theory of money, by examining historic evidence and showing that early coins never were of consistent value nor of more or less consistent metal content. Therefore, he concludes that sales is not exchange of goods for some universal commodity, but an exchange for credit. He argues that “credit and credit alone is money”. Anthropologist Caroline Humphrey examines the available ethnographic data and concludes that “No example of a barter economy, pure and simple, has ever been described, let alone the emergence from it of money; all available ethnography suggests that there never has been such a thing”.

Economists Robert P. Murphy and George Selgin replied to Graeber saying that the barter hypothesis is consistent with economic principles, and a barter system would be too brief to leave a permanent record.

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Emergence of money:

Anthropologists have noted many cases of ‘primitive’ societies using what looks to us very like money but for non-commercial purposes, indeed commercial use may have been prohibited. Often, such currencies are never used to buy and sell anything at all. Instead, they are used to create, maintain, and otherwise reorganize relations between people: to arrange marriages, establish the paternity of children, head off feuds, console mourners at funerals, seek forgiveness in the case of crimes, negotiate treaties, acquire followers—almost anything but trade in yams, shovels, pigs, or jewellery. This suggests that the basic idea of money may have long preceded its application to commercial trade.

After the domestication of cattle and the start of cultivation of crops in 9000–6000 BC, livestock and plant products were used as money.  However, it is in the nature of agricultural production that things take time to reach fruition. The farmer may need to buy things that he cannot pay for immediately. Thus the idea of debt and credit was introduced, and a need to record and track it arose.

The establishment of the first cities in Mesopotamia (c. 3000 BCE) provided the infrastructure for the next simplest form of money of account—asset-backed credit or Representative money. Farmers would deposit their grain in the temple which recorded the deposit on clay tablets and gave the farmer a receipt in the form of a clay token which they could then use to pay fees or other debts to the temple. Since the bulk of the deposits in the temple were of the main staple, barley, a fixed quantity of barley came to be used as a unit of account.

Aristotle’s opinion of the creation of money of exchange as a new thing in society is:

When the inhabitants of one country became more dependent on those of another, and they imported what they needed, and exported what they had too much of, money necessarily came into use.

Trading with foreigners required a form of money which was not tied to the local temple or economy, money that carried its value with it. A third, proxy, commodity that would mediate exchanges which could not be settled with direct barter was the solution. Which commodity would be used was a matter of agreement between the two parties, but as trade links expanded and the number of parties involved increased the number of acceptable proxies would have decreased. Ultimately, one or two commodities were converged on in each trading zone, the most common being gold and silver.

This process was independent of the local monetary system so in some cases societies may have used money of exchange before developing a local money of account. In societies where foreign trade was rare money of exchange may have appeared much later than money of account.

In early Mesopotamia copper was used in trade for a while but was soon superseded by silver. The temple (which financed and controlled most foreign trade) fixed exchange rates between barley and silver, and other important commodities, which enabled payment using any of them. It also enabled the extensive use of accounting in managing the whole economy, which led to the development of writing and thus the beginning of history.

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Commodity money, credit and debt:

Many cultures around the world developed the use of commodity money, that is, objects that have value in themselves as well as value in their use as money.  Ancient China, Africa, and India used cowry shells. The Mesopotamian civilization developed a large-scale economy based on commodity money. The shekel was the unit of weight and currency, first recorded c. 3000 BC, which was nominally equivalent to a specific weight of barley that was the preexisting and parallel form of currency. The Babylonians and their neighboring city states later developed the earliest system of economics as we think of it today, in terms of rules on debt, legal contracts and law codes relating to business practices and private property. Money emerged when the increasing complexity of transactions made it useful.

The Code of Hammurabi, the best-preserved ancient law code, was created c. 1760 BC (middle chronology) in ancient Babylon. It was enacted by the sixth Babylonian king, Hammurabi. Earlier collections of laws include the code of Ur-Nammu, king of Ur (c. 2050 BC), the Code of Eshnunna (c. 1930 BC) and the code of Lipit-Ishtar of Isin (c. 1870 BC). These law codes formalized the role of money in civil society. They set amounts of interest on debt, fines for “wrongdoing”, and compensation in money for various infractions of formalized law.

It has long been assumed that metals, where available, were favored for use as proto-money over such commodities as cattle, cowry shells, or salt, because metals are at once durable, portable, and easily divisible.  The use of gold as proto-money has been traced back to the fourth millennium BC when the Egyptians used gold bars of a set weight as a medium of exchange, as had been done earlier in Mesopotamia with silver bars.

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1000 BC – 400 AD

First coins:

From about 1000 BC, money in the form of small knives and spades made of bronze was in use in China during the Zhou dynasty, with cast bronze replicas of cowrie shells in use before this. The first manufactured actual coins seem to have appeared separately in India, China, and the cities around the Aegean Sea 7th century BC. While these Aegean coins were stamped (heated and hammered with insignia), the Indian coins (from the Ganges river valley) were punched metal disks, and Chinese coins (first developed in the Great Plain) were cast bronze with holes in the center to be strung together. The different forms and metallurgical processes imply a separate development.

All modern coins, in turn, are descended from the coins that appear to have been invented in the kingdom of Lydia in Asia Minor somewhere around 7th century BC and that spread throughout Greece in the following centuries: disk-shaped, made of gold, silver, bronze or imitations thereof, with both sides bearing an image produced by stamping; one side is often a human head.

Figure above shows a 7th century BC one-third stater coin from Lydia.

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Other coins made of electrum (a naturally occurring alloy of silver and gold) were manufactured on a larger scale about 7th century BC in Lydia (on the coast of what is now Turkey).  Similar coinage was adopted and manufactured to their own standards in nearby cities of Ionia, including Mytilene and Phokaia (using coins of electrum) and Aegina (using silver) during the 7th century BC, and soon became adopted in mainland Greece, and the Persian Empire (after it incorporated Lydia in 547 BC).

The use and export of silver coinage, along with soldiers paid in coins, contributed to the Athenian Empire’s dominance of the region in the 5th century BC. The silver used was mined in southern Attica at Laurium and Thorikos by a huge workforce of slave labour. A major silver vein discovery at Laurium in 483 BC led to the huge expansion of the Athenian military fleet.

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400–1450AD

Medieval coins and moneys of account:

Charlemagne, in 800 AD, implemented a series of reforms upon becoming “Holy Roman Emperor”, including the issuance of a standard coin, the silver penny. Between 794 and 1200 the penny was the only denomination of coin in Western Europe. Minted without oversight by bishops, cities, feudal lords and fiefdoms, by 1160, coins in Venice contained only 0.05g of silver, while England’s coins were minted at 1.3g. Large coins were introduced in the mid-13th century. In England, a dozen pennies was called a “shilling” and twenty shillings a “pound”.

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First paper money:

Earliest banknote from China during the Song Dynasty which is known as “Jiaozi” is seen in the figure above.

Paper money was introduced in Song dynasty China during the 11th century. The development of the banknote began in the seventh century, with local issues of paper currency. Its roots were in merchant receipts of deposit during the Tang dynasty (618–907), as merchants and wholesalers desired to avoid the heavy bulk of copper coinage in large commercial transactions. The issue of credit notes is often for a limited duration, and at some discount to the promised amount later. The jiaozi nevertheless did not replace coins during the Song Dynasty; paper money was used alongside the coins. The central government soon observed the economic advantages of printing paper money, issuing a monopoly right of several of the deposit shops to the issuance of these certificates of deposit. By the early 12th century, the amount of banknotes issued in a single year amounted to an annual rate of 26 million strings of cash coins.

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In the 13th century, paper money became known in Europe through the accounts of travellers, such as Marco Polo and William of Rubruck.  Marco Polo’s account of paper money during the Yuan dynasty is the subject of a chapter of his book, The Travels of Marco Polo, titled “How the Great Kaan Causeth the Bark of Trees, Made into Something Like Paper, to Pass for Money All Over his Country.” In medieval Italy and Flanders, because of the insecurity and impracticality of transporting large sums of money over long distances, money traders started using promissory notes. In the beginning these were personally registered, but they soon became a written order to pay the amount to whomever had it in their possession. These notes can be seen as a predecessor to regular banknotes.

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Trade bills of exchange:

Bills of exchange became prevalent with the expansion of European trade toward the end of the Middle Ages. A flourishing Italian wholesale trade in cloth, woolen clothing, wine, tin and other commodities was heavily dependent on credit for its rapid expansion. Goods were supplied to a buyer against a bill of exchange, which constituted the buyer’s promise to make payment at some specified future date. Provided that the buyer was reputable or the bill was endorsed by a credible guarantor, the seller could then present the bill to a merchant banker and redeem it in money at a discounted value before it actually became due. The main purpose of these bills nevertheless was, that traveling with cash was particularly dangerous at the time. A deposit could be made with a banker in one town, in turn a bill of exchange was handed out, that could be redeemed in another town.

These bills could also be used as a form of payment by the seller to make additional purchases from his own suppliers. Thus, the bills – an early form of credit – became both a medium of exchange and a medium for storage of value. Like the loans made by the Egyptian grain banks, this trade credit became a significant source for the creation of new money. In England, bills of exchange became an important form of credit and money during last quarter of the 18th century and the first quarter of the 19th century before banknotes, checks and cash credit lines were widely available.

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Islamic Golden Age:

At around the same time in the medieval Islamic world, a vigorous monetary economy was created during the 7th–12th centuries on the basis of the expanding levels of circulation of a stable high-value currency (the dinar). Innovations introduced by Muslim economists, traders and merchants include the earliest uses of credit, cheques, promissory notes, savings accounts, transactional accounts, loaning, trusts, exchange rates, the transfer of credit and debt, and banking institutions for loans and deposits.

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Indian subcontinent: 

Rupiya:

Figure above shows silver coin of the Maurya Empire, known as rupiya, with symbols of wheel and elephant.

In the Indian subcontinent, Sher Shah Suri (1540–1545), introduced a silver coin called a rupiya, weighing 178 grams. Its use was continued by the Mughal Empire. The history of the rupee traces back to Ancient India circa 3rd century BC. Ancient India was one of the earliest issuers of coins in the world, along with the Lydian staters, several other Middle Eastern coinages and the Chinese wen. The term is from rūpya, a Sanskrit term for silver coin, from Sanskrit rūpa, beautiful form.

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1450–1971

Goldsmith bankers:

Goldsmiths in England had been craftsmen, bullion merchants, money changers, and money lenders since the 16th century. But they were not the first to act as financial intermediaries; in the early 17th century, the scriveners were the first to keep deposits for the express purpose of relending them. Merchants and traders had amassed huge hoards of gold and entrusted their wealth to the Royal Mint for storage. In 1640 King Charles I seized the private gold stored in the mint as a forced loan (which was to be paid back over time). Thereafter merchants preferred to store their gold with the goldsmiths of London, who possessed private vaults, and charged a fee for that service. In exchange for each deposit of precious metal, the goldsmiths issued receipts certifying the quantity and purity of the metal they held as a bailee (i.e., in trust). These receipts could not be assigned (only the original depositor could collect the stored goods). Gradually the goldsmiths took over the function of the scriveners of relending on behalf of a depositor and also developed modern banking practices; promissory notes were issued for money deposited which by custom and/or law was a loan to the goldsmith, i.e., the depositor expressly allowed the goldsmith to use the money for any purpose including advances to his customers. The goldsmith charged no fee, or even paid interest on these deposits. Since the promissory notes were payable on demand, and the advances (loans) to the goldsmith’s customers were repayable over a longer time period, this was an early form of fractional reserve banking. The promissory notes developed into an assignable instrument, which could circulate as a safe and convenient form of money backed by the goldsmith’s promise to pay. Hence goldsmiths could advance loans in the form of gold money, or in the form of promissory notes, or in the form of checking accounts. Gold deposits were relatively stable, often remaining with the goldsmith for years on end, so there was little risk of default so long as public trust in the goldsmith’s integrity and financial soundness was maintained. Thus, the goldsmiths of London became the forerunners of British banking and prominent creators of new money based on credit.

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1816: The Gold Standard

Gold was officially made the standard of value in England in 1816. At this time, guidelines were made to allow for a non-inflationary production of standard banknotes which represented a certain amount of gold. Banknotes had been used in England and Europe for several hundred years before this time, but their worth had never been tied directly to gold. In the United States, the Gold Standard Act was officially enacted in 1900, which helped lead to the establishment of a central bank.

1930: End of the Gold Standard

The massive Depression of the 1930s, felt worldwide, marked the beginning of the end of the gold standard. In the United States, the gold standard was revised and the price of gold was devalued. This was the first step in ending the relationship altogether. The British and international gold standards soon ended as well, and the complexities of international monetary regulation began.

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First European banknotes:

The first European banknotes were issued by Stockholms Banco, a predecessor of Sweden’s central bank Sveriges Riksbank, in 1661. These replaced the copper-plates being used instead as a means of payment, although in 1664 the bank ran out of coins to redeem notes and ceased operating in the same year.

Inspired by the success of the London goldsmiths, some of whom became the forerunners of great English banks, banks began issuing paper notes quite properly termed “banknotes”, which circulated in the same way that government-issued currency circulates today. In England this practice continued up to 1694. Scottish banks continued issuing notes until 1850, and still do issue banknotes backed by Bank of England notes. In the United States, this practice continued through the 19th century; at one time there were more than 5,000 different types of banknotes issued by various commercial banks in America. Only the notes issued by the largest, most creditworthy banks were widely accepted. The scrip of smaller, lesser-known institutions circulated locally. Farther from home it was only accepted at a discounted rate, if at all. The proliferation of types of money went hand in hand with a multiplication in the number of financial institutions.

These banknotes were a form of representative money which could be converted into gold or silver by application at the bank. Since banks issued notes far in excess of the gold and silver they kept on deposit, sudden loss of public confidence in a bank could precipitate mass redemption of banknotes and result in bankruptcy.

In India the earliest paper money was issued by Bank of Hindostan (1770– 1832), General Bank of Bengal and Bihar (1773–75), and Bengal Bank (1784–91).

The use of banknotes issued by private commercial banks as legal tender has gradually been replaced by the issuance of bank notes authorized and controlled by national governments. The Bank of England was granted sole rights to issue banknotes in England after 1694. In the United States, the Federal Reserve Bank was granted similar rights after its establishment in 1913. Until recently, these government-authorized currencies were forms of representative money, since they were partially backed by gold or silver and were theoretically convertible into gold or silver.

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The Bretton Woods system:

During World War II, Great Britain and the United States outlined the post-war monetary system. Their plan, approved by more than 40 countries at the Bretton Woods Conference in July 1944, aimed to correct the perceived deficiencies of the interwar gold exchange standard. These included the volatility of floating exchange rates, the inflexibility of fixed exchange rates, and reliance on an adjustment mechanism for countries with payment surpluses or deficits; these problems were often resolved by recession and deflation in deficit countries coupled with expansion and inflation in surplus countries. The agreement that resulted from the conference led to the creation of the International Monetary Fund (IMF), which countries joined by paying a subscription. Members agreed to maintain a system of fixed but adjustable exchange rates. Countries with payment deficits could borrow from the fund, while those with surpluses would lend. If deficits or surpluses persisted, the agreement provided for changes in exchange rates. The IMF began operations in 1947, with the U.S. dollar serving as the fund’s reserve currency and the price of gold fixed at $35 per ounce. The U.S. agreed to maintain that price by buying or selling gold.

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1971–present

In 1971, United States President Richard Nixon announced that the US dollar would not be directly convertible to Gold anymore. This measure effectively destroyed the Bretton Woods system by removing one of its key components, in what came to be known as the Nixon shock. Since then, the US dollar, and thus all national currencies, are Free-floating currencies. Additionally, international, national and local money is now dominated by virtual credit rather than real bullion.

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Payment cards:

In the late 20th century, payment cards such as credit cards and debit cards became the dominant mode of consumer payment in the First World. The Bankamericard, launched in 1958, became the first third-party credit card to acquire widespread use and be accepted in shops and stores all over the United States, soon followed by the Mastercard and the American Express.  Since 1980, Credit Card companies are exempt from state usury laws, and so can charge any interest rate they see fit. Outside America, other payment cards became more popular that credit cards, such as France’s Carte Bleue.

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Electronic transfer:

The development of computer technology in the second part of the twentieth century allowed money to be represented digitally. By 1990, in the United States, all money transferred between its central bank and commercial banks was in electronic form. By the 2000s most money existed in digital forms in banks databases.  In 2012, by number of transaction, 20 to 58 percent of transactions were electronic (dependent on country). The benefit of digital transaction is that it allows for easier, faster, and more flexible payments.

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Cryptocurrencies:

In 2008, Bitcoin was proposed by an unknown author/s under the pseudonym of Satoshi Nakamoto. It was implemented the same year. Its use of cryptography allowed the currency to have a trustless, fungible and tamper resistant distributed ledger called a blockchain. In blockchain terminology, trustless refers to a system wherein we do not have to depend on one stranger, institution, or third party for a network or payment system to function. It became the first widely used decentralized, peer-to-peer, cryptocurrency. Other comparable systems had been proposed since the 1980s. The protocol proposed by Nakamoto solved what is known as the double-spending problem without the need of a trusted third-party. Since Bitcoin’s inception, thousands of other cryptocurrencies have been introduced.

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Origin of money in nutshell:

Barter replaced self-sufficiency and increased efficiency by allowing for specialization.1 It was then discovered that further efficiency could be gained by using some object as a medium of exchange to eliminate the necessity of a happy coincidence of wants required for barter to take place. Thus, money springs forth to facilitate exchange by lubricating the market mechanism, which had previously relied upon barter: money is created to minimize transactions costs. Further, “fairground barter” replaced “isolated barter” because this lowered the cost per unit of time taken to complete a transaction. Thus, the development of money and markets allowed the economy to move toward its optimum position with the lowest transactions costs. The argument is extended to the development of fiat money by noting that in the 17th century, commodity money was commonly deposited with “goldsmiths” for safekeeping against receipts called “goldsmiths’ notes.” Time and effort (now called shoe leather costs) could be saved by exchanging notes, rather than by reclaiming the gold each time an exchange was made. The goldsmith discovered that as a result, some notes were permanently in circulation so that the gold they represented was never withdrawn. Thus, goldsmiths could safely lend these gold reserves, or issue additional receipts as loans, creating the equivalent of modern fractional reserve banking. Since the cost of writing out the receipts was less than that of mining gold, goldsmith “banking” was also a rational economic decision taken to reduce the costs of the transactions structure; paper money thus replaced commodity money.

However, as goldsmiths had to keep some commodity money to facilitate clearing with other goldsmiths and for deposit withdrawals, the quantity of paper money issued would be closely governed by the quantity of commodity money held in reserve. Some of the goldsmiths gradually specialized, and the modern private banking system emerged, based on fractional reserve deposit banking. Governments began to compete by issuing fiat money either through their treasuries or through their central banks. Private banks were permitted (or required) to hold this governmental (or quasi-governmental) fiat money as reserves. Thus, an increase in the issue of government fiat money would lead to a multiple expansion of bank deposits in the fractional reserve system. While the deposit multiplier might vary, central bank control over the privately-issued supply of paper money (and, later, demand deposits) is ensured through control of bank reserves. In order to prevent excessive money from being privately created, the central bank must closely regulate the quantity of reserves. Lack of moral fiber on the part of the authorities leads to excessive reserves and to excessive money. When the public finds itself with too much money, it spends the excess, causing inflation. Thus, the primary responsibility of the central bank is to serve as an inflation guard dog.

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Technological Evolution of Money:

Around A.D. 100, a Chinese court official ground up a mash of mulberry bark, rags and fishnets, and invented paper. A few centuries later, someone—maybe a Buddhist monk who was tired of writing the same sacred text again and again—carved a sacred text into a block of wood and invented printing. A few centuries after that, a merchant in the capital of Sichuan set out to solve another problem: the money his customers were using was terrible. It was mostly iron coins, and it took a pound and a half of iron to buy a pound of salt. It would be the modern equivalent of going grocery shopping with nothing but pennies. So the merchant told his customers that they could leave their coins with him. In exchange, he gave them a claim check—a piece of paper that could be used to retrieve the coins. People started using the claim checks themselves to buy stuff, and paper money was born. It was a huge hit.

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Pretty soon, the government took over the business of printing paper money, and it spread throughout China. In an era when there was no mechanized transport, the ability to move value around on a few pieces of paper—rather than a wagon full of metal coins—was a breakthrough. Paper money relied on paper and printing, which were a kind of technology. But paper money itself also was a new technology—a tool that made trade easier. This led to an increased exchange of ideas and more economic specialization, which in turn meant people could grow more food and make more stuff. Paper money helped China get richer. At the same time, that new technology came with risks—it meant rulers could print lots of money, which sometimes led to ruinous inflation.

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Consider the case of America in the mid–19th century, when almost any bank could print its own paper money. The $2 bill from Stonington Bank in Connecticut had a whale on the front; the $5 bill from the St. Nicholas Bank of New York City had a picture of Santa Claus. At one point, private banks were printing more than 8,000 different kinds of money. This was still the era when paper money was a claim check for gold or silver. If a bank went bust, the valuable claim check was suddenly just a piece of paper with a picture of Santa Claus on it. This presented a problem for merchants who faced customers using thousands of kinds of money. How could they know which banks were sound? For that matter, how could they tell real money from counterfeit? Publications called banknote reporters sprang up to solve both problems. They were little magazines that listed bills from all around the country, with brief physical descriptions and recommendations for whether to accept the money at full value or, in the case of shaky banks, at a discount. That world disappeared around the time of the Civil War, when a new federal tax on paper money drove most of the old banknotes out of existence. But even as the variety of paper money declined, money created by private banks persisted. Even today, banks create new money out of thin air every time they make a loan. This money, stored as balances in checking and savings accounts, is not so different from the paper money banks used to print. Well into the 20th century, depositors in the U.S. could lose their money when a bank went bust—just like their ancestors who were left holding worthless pieces of paper.

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It was only in the 1930s, when the federal government started insuring most bank deposits, that this risk disappeared. In other words, modern banks create money that is in turn guaranteed by the federal government. Is this money public or private? It is both! The original dream of cryptocurrency was purely private money—a currency that needed neither governments nor banks. And although this remains a technical possibility, it’s striking that more than a decade after Bitcoin was invented, almost no one uses crypto-currency in the ordinary way people use money—to buy stuff in everyday life. If crypto-currency does become ordinary money, it probably won’t be as some purely private libertarian money, but as the kind of public-private hybrid that money has almost always been. In fact, regulators have started to crack down on so-called stablecoins, a type of crypto-currency designed to substitute for our existing money.

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When Franklin Roosevelt told his economic advisers he was about to take the U.S. off the gold standard, they freaked out. The President was leading the country into “uncontrolled inflation and complete chaos,” one of them said. Another said it was “the end of Western civilization.” Roosevelt’s aides weren’t wild-eyed reactionaries; their view was conventional wisdom. The gold standard, almost everybody agreed, was the natural way to do money. Under its rules, anybody who wanted to could trade in paper money for a fixed amount of gold. In the U.S., $20.67 got you an ounce of gold, year in and year out. That unchanging value was the whole point of the gold standard. Take away the gold, and money would obviously be just worthless paper.

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This worldview turned out to be completely wrong. Clinging to the gold standard was part of what created the Great Depression in the first place. Leaving it in 1933 was an essential step toward economic recovery. So why were Roosevelt’s advisers, and most of the leading economists of the day, blinded by their devotion to gold? There’s this thinking error we almost always make with money. The way money works at any given moment feels like part of the natural order, as with water or gravity. Any alternative to the way money works seems like some absurd game. Paper money not backed by anything? That’s like expecting water to flow uphill! Then some political or technological or financial shock comes along, and suddenly there’s something new: paper money backed by metal, or paper money backed by nothing, or simply numbers on a screen. Pretty soon, we get used to the new money. It comes to seem like the natural state of things, and anything else is foolishness.

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Then came Money-market mutual funds. They were invented in the 1970s, and the idea was to offer something that seemed like a bank account but paid higher interest. As Bruce Bent, the inventor of the money-market fund, said again and again, “The purpose of the money fund is to bore the investor into a sound night’s sleep.” Even the name is dull. Money-market funds worked like banks. Investors put money in. The fund then lent that money out, collected interest and paid some of the interest back to the investors. People and companies put trillions of dollars into money-market funds for safekeeping, and it seemed a lot like money in the bank—put a dollar in, take a dollar out, plus interest. But, unlike bank deposits, money-market fund investments were not guaranteed by the federal government.

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In September 2008, the investment bank Lehman Brothers went bankrupt. As it happened, a large money-market mutual fund had lent $785 million to Lehman Brothers—and the bankruptcy meant that the fund might not get that money back. Investors in the money-market fund started demanding their money back. But the fund couldn’t deliver. In the parlance of money-market mutual funds, it “broke the buck”—investors could no longer take out a dollar for every dollar they put in. The moment an asset that seemed safe suddenly seems risky can be profoundly destabilizing. Overnight, investors started trying to pull hundreds of billions of dollars out of money-market mutual funds. It was like a bank run, and as often happens in a run, the money-market funds weren’t going to be able to come up with all the money. Within a few days, as part of an effort to prevent a broader economic collapse, the federal government stepped in.

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Then came stablecoins. Stablecoins are cryptocurrencies the value of which is pegged, or tied, to that of another currency, commodity or financial instrument. Stablecoins aim to provide an alternative to the high volatility of the most popular cryptocurrencies including Bitcoin, which has made such investments less suitable for wide use in transactions. The most popular stablecoins work a lot like these funds. When people buy stablecoins, some of the companies that run stablecoins turn around and invest that money. When people want to redeem their stablecoins for dollars, the creators of the coins have to sell off those investments. If the investments lose a lot of money, or if everyone suddenly wants to redeem their stablecoins at once, stablecoins might prove unstable—investors might suddenly be unable to get a dollar out for every dollar they put in. Regulators know this. And so some of the most powerful economic officials in the country have suggested that stablecoins may soon come in for stricter regulation. The rise of stablecoins, and the government’s response, is the history of money and the future of money playing out in the present: a new monetary technology that brings new benefits, new risks and new fights between public and private interests.

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Evolution of types of money:

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Human beings began using money as far back as 11,000 years ago. During that time, money has roughly evolved in three stages:

-1. Commodity Money

-2. Representative Money

-3. Fiat Money

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Commodity Money (9000 BCE to Present):

From about 9000 to 6000 BCE, early human civilizations started using money. The earliest known form is cattle. Cattle had value because it was helpful in many ways: they helped till the fields and produce milk. Apart from being the first known form of money, they are also the earliest form of capital: a resource exploited for production. The word ‘cattle’ comes from the same Latin roots that gave us the term ‘capital.’ Afterward, humans turned to other agricultural products to use as money. Grains like barley and rice had value because they were food, so people were willing to accept them as payment for goods or services.

Later, people began using metals as a form of money. Unlike vegetables, coffee or chocolate, they did not spoil or rot. They remained valuable even when not being used as a medium of exchange. Metal could be melted down and re-shaped as tools, jewellery, or weapons. This property helped them retain their value. Further, they could be divided into varied sizes to settle transactions of equally-varied amounts. In the form of metal coins, money became more portable and transferrable.

Of all the metals, gold has been the most revered by humans. Gold was, and still is, valued for its beauty and rarity, with its brilliant yellow resembling that of the sun. People around the world were attracted to it and wanted to possess it. Unlike iron which corrodes and rusts, or copper that turns green, gold has this mysterious quality of remaining pure and unchanging. People associated such properties with something divine or magical and consequently embellished their temples and tombs and made idols with gold. In addition, gold is scarce, which has helped maintain its value. People were happy to receive gold as payment for goods and services because they were sure others would accept it for things they would need in the future. These qualities explain why gold functioned so well as money for thousands of years.

Commodities utilized as money can be characterized as having value because they have another use apart from being a medium of exchange. In other words, they have ‘use-value’ or ‘intrinsic value,’ like ‘melt value’ in the case of metals.

Today, people still use commodities as cash when their national currencies devalue, like when Russians paid salaries in vodka when the Rouble’s value collapsed. Cigarettes have also become commodity money in places like prisons, where people find themselves in situations where they cannot get money in the form of their national currencies.

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Representative money (dominant in 1944 to 1971):

Even though gold and silver coins were more portable and convenient to carry around than most commodity money, it became problematic when people needed to travel longer distances or pay more considerable sums to settle transactions. It was not safe to transport large bags of gold or silver. This gave rise to a new industry, where people provided secure storage services for gold and other valuables. They started issuing paper receipts, promissory notes, or certificates that verified a person’s access, ownership, or control over something valuable—like gold stored in a vault, protected and secured from thieves and bandits. So instead of exchanging commodity money like gold or silver, it was more convenient for people to exchange these pieces of paper for another good or service since they stood in place for the underlying assets they represented.

Representative money was what much of the world used when money could be swapped directly for a specified amount of gold or silver. The Gold Standard is based on the idea that money represents how much gold a nation has in its vaults. Therefore, paper money could be exchanged for gold. This has been the basis for our international monetary system called the ‘Bretton Woods system’ that began after World War II. But when the U.S. stopped allowing the U.S. dollar to be convertible to gold in 1971, the U.S. dollar and all other national currencies were no longer backed by gold. They became ‘fiat’ money.

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Fiat money (dominant from 1971 to the present day):

‘Fiat’ is a word derived from Latin and means “let it be done” in the sense of an order, decree, or resolution. Indeed, fiat money is declared as money by a central authority, usually the government. China introduced the first fiat money in the 11th Century. Today, all nations use fiat money, like the U.S. Dollar, the Japanese Yen, and the Euro.

Commodities adapted as money have value because they are helpful. Representative money represents direct access, ownership, or control over something useful or valuable. On the other hand, fiat money is not useful on its own. It only has value because it functions as a medium of exchange. Fiat money is created in a complicated and elaborate process. For simplicity, we can say that a nation’s government and its central bank create fiat money, expecting that it will all be paid for later by taxpayers.

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Face value vs. intrinsic value: 

Face value	Intrinsic value
The face value of a coin/currency is its legal value in relation to other forms of currency.	The market value of the constituent metal within a coin is referred to as intrinsic value.
Fiat money has face value.	Fiat money does not have intrinsic value. Only metal currency has intrinsic value.
The selling of the constituent metal/currency cannot be used to calculate face value.	Intrinsic value can be derived from the selling of constituent metal itself.

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Four principles of Modern monetary exchange and operations:

It was in Early Modern Europe (1500s-1800s) that complex financial instruments and monetary operations developed that shapes our world today. Because of their diversity and capacity for change, a more efficient way of grouping financial instruments is by looking at their driving principles.

Broadly, they can be classified as:

Mutuality Principle

Circulation Principle

Phantasmal Principle

Regimental Principle

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Mutuality Principle:

This refers to a type of financial instrument driven by mutual aid or trust in-person/organisation A’s ability to repay person/organization B’s loan. This was the dominant form of investment vehicle in the human past; with basic exchanges of goods with value gradually giving way to currencies (initially rare-metal currencies like gold). Found in various cultures worldwide. One such organisation was the Caja De Ahorros y Monte De Piedad De Madrid, founded in 1702 and still operating today. This also offered a moderate interest rate for people in need by using donations from wealthy people.

Circulation Principle:

A new type of financial vehicle overtook mutuality over the past few hundred years, generally termed the ‘modern era’. This began with the work of Italian merchants, Jewish financiers and Dutch bankers in Europe in the 1400s-1700s. The new type of financial instruments they created encouraged the circulation of money and commodities thus creating value-in-motion. The watermelon is a sugary food for those with money to enjoy on the beach. The bread is what the watermelon man needs to buy to feed him and his children. In this view, money is the facilitator of exchange. It is an object that people agree to as a signal of value. In older times it had to have an inherent value. So a coin was actually made of gold or silver. But now, it was simply symbolizing the real inherent value of goods and services being exchanged.

Phantasmal Principle:

In the late modern or industrial-era (1800s- 2000s), a new kind of financial instrument has emerged. This kind of instrument has become increasingly detached from what is known as the “real economy”. It seeks, through financial engineering, to create profit from finance in and of itself. This is called financialization. 

Regimental Principle:

Finance and economics have always been recognised as powerful aspects of relations between nations, otherwise known as geopolitics. As state intervention into financials affairs increased in the 20th century, however, so too have new financial instruments been born that seek to restructure countries, regions and peoples according to systemic political and economic goals. The creation of institutions seeking to direct national monetary policy and to support national sponsorship of international endeavours began in the early modern period but has become a defining feature of financial systems in the 20th century.

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Modern monetary systems:

Domestic monetary systems are today very much alike in all the major countries of the world. They have three levels: (1) the holders of money (the “public”), which comprise individuals, businesses, and governmental units, (2) commercial banks (private or government-owned), which borrow from the public, mainly by taking their deposits, and make loans to individuals, firms, or governments, and (3) central banks, which have a monopoly on the issue of certain types of money, serve as the bankers for the central government and the commercial banks, and have the power to determine the quantity of money. The public holds its money in two ways: as currency (including coin) and as bank deposits.

Currency:

In most countries the bulk of the currency consists of notes issued by the central bank. In the United Kingdom these are Bank of England notes; in the United States, Federal Reserve notes; and so on. It is hard to say precisely what “issued by the central bank” means. In the United States, for example, the currency bears the words “Federal Reserve Note,” but these notes are not obligations of the Federal Reserve banks in any meaningful sense. The holder who presents them to a Federal Reserve bank has no right to anything except other pieces of paper adding up to the same face value. The situation is much the same in most other countries. The other major item of currency held by the public is coin. In almost all countries this is token coin, whose worth as metal is much less than its face value.

In countries with a history of high inflation, the public may choose to use foreign currency as a medium of exchange and a standard of value. The U.S. dollar has been chosen most often for these purposes, and, although other currencies have had lower average inflation rates than the dollar in the years since World War II, the dollar compensates by having lower costs of information and recognition than any other currency. Societies agree on the use of dollars not by a formal decision but from knowledge that others recognize the dollar and accept it as a means of payment. At the turn of the 21st century, estimates suggested that as much as two-thirds of all dollars in circulation were found outside the United States. Dollars could be found in use in Russia, Argentina, and many other Latin American and Asian countries.

Bank deposits:

In addition to currency, bank deposits are counted as part of the money holdings of the public. In the 19th century most economists regarded only currency and coin, including gold and other metals, as “money.” They treated deposits as claims to money. As deposits became more and more widely held and as a larger fraction of transactions were made by check, economists started to include not the checks but the deposits they transferred as money on a par with currency and coin.

The term deposits is highly misleading. It connotes something deposited for safekeeping, like currency in a safe-deposit box. Bank deposits are not like that. When one brings currency to a bank for deposit, the bank does not put the currency in a vault and keep it there. It may put a small fraction of the currency in the vault as reserves, but it will lend most of it to someone else or will buy an investment such as a bond or some other security. As part of the inducement to depositors to lend it money, a bank provides facilities for transferring demand deposits from one person to another by check.

The deposits of commercial banks are assets of their holders but are liabilities of the banks. The assets of the banks consist of “reserves” (currency plus deposits at other banks, including the central bank) and “earning assets” (loans plus investments in the form of bonds and other securities). The banks’ reserves are only a small fraction of the aggregate (total) deposits. Early in the history of banking, each bank determined its own level of reserves by judging the likelihood of demands for withdrawals of deposits. Now reserve amounts are determined through government regulation.

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Commercial bank money refers to money in an economy that is created through debt issued by commercial banks. Banks take client deposits into savings accounts and then loan a portion to other clients. The reserve requirement ratio is the portion banks cannot lend to different clients from their savings accounts. The lower the reserve requirement ratio, the more funds will be loaned to other people, creating commercial bank money. This re-lending process (with no currency drain) can be depicted as follows, assuming a 20% reserve ratio and a $100 initial deposit:  

Individual bank	Amount deposited	Lent out	Reserves
A	100.00	80.00	20.00
B	80.00	64.00	16.00
C	64.00	51.20	12.80
D	51.20	40.96	10.24
E	40.96	32.77	8.19
F	32.77	26.21	6.55
G	26.21	20.97	5.24
H	20.97	16.78	4.19
I	16.78	13.42	3.36
J	13.42	10.74	2.68
K	10.74
			Total reserves:
			89.26
	Total amount of deposits:	Total amount lent out:	Total reserves + last amount deposited:
	457.05	357.05	100.00

Note that no matter how many times the smaller and smaller amounts of money are re-lended, the legal reserve requirement is never exceeded – because that would be illegal.

All in all, $457.05 is traveling around in circulation, having started with only $100 in fiat money. The money supply increases by $357.05 in this example. The additional $357.05has been generated as debt by the bank and reflects commercial bank money. (Vide infra money multiplier) 

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Evolution of electronic transfer of money:

Currency protects anonymity, avoids record keeping, and permits lower costs of payment. But currency can be lost, stolen, or forged, so it is used most often for relatively small transactions or where anonymity is valued. Paper currency and coins can easily be stolen and can be expensive to transport because of their size. As a consequence, with the development of modern banking, cheques were invented. Cheques are a type of IOU (I owe you) payable on demand that allows transactions without the use of currency. They can also be written for any amount up to the balance in the account. This simplifies the transactions for large amounts of balances a lot. As a result, it reduces transportation costs and therefore, improves economic efficiency. (Mishkin, 1992, p.27)

Despite the advantages, it is very time consuming to trade a cheque for currency. This may result in difficulties if something has to be paid quickly. Furthermore, it takes a few days until the bank will credit the account with a cheque that a person has deposited. To process cheques is very costly. For example, it has been estimated that it costs over 5 billion U.S. Dollars per year to process cheques written within the USA. (Mishkin, 1992, p.27)

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Due to the development of the computer and advanced telecommunication technologies, new advances in the payment system were made, like the invention of the electronic funds transfer system (EFTS). This technology introduced individual access to the payment system by means of a debit card reader or a personal computer. Deposits are simply transferred from payer to payee using electronic devices. Nowadays, for example, central banks, commercial banks, or corporations can transfer funds to other institutions by using EFTS. The whole paperwork can actually be eliminated by converting it to the EFTS. It is much more efficient than payment systems based on paper, because it reduces the cost of transferring money and, therefore, decreases the frequency of using cheques and paper money. During the last years, people have begun to use EFTS more and more in daily life.  In connection with EFTS the evolution of plastic cards, e.g., debit and credit cards (American Express, Visa, etc.), should be mentioned. These cards allow people to make purchases which are paid for by booking the amount from the person’s bank account either immediately or at the end of a month. (Goede, 2000, pp.309,342). The main difference between credit and debit cards is that credit cardholders can extend their credit up to a given limit. Today, credit cards are the most widely used method of payment. (Besson, 1999, p.58). A credit card is not money. It provides an efficient way to obtain credit through a bank or financial institution. EFTS, debit and credit cards are basically the beginning of electronic payment systems. Innovations of these electronic payment systems helped to reduce transaction costs a lot and initiated the creation of digital money.

“Electronic money” is the name given to several different ways in which the public and financial and nonfinancial firms use electronic transfers as part of the payments system. Electronic money (digital money) is an electronic equivalent of physical cash. Digital money is traditional bank money held on computers (in software) and store-value payment cards. Basically, all your money in banks today is money represented digitally. They are digital money and not digital currency. Digital money is a technology that moves economic transactions, payments, remittances and transfers from the physical into the digital world. Various different types of money transfer can be distinguished.

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Digital currency:

Digital currency can be defined as an Internet-based form of currency or medium of exchange distinct from physical (such as banknotes and coins) that exhibits properties similar to physical currencies, but allows for instantaneous transactions and borderless transfer-of-ownership. Types of digital currencies include cryptocurrency, virtual currency and central bank digital currency. Although digital currency provides a host of features like ease-of-use, anonymity, efficiency; there are potential issues with its use like tax evasion, money laundering, and instability in exchange rates and so on. Digital currencies are exactly what they sound like: currencies stored and transferred electronically. Any money based in 1’s and 0’s meets this definition; dollars stored in a bank account are supposed to be a representation of dollars actually held somewhere, whereas physical bitcoins are a representation of their digital counterparts. From the perspective of economic theory, whether a digital currency may be considered to be money depends on the extent to which it acts as a store of value, a medium of exchange and a unit of account. How far an asset serves these roles can differ, both from person to person and over time. And meeting these economic definitions does not necessarily imply that an asset will be regarded as money for legal or regulatory purposes. Bitcoin, Ether (ETH), Dogecoin or any of the other estimated 10,000 cryptocurrencies do not possess the needed characteristics of money, and very, very rarely are they used as such. Instead, they are a speculative investment into a highly, volatile, immaterial asset. No cryptocurrency could ever be practical as money if it does not have a stable value.   

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Virtual currency:

A virtual currency has been defined in 2012 by the European Central Bank as “a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community”. The US Department of Treasury in 2013 defined it more tersely as “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency”. The US Department of Treasury also stated that, “Virtual currency does not have legal-tender status in any jurisdiction.” Usually not issued by a governmental body, virtual currencies are not considered a legal tender and they enable ownership transfer across governmental borders. This type of currency may be used to buy physical goods and services, but may also be restricted to certain communities such as for use inside an online game.

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Taxonomy of money:

Figure below shows taxonomy of money, based on “Central bank cryptocurrencies” by Morten Linnemann Bech and Rodney Garratt.

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Introduction to an Alternative History of Money, a 2012 paper:   

This paper integrates the various strands of an alternative, heterodox view on the origins of money and the development of the modern financial system in a manner that is consistent with the findings of historians and anthropologists. As is well known, the orthodox story of money’s origins and evolution begins with the creation of a medium of exchange to reduce the costs of barter. To be sure, the history of money is “lost in the mists of time,” as money’s invention probably predates writing. Further, the history of money is contentious. And, finally, even orthodox economists would reject the Robinson Crusoe story and the evolution from a commodity money through to modern fiat money as historically accurate. Rather, the story told about the origins and evolution of money is designed to shed light on the “nature” of money. The orthodox story draws attention to money as a transactions-cost-minimizing medium of exchange. This paper has argued the orthodox approach to money and to policy is historically and logically flawed. Money was not injected into a well-functioning barter economy; instead, money and the market developed together. This helps to explain why production in a market economy is always monetary production: money now for more money later. It also means that the money supply in a monetary economy is necessarily endogenously determined. Monetary economies have not, and cannot, operate with exogenous money supplies. Finally, while a monetary economy with an endogenous money supply can operate with a commodity reserve system, such a system is subject to periodic debt deflations. Thus, in all developed capitalist economies, this has been replaced by an accommodative central bank reserve system. This paper uses the understanding developed by comparative anthropology and comparative history of precapitalist societies in order to logically reconstruct the origins of money.

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How money became the measure of wellbeing of people in America:

Two centuries ago, America pioneered a way of thinking that puts human well-being in economic terms.

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Money and markets have been around for thousands of years. Yet as central as currency has been to so many civilizations, people in societies as different as ancient Greece, imperial China, medieval Europe, and colonial America did not measure residents’ well-being in terms of monetary earnings or economic output. In the mid-19th century, the United States—and to a lesser extent other industrializing nations such as England and Germany—departed from this historical pattern. It was then that American businesspeople and policymakers started to measure progress in dollar amounts, tabulating social welfare based on people’s capacity to generate income. This fundamental shift, in time, transformed the way Americans appraised not only investments and businesses but also their communities, their environment, and even themselves.

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Today, well-being may seem hard to quantify in a nonmonetary way, but indeed other metrics—from incarceration rates to life expectancy—have held sway in the course of the country’s history. The turn away from these statistics, and toward financial ones, means that rather than considering how economic developments could meet Americans’ needs, the default stance—in policy, business, and everyday life—is to assess whether individuals are meeting the exigencies of the economy.

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At the turn of the 19th century, it did not appear that financial metrics were going to define Americans’ concept of progress. In 1791, then-Secretary of the Treasury Alexander Hamilton wrote to various Americans across the country, asking them to calculate the moneymaking capacities of their farms, workshops, and families so that he could use that data to create economic indicators for his famous Report on Manufactures. Hamilton was greatly disappointed by the paltry responses he received and had to give up on adding price statistics to his report. Apparently, most Americans in the early republic did not see, count, or put a price on the world as he did.

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Until the 1850s, in fact, by far the most popular and dominant form of social measurement in 19th-century America (as in Europe) were a collection of social indicators known then as “moral statistics,” which quantified such phenomena as prostitution, incarceration, literacy, crime, education, insanity, pauperism, life expectancy, and disease. While these moral statistics were laden with paternalism, they nevertheless focused squarely on the physical, social, spiritual, and mental condition of the American people. For better or for worse, they placed human beings at the center of their calculating vision. Their unit of measure was bodies and minds, never dollars and cents.

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Yet around the middle of the century, money-based economic indicators began to gain prominence, eventually supplanting moral statistics as the leading benchmarks of American prosperity. This epochal shift can be seen in the national debates over slavery. In the earlier parts of the 19th century, Americans in the North and South wielded moral statistics in order to prove that their society was the more advanced and successful one. In the North, abolitionist newspapers like the Liberty Almanac pointed to the fact that the North had far more students, scholars, libraries, and colleges. In the South, politicians like John Calhoun used dubious data to argue that freedom was bad for black people. The proportion of Northern blacks “who are deaf and dumb, blind, idiots, insane, paupers and in prison,” Calhoun claimed in 1844, was “one out of every six,” while in the South it was “one of every one hundred and fifty-four.”

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By the late 1850s, however, most Northern and Southern politicians and businessmen had abandoned such moral statistics in favor of economic metrics. In the opening chapter of his best-selling 1857 book against slavery, the author Hinton Helper measured the “progress and prosperity” of the North and the South by tabulating the cash value of agricultural produce that both regions had extracted from the earth. In so doing, he calculated that in 1850 the North was clearly the more advanced society, for it had produced $351,709,703 of goods and the South only $306,927,067. Speaking the language of productivity, Helper’s book became a hit with Northern businessmen, turning many men of capital to the antislavery cause.

The Southern planter class, meanwhile, underwent a similar shift. When South Carolina’s governor, the planter and enslaver James Henry Hammond, sought to legitimize slavery in his famous 1858 “Cotton Is King” speech, he did so in part by declaring that “there is not a nation on the face of the earth, with any numerous population, that can compete with us in produce per capita … It amounts to $16.66 per head.”

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What happened in the mid-19th century that led to this historically unprecedented pricing of progress?

The short answer is straightforward enough: Capitalism happened.

In the first few decades of the Republic, the United States developed into a commercial society, but not yet a fully capitalist one. One of the main elements that distinguishes capitalism from other forms of social and cultural organization is not just the existence of markets but also of capitalized investment, the act through which basic elements of society and life—including natural resources, technological discoveries, works of art, urban spaces, educational institutions, human beings, and nations—are transformed (or “capitalized”) into income-generating assets that are valued and allocated in accordance with their capacity to make money and yield future returns. Save for a smattering of government-issued bonds and insurance companies, such a capitalization of everyday life was mostly absent until the mid-19th century. There existed few assets in early America through which one could invest wealth and earn an annual return.

Capitalization, then, was crucial to the rise of economic indicators. As upper-class Americans in both the North and South began to plow their wealth into novel financial assets, they began to imagine not only their portfolio but their entire society as a capitalized investment and its inhabitants (free or enslaved) as inputs of human capital that could be plugged into output-maximizing equations of monetized growth.

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In the North, such investments mostly took the form of urban real estate and companies that were building railroads. As capital flowed into these new channels, investors were putting money—via loans, bonds, stocks, banks, trusts, mortgages, and other financial instruments—into communities they might never even set foot in. As local businesspeople and producers lost significant power to these distant East Coast investors, a national business class came into being that cared less about moral statistics—say, the number of prostitutes in Peoria or drunks in Detroit—than about a town’s industrial output, population growth, real-estate prices, labor costs, railway traffic, and per-capita productivity.

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Capitalization was also behind the statistical shift in the South, only there it was less about investment in railroad stocks or urban real estate than in human bodies. Enslaved people had long been seen as pieces of property in the United States, but only in the antebellum Deep South did they truly become pieces of capital that could be mortgaged, rented, insured, and sold in highly liquid markets. Viewing enslaved people first and foremost as income-yielding investments, planters began to keep careful track of their market output and value. Hammond, in his speech, had chosen to measure American prosperity in the same way that he valued, monitored, and disciplined those forced to work on his own cotton plantation.

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As corporate consolidation and factories’ technological capabilities ramped up in the Gilded Age and Progressive Era, additional techniques of capitalist quantification seeped from the business world into other facets of American society. By the Progressive Era, the logic of money could be found everywhere. “An eight-pound baby is worth, at birth, $362 a pound,” declared The New York Times on January 30th, 1910. “That is a child’s value as a potential wealth-producer. If he lives out the normal term of years, he can produce $2900 more wealth than it costs to rear him and maintain him as an adult.” The title of this article was “What the Baby Is Worth as a National Asset: Last Year’s Crop Reached a Value Estimated at $6,960,000,000.” During this era, an array of Progressive reformers priced not only babies but the annual social cost of everything from intemperance ($2 billion), the common cold ($21 a month per employee), typhoid ($271 million), and housewife labor ($7.5 billion), as well as the annual social benefit of skunks ($3 million), Niagara Falls ($122.5 million), and government health insurance ($3 billion).

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This particular way of thinking is still around, and hard to miss today in reports from the government, research organizations, and the media. For instance, researchers in this century have calculated the annual cost of excessive alcohol consumption ($223.5 billion) and of mental disorders ($467 billion), as well as the value of the average American life ($9.1 million according to one Obama-era government estimate, up from $6.8 million at one point during George W. Bush’s presidency).

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A century ago, money-based ideas of progress resonated most with business executives, most of whom were well-to-do white men. Measuring prosperity according to the Dow Jones Industrial Average (invented in 1896), manufacturing output, or per-capita wealth made a good deal of sense for America’s upper classes, since they were usually the ones who possessed the stocks, owned the factories, and held the wealth. As recognized by the Yale economist Irving Fisher, a man who rarely met a social problem he did not put a price on, economic statistics could be potent in early-20th-century political debates. In arguing for why people needed to be treated as “money-making machines,” Fisher explained how “newspapers showed a strong aversion to the harrowing side of the tuberculosis campaign but were always ready to ‘sit up and take notice’ when the cost of tuberculosis in dollars and cents was mentioned.”

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John Rockefeller Jr., J.P. Morgan, and other millionaire capitalists also came to recognize the power of financial metrics in their era. They began to plan for a private research bureau that would focus on the pricing of everyday life. Those plans came to fruition in the 1920s with the formation of the corporate-funded National Bureau of Economic Research. The private institution would go on to play a major role in the invention of Gross Net Product in the 1930s (and continues to operate today).

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Many working-class Americans, though, were not as enthusiastic about the rise of economic indicators. This was largely because they believed the human experience to be “priceless” (a word that took off just as progress became conceptualized in terms of money) and because they (astutely) viewed such figures as tools that could be used to justify increased production quotas, more control over workers, or reduced wages. Massachusetts labor activists fighting for the eight-hour workday spoke for many American workers when they said, in 1870, that “the true prosperity and abiding good of the commonwealth can only be learned, by placing money [on] one scale, and man [on another].”

The assignment of prices to features of daily life, therefore, was never a foregone conclusion but rather a highly contested development. In the Gilded Age, some labor unions and Populist farmers succeeded in pushing state bureaus of labor statistics to offer up a series of alternative metrics that measured not economic growth or market output, but rather urban poverty, gender discrimination, leisure time, indebtedness, class mobility, rent-seeking behavior, and exploitation of workers. The interests of businessmen, though, won the day more often than not, and by the mid-20th century economic indicators that focused on monetary output came to be seen as apolitical and objective.

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That shift carried tremendous social ramifications: The necessary conditions for economic growth were frequently placed before the necessary conditions for individuals’ well-being. In 1911, Frederick Winslow Taylor, the efficiency expert who dreamed of measuring every human movement in terms of its cost to employers, bluntly articulated this reversal of ends and means: “In the past the man has been first; in the future the system must be first.”

In the end, men like Taylor got their wish. Since the mid-20th century—whether in the Keynesian 1950s or the neoliberal 1980s—economic indicators have promoted an idea of American society as a capital investment whose main goal, like that of any investment, is ever-increasing monetary growth. Americans have surely benefited materially from the remarkable economic growth over this period of time, an expansion wholly unique to capitalist societies. Nevertheless, by making capital accumulation synonymous with progress, money-based metrics have turned human betterment into a secondary concern. By the early 21st century, American society’s top priority became its bottom line, net worth became synonymous with self-worth, and a billionaire businessman who repeatedly pointed to his own wealth as proof of his fitness for office was elected president.

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Evolution of Money as a measure of military effectiveness:

In 2010, Professor Michael Beckley, then of Columbia University, wrote a paper analysing the relationship between military effectiveness and economic development. Modelling hundreds of battles over a nearly 100-year period (between 1898 and 1987), he sought to examine if military effectiveness is determined by economic strength or are there other factors like democracy, culture and human capital that are material to the outcomes.

His study found a stark causality – military effectiveness is primarily a function of economic development. Other political and social factors are marginal in effect. The hypothesis is simple – economically developed states have greater surplus of wealth, better technology base, efficient production techniques and in essence an ability to sustain larger investments in military without draining the economy of resources. In recent times China has used its spectacular economic growth to fund the fastest military expansion seen since World War II. In 2011, Admiral Mike Mullen, then Chairman Joint Chiefs of Staff in the US, identified America’s “public debt as the single biggest threat to national security”. In 2016, Admiral Mullen led a group of distinguished security and foreign policy experts, including Henry Kissinger and Madeleine Albright, that put paring down of America’s national debt as a central issue to ensure national security.

Even on the most proximate national security threat from China, India’s ability to deter is constrained by the amount that India can spend on defence. The trick isn’t about the much-debated % of GDP – that is already at a fairly optimum 4%, but on the base, i.e., GDP itself. Without a bigger economic base, India won’t be able to afford extra ships, fighters and tanks needed to keep force balances against China at a comparable keel. In short, it will only be a strong economic base that can fund national power sinews – both for deterrence as well as to maintain India’s position as an attractive partner to major powers of the world.

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Section-4

Money and economy:

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The English words “economy” and “economics” can be traced back to the Greek words meaning “one who manages a household”. Economy means the production, exchange, distribution, and consumption of goods & services of an area; using labor, capital and land resources; and the economic agents that participate in the process. Economics is the study of how society allocates scarce resources and goods. Resources are the inputs that society uses to produce output, called goods. Resources include inputs such as labor, capital, and land. Goods include products such as food, clothing, and housing as well as services such as those provided by barbers, doctors, and police officers. These resources and goods are considered scarce because of society’s tendency to demand more resources and goods than are available.

While most resources and goods are scarce, some are not—for example, the air that we breathe. A resource or good that is not scarce, even when its price is zero, is called a free resource or good. Economics, however, is mainly concerned with scarce resources and goods. It is the presence of scarcity that motivates the study of how society allocates resources and goods.

One means by which society allocates scarce resources and goods is the market system. The term market refers to any arrangement that allows people to trade with one another. The market system is the name given to the collection of all markets and also refers to the relationships among these markets. The study of the market system, which is the subject of economics, is divided into two main branches or theories; they are macroeconomics and microeconomics.

Macroeconomics:

The prefix macro means large, indicating that macroeconomics is concerned with the study of the market system on a large scale. Macroeconomics considers the aggregate performance of all markets in the market system and is concerned with the choices made by the large subsectors of the economy—the household sector, which includes all consumers; the business sector, which includes all firms; and the government sector, which includes all government agencies.

Microeconomics:

The prefix micro means small, indicating that microeconomics is concerned with the study of the market system on a small scale. Microeconomics looks at the individual markets that make up the market system and is concerned with the choices made by small economic units such as individual consumers, individual firms, or individual government agencies.

The primary textbook distinction exits between the microeconomics which examines the behavior of basic elements in the economy including individual markets and agents (such as consumers & firms, buyers & sellers) and the macroeconomics, which addresses issues affecting an entire economy including unemployment, inflation, economic growth, and monetary & fiscal policy. Microeconomics is the study of decisions that people & businesses make regarding the allocation of resources and prices of goods & services. This means also taking into account taxes and regulations created by governments. Microeconomics focuses on supply & demand and other forces that determine the price levels seen in the economy and how prices, in turn, determine the quantity supplied and the quantity demanded of goods and services. Macroeconomics, on the other hand, is the field of economics that studies the behavior of the economy as a whole and not just on specific companies, but entire industries and economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. The bottom line is that microeconomics takes a bottoms-up approach to analyzing the economy while macroeconomics takes a top-down approach.  

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The Classical Theory:

The fundamental principle of the classical theory is that the economy is self‐regulating. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy’s resources are fully employed. While circumstances arise from time to time that cause the economy to fall below or to exceed the natural level of real GDP, self‐adjustment mechanisms exist within the market system that work to bring the economy back to the natural level of real GDP. The classical doctrine—that the economy is always at or near the natural level of real GDP—is based on two firmly held beliefs: Say’s Law and the belief that prices, wages, and interest rates are flexible. According to Say’s Law, when an economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP. In other words, the economy is always capable of demanding all of the output that its workers and firms choose to produce. Hence, the economy is always capable of achieving the natural level of real GDP.

The achievement of the natural level of real GDP is not as simple as Say’s Law would seem to suggest. While it is true that the income obtained from producing a certain level of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income will be saved. Income that is saved is not used to purchase consumption goods and services, implying that the demand for these goods and services will be less than the supply. If aggregate demand falls below aggregate supply due to aggregate saving, suppliers will cut back on their production and reduce the number of resources that they employ. When employment of the economy’s resources falls below the full employment level, the equilibrium level of real GDP also falls below its natural level. Consequently, the economy may not achieve the natural level of real GDP if there is aggregate saving. The classical theorists’ response is that the funds from aggregate saving are eventually borrowed and turned into investment expenditures, which are a component of real GDP. Hence, aggregate saving need not lead to a reduction in real GDP.

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The Keynesian Theory:     

Keynes’s theory of the determination of equilibrium real GDP, employment, and prices focuses on the relationship between aggregate income and expenditure. Keynes used his income‐expenditure model to argue that the economy’s equilibrium level of output or real GDP may not correspond to the natural level of real GDP. In the income‐expenditure model, the equilibrium level of real GDP is the level of real GDP that is consistent with the current level of aggregate expenditure. If the current level of aggregate expenditure is not sufficient to purchase all of the real GDP supplied, output will be cut back until the level of real GDP is equal to the level of aggregate expenditure. Hence, if the current level of aggregate expenditure is not sufficient to purchase the natural level of real GDP, then the equilibrium level of real GDP will lie somewhere below the natural level.

In this situation, the classical theorists believe that prices and wages will fall, reducing producer costs and increasing the supply of real GDP until it is again equal to the natural level of real GDP.

Keynesians, however, believe that prices and wages are not so flexible. They believe that prices and wages are sticky, especially downward. The stickiness of prices and wages in the downward direction prevents the economy’s resources from being fully employed and thereby prevents the economy from returning to the natural level of real GDP. Thus, the Keynesian theory is a rejection of Say’s Law and the notion that the economy is self‐regulating.

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Economic Policy:

An economic policy is a course of action that is intended to influence or control the behavior of the economy. Economic policies are typically implemented and administered by the government. Examples of economic policies include decisions made about government spending and taxation, about the redistribution of income from rich to poor, and about the supply of money. The effectiveness of economic policies can be assessed in one of two ways, known as positive and normative economics.

Positive and normative economics:

Positive economics attempts to describe how the economy and economic policies work without resorting to value judgments about which results are best. The distinguishing feature of positive economic hypotheses is that they can be tested and either confirmed or rejected. For example, the hypothesis that “an increase in the supply of money leads to an increase in prices” belongs to the realm of positive economics because it can be tested by examining the data on the supply of money and the level of prices.

Normative economics involves the use of value judgments to assess the performance of the economy and economic policies. Consequently, normative economic hypotheses cannot be tested. Normative economics aims to determine people’s desirability or the lack thereof to various economic programs, situations, and conditions by asking what should happen or what ought to be. Therefore, normative statements typically present an opinion-based analysis in terms of what is thought to be desirable. For example, stating that the government should strive for economic growth of x% or inflation of y% could be seen as normative. Unlike positive economics, which relies on objective data analysis, normative economics heavily concerns itself with value judgments and statements of “what ought to be” rather than facts based on cause-and-effect statements. It expresses ideological judgments about what may result in economic activity if public policy changes are made. Normative economic statements can’t be verified or tested. Not surprisingly, most of the disagreements among economists concern normative economic hypotheses.

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Money and Economic System:  

Money is a fulcrum of paradoxes. It is, in the famous characterization by Simmel, heartless – and yet, according to Zelizer, deeply emotional, ubiquitous but elusive, uniform and endlessly varied. The paradox to be explored here is that of the relationship between money and economic systems. This relationship is simultaneously tight and loose. It is tight to the extent that money appears as a fundamental dimension of the economy, a yardstick by which its growth and wealth accumulation are measured. The difference in monetary systems can be used to discriminate among various economic systems. Thus, fiduciary money was the dominant monetary system in the feudal economy, and the emergence of the capitalist economy was accompanied and facilitated by the development of scriptural money. Fiduciary money refers to money backed up by trust between the payer and payee. Scriptural money is currency that moves from account to account rather than hand to hand. Monetization of the economy – the general use of money to effect transactions and establish prices – was seen as a major vector of transition from the feudal to capitalist economy. But the relationship goes deeper. Money has been the lever of power, whether economic or political, in what Carlyle [and more recently Fergusson (2001)] called the “cash nexus”. It is also a vector of statement and measurement of social value and preferences.

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And yet, relationships between money and economic systems can also be characterised as – if not loose, at least relatively autonomous. Both fiduciary and scriptural money were created long before the emergence of feudal and capitalist systems. The path of their evolution has been long rather than short, circuitous rather than linear, agitated rather than smooth – and rarely guided by a grand overriding design. Most often, changes in monetary systems result from limited actions aiming to solve particular problems. It is an accumulation of incremental changes that periodically leads to massive systemic shifts. Money itself is a multifarious phenomenon. The two broad categories cover a wide variety of specific currencies, which are backed by distinct institutional arrangements for issuing and settling them. Over time, these arrangements have become ever more complex, a fact stemming partially from the coexistence of various currencies and forms of money. Thus fiduciary money managed by central banks coexists and interacts with scriptural monies managed by commercial banks. National, regional and global monetary systems are all composite; their internal structure and boundaries are constantly changing.

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Clearly, the evolution of monetary systems has been strongly shaped by economic and political requirements: trade facilitation for the private sector, debt funding for the public authorities. But the causality has been bi-directional, with monetary developments strongly impacting economic systems and their performance. This impact has not always been symbiotic. Money has often proved a recalcitrant instrument, its logic defying goals imposed by its putative masters and triggering, in the apt sentence of Charles Kindleberger (1978), “manias, panics and crashes”. Management of money has never been a deterministic endeavour that could be put on automatic pilot. Rather, it is a discretionary undertaking requiring constant attention and a deft touch.

The relationship between monetary and economic systems is a dynamic process. There is a broad public consensus that the underlying trend is one of a growing importance and visibility of money. As money becomes more ubiquitous throughout the economy, it morphs into a self-sustained financial system, simultaneously the support and the object of economic exchanges. Its complexity increases, its transparency decreases and its behaviour becomes ever more difficult to comprehend and to predict. The omnipresence of markets has changed the nature of value determination. Value is no longer established by reference to objective and immutable rules and yardsticks but by a trading process, which makes it unstable and path-dependent.

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As a result, the economic system is subject to chronic volatility and frequent shocks. The invisible hand becomes conspicuous, but more importantly its benevolence can no longer be assumed. For many observers, the financial system got out of hand and the hypertrophied “artificial” financial economy is literally a vampire that drains the “real” economy. And money, electronic, global and uncontrollable, is the weapon of destruction. For instance, Joel Kurtzman – who, having worked as Editor of Fortune and Harvard Business Review and having collaborated closely with Michael Milken, can hardly be suspected of an anti-capitalist bias – deplores the emergence of “megabyte money”, which he believes will destabilize the world economy and provoke financial chaos (1993).

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Criticism of the excessive importance of money is a long-standing tradition in social sciences. There is, however, a crucial difference between past and current criticism. Thinkers such as Marx or Simmel (1900) accused money of being a tool that put society at the service of the economy. They saw money as the all-powerful lever of economic uniformization and integration. New critics agree on the pervasive nature of money but paint the financial system as a mechanism that destructures and destroys the economy. They question its utility and rationality.

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The financial economy also has its vocal and enthusiastic defenders, who applaud its ability to transfer resources and allocate capital rapidly and massively. They see it as a vehicle of creative destruction, a ruthless but efficient mechanism to promote innovation and eliminate obstacles to growth and development. In any case, the view that the financial economy is running amok is an oversimplification. Its hypergrowth has not taken place in a vacuum but is favoured by the peculiarities of the evolution of the real economy. Furthermore, this evolution has impacted the nature of financial markets.

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The history of the relationship between money and the economy is instructive as a general framework to provide broad analogies. Revolutionary change is a useful example of such an analogy. We live in a period of radical transformation of the economy, comparable to that of the earth-shattering transition from feudal to capitalist economy. To the extent that this transition was accompanied and stimulated by the emergence of an institutionalized banking sector and the concomitant development of scriptural money, it can be asked whether the current economic transformation will stimulate the emergence of the new financial intermediaries and a new form of money. This indeed seems the case: the emerging new economy, which we call the “intangible economy”, fuels the spread of the market as the primary intermediation mechanism and the deployment of electronic money, both of which in return accelerate the transition.

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History can also enhance our understanding by highlighting critical differences between the past and the present. One such difference is in the technology of money. Both fiduciary and scriptural money require specific technologies and infrastructure to produce, circulate and settle currency. However, these technologies were confined to the monetary realm and thus tightly controlled by the money issuers, who did their best to keep them away from public scrutiny. In the case of electronic money, technology is pervasive and transcends the monetary domain. The technology of money becomes more visible and hence more widely used. At the same time that technology becomes embedded in money, it becomes more difficult to control by those who traditionally regulate the monetary and financial systems. There a close and mutually reinforcing relationship between the intangible economy, the triumph of markets and the flow of electronic money.

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Theories of money:  

“There are only two theories of money which deserve the name”, Joseph Schumpeter accurately observed almost a century ago, “… the commodity theory and the claim theory. From their very nature they are incompatible” (quoted in Ellis, 1934, p. 3). The commodity theory of money (money of exchange) is preferred by those who wish to view money as a natural outgrowth of market activity.  Others view the credit (a “claim” on goods) theory of money (money of account) as more plausible and may posit a key role for the state in establishing money. Each theory gives different answers to the basic questions about money – that is to say, those concerned with the functions of money; its historical origins; how it gets into society; and how it gets and maintains (or loses) its value. Both theories have long and complex pedigrees.

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-1. Money as a medium of exchange (commodity theory):

In the most general sense, the understanding of money in orthodox economic analysis remains based on the analytical structure of the commodity-exchange theory of money. Here money is seen either as a tradable commodity, or the direct symbol of commodities, that functions as a medium of exchange. In mainstream economic theory, only the “real” properties of the economy – “capital” and “commodities” – are of fundamental importance. There is no analytical difference between barter exchange and monetary exchange. Money, in J.S. Mill’s view, merely enables us to do more easily that which we can do without it. It is in this sense that money is a neutral veil over transactions. In classical and neoclassical economic analysis, the existence of money is explained as a spontaneous evolution that resolves the problem of the inefficiencies of barter. The market, comprising rational economic agents, is capable of solving its own problems; it is self-equilibrating and self-correcting. Consequently, money originated as the most tradable (liquid) commodity that would be held by traders in order to maximise their exchange options (Menger, 1892; Klein and Selgin in Smithin, 2000). It is primarily, and in some cases exclusively, seen as a medium of exchange. From an analytical standpoint, there is no essential difference in terms of money between, say, the “cashless” euro and the use of cigarettes as a medium of exchange in prisons.

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The progressive “dematerialisation” of money in the modern world has created difficulties for this theory. Over the last two centuries, there has been a seemingly interminable dispute in economic theory over the role of “paper” and “credit” as symbols or representations of the “real” value of commodity money, or of the “real” value of the other commodities in market exchange. As a result of its intellectual origins in commodity theory, this conceptual framework has resulted in a preoccupation with the actual form taken by the “money stuff” referred to above. Consequently, orthodox economic theories have, in general, maintained that the value of money is determined by the ratio of the quantities of money and goods. Perhaps the last complete incarnation of the theory was seen in the “monetarism” of the late 20th century. But the economic mainstream continues to conceptualise money and its qualities as “things” that constitute “stocks” or that “flow” or “circulate” at variable “velocity”. The current debates on e-money are a continuation of this difficulty in understanding so-called dematerialised money.

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There are, however, a number of problems with this theory, which relate in one way or another to its concept of money as a “thing”. The question of the significance and the origins or basis of a money of account is the most important. As Keynes noted, money of account is all that is necessary to establish the essentials of complex economic activity, i.e., price lists and debt contracts. However, the commodity-exchange theory of money cannot provide an explanation of money of account – that is, of the concept of abstract value (Grierson, 1977; Ingham, 2000). It is exceedingly difficult for barter exchange to extend beyond establishing bilateral exchange ratios; for example, one hundred goods could yield 4950 exchange ratios (Davies, 1994). Without making implausible assumptions, it is difficult to see how an agreed money of account could spontaneously emerge from barter. As the numismatist Grierson explained (1977), tobacco was used as a medium of exchange in 16th century Virginia, but it only became money when its price was fixed at three shillings a pound. Money is a commodity, but it has to be constituted as money, according to an abstract money of account, before it becomes a commodity.

Secondly, the identification of the quality of “moneyness” with the “money stuff” of the medium of exchange – rather than in the abstract quality of money of account – constitutes a “category error” that has led to hasty and mistaken conclusions when the form of money evolves. Money consists in a “promise to pay” – that is, in a “social relation”. This has taken myriad technologically determined forms over the centuries – clay tablets, coins, paper, book entries, plastic cards, electronic messages. All these forms of money, including precious metals, only become money when they are expressed in abstract money of account.

Third, the analytical primacy given to money as a medium for the exchange of existing value diverts attention from its obvious role in the capitalist system. Like all money, bank credit money is created in a complex set of social relations of credit and debt. But the social relations that constitute money are most clearly apparent in modern capitalism. As post-Keynesian economists argue, loans make deposits of money – that is to say, money-capital.

Finally, we should note that the hypothetical evolution from barter to commodity money to “dematerialisation” and forms of credit money is not borne out by the historical record (Innes, 1913, 1914; Aglietta and Orlean, 1998; Wray, 1999; Ingham, 2000).

Almost all of the most recent conjectures about new forms of money are to some extent informed by this commodity-exchange theory. It is assumed that economic agents in global or local markets are themselves able to create their own, possibly more “efficient” forms of money – as Hayek, the “free banking school” and economic liberals have always maintained. Communication and information technology has made this easier to achieve by overcoming the technical and information problems that hitherto have necessitated the “public goods” role of the monetary authority.

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-2. Money as credit – a “claim” on goods (credit theory):

In this conception, money, regardless of its specific form or substance, is always a “token” claim to goods. It is a socially constructed abstract value – that is to say, purchasing power denominated in a money of account, as Keynes emphasised. For example, the values in Charlemagne’s money of account were never minted (Einaudi, 1953 [1936]); it was the first “cashless” euro! Money of account may be linked to some material standard of value – but this is always first established authoritatively, not by the market.  In this theory, it is the social and political relationship between the issuers and users of money that is of central importance in the creation of money. Issuers establish both the “description” (money of account) and what form of money “answers” the description (Keynes, 1930, pp. 3-4).

All money is created and maintained by the social relation of credit-debt (Innes, 1914; Ingham, 1996, 2000; Aglietta and Orlean, 1998; Simmel, 1978 [1907]). Issuers of money issue “claims” or “credits” and holders of money are “owed” goods. These relations create the monetary space – that is, a social sphere in which impersonal exchange takes place. This theory argues that such spaces are social and political, in that they cannot be constituted exclusively by the exchange relations of economic agents. This socially constructed space is logically anterior and historically prior to the market. Without money there can be no market, whereas orthodox economic theory sees money as a convenient medium of exchange that enables a pre-existing – primordial – market to function more efficiently. A genuinely competitive issue of money would entail a competition of nominal moneys of account; anarchy would follow (Hoover, 1996; Ingham, 2000; Issing, 1999).

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Historical evidence supports Knapp’s state theory’s focus on taxation (debts to state) as the basis for creation of monetary spaces (Knapp, 1973 [1924]; Wray, 1999). States issue money in order to get it back in taxes. Tax debts to the state can only be paid by acquiring, through economic activity, the money that will be accepted (Wray, 1999). In this regard, it is important to bear in mind Knapp’s important but widely misunderstood distinction between valuableness and value, valuableness being the quality conferred by authority and value being actual purchasing power. In other words, all money is, in a very important sense, “fiat” money.

“Private” or “market” money exists; but two important points must be borne in mind. First, there is no known case where entirely private money has been able successfully to maintain its own unit of account over the long term. Secondly, early capitalist bank money or market money was chronically unstable until it “hybridised” with the public banks of the early modern states (Boyer-Xambeu, 1994; Ingham, 1999).

A further important feature of the credit theory of money is that abstract value in the form of the social relation of money is value sui generis. A specific feature of money is not so much the utility of medium of exchange in “spot” exchanges, but rather the projection of abstract value through time. Without this quality, the “endogenous” creation of money through the creation of debt and capitalist financing would not be possible.

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Classical Monetary theory and neoclassical monetary theory (i.e., Quantity theory of money):

The relation between money and what it will buy has always been a central issue of monetary theory.  Classical Monetary theory is based on the idea that a change in money supply is a key driver of economic activity. It argues that central banks, which control the levers of monetary policy, can exert much power over economic growth rates by tinkering with the amount of currency and other liquid instruments circulating in a country’s economy.  Quantity theory of money states that money supply and price level in an economy are in direct proportion to one another. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa.

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Money does not retain a constant value over a period of time, i.e., value of money increases or decreases over a period of time. Value of money means the purchasing power of money. Value of money is dependent on the general price level. A rise in the general price level means a fall in the value of money. On the other hand, a fall in the general price level means a rise in the value of money. Crucial to understanding this matter is the distinction economists make between face (or nominal) values and real values. In economics, nominal value is measured in terms of money, whereas real value is measured against goods or services. A real value is one which has been adjusted for inflation, enabling comparison of quantities as if the prices of goods had not changed on average. Changes in value in real terms therefore exclude the effect of inflation. In contrast with a real value, a nominal value has not been adjusted for inflation, and so changes in nominal value reflect at least in part the effect of inflation.

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Economists have generally held that the level of prices is determined mainly by the quantity of money. The quantity theory of money gives reasons for changes in the general price level. According to this theory, an increase in the quantity of money in country will lead to a rise in the price level. On the other hand, a decrease in the quantity of money in the country will lead to a fall in the price level. It is also asserted that, other things remaining the same, the value of money falls proportionately with a given increase in the quantity of money. Conversely, the value of money rises proportionately with a given decrease in the quantity of money. In other words, changes in the general price level, other things remaining the same, are directly proportional to changes in money supply.

But precisely how the quantity of money affects the level of prices and what the effects are of changes in the quantity of money have been conceptualized in different ways at different times. There are two principal issues to consider. First, what determines the demand for money (the amount of money that the public willingly holds)? And second, how do changes in the stock of money affect the price level and other nominal values?

A government or its central bank determines the nominal quantity of money that circulates and is held, but the public determines money’s real value. If the central bank provides more money than the public wants to hold, the public spends the excess on goods, services, or assets. While the additional spending cannot reduce the nominal money stock, this spending will bid up the prices of nonmoney objects, because too much money is chasing the limited stock of goods and assets. The subsequent rise in prices will lower the real value of the money stock until the public possesses the real value it desires to hold in the aggregate. Conversely, if the central bank provides less money than the public desires to hold, spending slows. Prices fall, thereby raising the quantity of real balances.

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The amount of desired real balances for a country (that is, the real value of money within a country) is not a fixed number. It depends on the opportunity cost of holding money, the direct return earned when holding money, and income or wealth. A short-term interest rate is the usual measure of the opportunity cost of holding money, but money holders participate in many different markets, so other relative prices may affect real money holdings. Inflation increases market interest rates and thus raises the opportunity cost of holding money. In countries experiencing rapid inflation, the real value of the money stock shrinks because people choose to hold less of their wealth in this form. If inflation is brought to a halt, however, the opportunity cost of holding money will drop, and real balances will rise.

Inflation has a particularly strong effect on the demand for money because currency pays no interest, and checking deposits typically receive little or no interest return. (Most of the direct return to money balances takes the form of transaction services and convenience.) As the opposite of inflation, deflation raises the return on money that is held by giving each nominal unit greater command over goods and assets. Consumer spending will thus decrease as people hold onto their money in expectation of lower prices in the future. Other phenomena affecting the amount of money that people willingly hold include income, wealth, and some measure of transactions volume. Increases in the real value of these measures will be followed by increases in the amount of real balances.

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Quantity theory of money:  

From the very earliest systematic work on economics, observers have noted a relationship between the stock of money and the price level. Often the relation was one of proportionality, as, for example, when the price level rose in direct proportion to an increase in money. By the middle of the 18th century, systematic observers such as John Locke recognized that changes in money affect the output of real goods and services, but they also found that this effect vanishes once prices adjust fully to the change in money.

An early formulation of this insight was expressed in the quantity theory of money, which hinges on the distinction between the nominal (face) and real values, or quantity, of money. The nominal quantity is expressed in whatever units are used to designate money—talents, shekels, pounds, pesos, euros, dollars, yen, and so on. The real quantity, by comparison, is expressed in terms of the volume of goods and services that the money will purchase. According to the quantity theory of money, what ultimately matters to holders of money is the real rather than the nominal quantity of money. If this is so, then—no matter what factors may determine the nominal quantity of money—it is the holders of money who determine the real quantity and, in the process, also determine the price level.

The Quantity Theory of Money refers to the idea that the quantity of money available (money supply) grows at the same rate as price levels do in the long run. When interest rates fall or taxes decrease and the access to money becomes less restricted, consumers become less sensitive to price changes and, thus, will have a higher propensity to consume. As a result, the aggregate demand curve will shift right, thus shifting up the equilibrium price level. Critics of the theory argue that money velocity is not stable and, in the short-run, prices are sticky, so the direct relationship between money supply and price level does not hold. In mainstream macroeconomic theory, changes in the money supply play no role in determining the inflation rate as it is measured by the CPI.

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Velocity of money:

The velocity of money is a measure of the number of times that the average unit of currency is used to purchase goods and services within a given time period. The concept relates the size of economic activity to a given money supply, and the speed of money exchange is one of the variables that determine inflation. The measure of the velocity of money is usually the ratio of the gross national product (GNP) to a country’s money supply.

If the velocity of money is increasing, then transactions are occurring between individuals more frequently. The velocity of money changes over time and is influenced by a variety of factors. The velocity of circulation of cash depends on various factors, such as frequency of transactions, trade volume, type of business conditions, price levels, and borrowing and lending policies. According to the quantity theory of money, the changes in price level of a country occur due to changes in the quantity of money in circulation, while keeping other factors at constant. In other words, an increase or decrease in the price level would occur due to increase or decrease in the quantity of money.

If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy new goods and services from each other in just three transactions over the course of a year:

-A farmer spends $50 on tractor repair from a mechanic.

-The mechanic buys $40 of corn from the farmer.

-The mechanic spends $10 on barn cats from the farmer.

then $100 changed hands in the course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent on new goods and services an average of twice a year, which is to say that the velocity was 2/year. Note that if the farmer bought a used tractor from the mechanic or made a gift to the mechanic, it would not go into the numerator of velocity because that transaction would not be part of this tiny economy’s gross domestic product (GDP). 

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An illustration of the quantity theory:

In the following example, the quantity of money in existence in a hypothetical community is $1 million, and the total income of the community is $10 million per year. On average, each member of the community holds an amount of money equal in value to one-tenth of a year’s income, or to 5.2 weeks’ income. Put differently, the income velocity of circulation is equal to 10 per year; that is, each $1 on average is paid out 10 times a year. (For the sake of simplicity there are no business enterprises in this example; the members of the community buy and sell services from and to one another.)

Now assume, in the case of this example, that the quantity of money in this community is somehow doubled, but in such a way that no one expects the quantity to change again. All members of the community regard themselves as better off. Each now has 10.4 weeks’ income in the form of cash instead of the previous 5.2 weeks’. If everyone were to hold onto the extra cash, nothing further would happen. But experience dictates that people will try to spend it to reduce the amount of wealth held as money. Because this is an example of a closed community, one person’s expenditure, however, becomes another person’s income. All the people together cannot spend more than all the people receive. The attempt of each to do so is bound to be frustrated. In the attempt to spend more than they receive, people will simultaneously try to buy more of various services from each other and to sell less. To induce others to sell, they will offer higher prices; to induce others not to buy, they will ask higher prices. Whether the quantity sold goes up or down depends on whether the attempt to buy more is stronger or weaker than the attempt to sell less. But in either case total spending is sure to go up and so are total income and prices paid. When income has doubled, to $20 million, the amount of money in existence will again be equal in value to 5.2 weeks’ income. The community will have succeeded in reducing its real cash balances to their former level, not by reducing nominal balances but by raising prices and the money value of incomes. The process of adjustment may not be smooth—spending may go too far and leave people with real balances that are too small, requiring a subsequent fall in the price level—but the final position will tend toward a doubling of prices, and the previous real flows of services will be resumed with no one any better off than before the new money was distributed.

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This simple example embodies three of the most basic principles of quantity theory:

(1) the central distinction between the nominal and the real quantity of money (because to each individual separately—in this hypothetical example and in the real world—it looks as if income is outside personal control, but each individual can determine how much cash to hold);

(2) the equally crucial contrast between the alternatives open to the individual and to the community as a whole (because for the community as a whole, the total amount of cash is fixed, but the community is able to determine the size of its income in dollars); and

(3) the importance of attempts (that is to say, the collective attempt) of people to spend more than they receive, even though doomed to frustration, because this ultimately raises total nominal expenditures and receipts.

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Characteristics of monetary changes:

These principles were the building blocks for ideas about the transmission of monetary changes that developed beginning in the 18th century. Some of the main propositions relating to the transmission of monetary changes are:

-1. The growth rate of the quantity of money is consistently, though not precisely, related to the growth rate of nominal income. That is, if the quantity of money grows rapidly, so will nominal income, and vice versa. Although the velocity of circulation is not constant, it is relatively predictable.

-2. This relation is not obvious, mainly because it takes time for changes in monetary growth to affect income.

-3. On the average, a change in the rate of monetary growth produces a change in the rate of growth of nominal income six to nine months later. But this is an average.

-4. If the rate of monetary growth is reduced, then about six to nine months later the rate of growth of nominal income and also of physical output will decline, but the rate of increase in price will be affected very little. There will be downward pressure on prices only as a gap emerges between actual and potential output.

-5. The effect on prices comes on the average about a year after the effect on nominal income and output, so that the total delay between a change in monetary growth and a change in the rate of inflation averages roughly two years.

-6. The above relationships are variable. There is many a slip between the monetary change and the income change.

-7. Monetary changes affect output only in the short run—though “short run” may mean three to five years. In the longer run the rate of monetary growth affects only prices. What happens to output in the long run depends on such “real” factors as the enterprise, ingenuity, and industry of the people; the extent of thrift; the structure of industry and government; the rule of law; the relations among nations; and so on.

-8. It follows that inflation—a sustained increase in the rate of price change—cannot occur without a more rapid increase in the quantity of money than in output. There are, of course, many possible reasons for monetary growth—from gold discoveries to the manner in which government spending is financed and even the manner in which private spending is financed. The price level may rise or fall for other reasons, too, such as changes in productivity. These produce one-time changes, however—not sustained rates of change.

-9. Government spending may or may not be inflationary. It will be inflationary if it is financed by creating money—that is, by printing currency or creating bank deposits—and if the resultant rate of monetary growth exceeds the rate of growth of output. If it is financed by taxes or by borrowing from the public, the main effect is that the government spends the funds instead of someone else.

-10. One of the most difficult things to explain is the way in which a change in the quantity of money affects income. Generally, the initial effect is not on income at all but on the prices of existing assets (bonds, equities, houses, and other physical capital). An increased rate of monetary growth raises the amount of cash people (or businesses) have relative to other assets. The holders of the excess cash will try to correct this imbalance by buying other assets. But one person’s spending is another’s receipts. All the people together cannot change the amount of cash all hold—only the monetary authorities can do that. Their attempts will tend, however, to raise the prices of assets and to reduce interest rates. These changes will in turn encourage spending to produce new assets. Thus the initial effect on balance sheets is translated into an effect on income and spending. In this connection many economists emphasize such assets as durable consumer goods and other real property, and they regard market interest rates as only a small part of the whole complex of relevant rates.

-11. One important feature of this mechanism is that a change in monetary growth affects interest rates in one direction at the outset and in the opposite direction later on. More rapid monetary growth at first tends to lower interest rates. But later on, as it raises spending and stimulates price inflation, it also produces a rise in the demand for loans that will tend to raise nominal interest rates. Taking the opposite case, a slower rate of monetary growth at first raises interest rates, but later on, as it reduces spending and price inflation, it lowers interest rates. This inconsistent relation between the quantity of money and interest rates explains why interest rates are often a misleading guide to monetary policy.

-12. These propositions clearly imply that monetary policy is important and that what is most important about monetary policy is its effect on the quantity of money, not on bank credit or total credit or interest rates. Wide swings in the rate of change of the quantity of money are evidently destabilizing and should be avoided. Beyond this, different economists draw different conclusions. Some conclude that the monetary authorities should make deliberate changes in the rate of monetary growth in order to offset other forces making for instability; these changes should be gradual and small and make allowance for the lags involved. Others maintain that not enough is known about the relations between changes in the quantity of money and in prices and output to assure that a discretionary monetary policy will do good rather than harm. They believe that a wiser policy would be simply to have the quantity of money grow at a steady rate over time. Most central banks now set a short-term interest rate target and adjust it frequently. Some also set an inflation target to be achieved over several years, and they adjust the interest rate to keep inflation near the target.

-13. Countries that choose to control domestic prices must allow their exchange rates to float. The central bank or monetary authority cannot control both interest rates and money stock or both money and the exchange rate. It must choose one of the three.

-14. If the central bank fixes the exchange rate and permits capital to flow in and out freely, it leaves control of money to external forces and must accept the rate of inflation consistent with its exchange rate.

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Understanding Classical Monetary Theory:

Supply of Money:

On any day, the supply of money is equal to the total amount of money in circulation in the country. Over a period of time, money changes from hand to hand. The number of times it is passed on from one person to another is called the velocity of circulation of money. Thus, to find out total money supply during a period of, say, one year, we have to take into account, (1) the total amount of money and (2) the velocity of money circulation.

The total supply of money is given by:

Supply of Money = MV where M = total money in circulation, V = Velocity of circulation of M

Spending of Money:

In order to find out the money spent by people during one year period, we consider, (1) the total amount of goods purchased by people, that is, the total volume of transactions in the country (Q) and (ii) the general price level (P). Therefore, spending of money = PQ.

Spending of money will equal its supply, i.e., PQ = MV        

According to classical monetary theory, if a nation’s supply of money increases, economic activity will rise, too, and vice versa. A simple formula governs monetary theory: MV = PQ. M represents the money supply (nominal quantity of money), V is the velocity (number of times per year the average dollar is spent), P is the price of goods and services, and Q is the number of goods and services (real quantity of transaction). Assuming constant V, when M is increased, either P, Q, or both P and Q rise.

General price levels tend to rise more than the production of goods and services when the economy is closer to full employment. When there is slack in the economy, Q will increase at a faster rate than P under monetary theory. This equation of exchange is a simple model of a macroeconomy during a time period.

This equation is transformed to the equation P = MV/Q that determines P by means of M if we assume that V and Q are constant and M is determined exogenously by the existing quantity of the gold or by the monetary policy by the central bank. If money does not affect the real variables such as real national income and labor employment but it only affects the general price level as the quantity theory of money (neoclassical monetary theory) assumes, money is said to be ‘neutral’. On the other hand, money is not neutral if it affects the real variables as well as the general price level, as the classical monetary theory assumes.

In other words, according to quantity theory of money, money is neutral and changes in money supply changes general price level. According to classical monetary theory, money is non-neutral and money supply is a key driver of economic activity, and changes in money supply changes real national income and labor employment. The quantity of money in an economy has a large influence on its level of economic activity. So, a change in the money supply results in either a change in the price levels or a change in the supply of goods and services, or both. In addition, changes in the money supply are the primary reason for changes in spending.

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In many developing economies, classical monetary theory is controlled by the central government, which may also be conducting most of the monetary policy decisions. In the U.S., the Federal Reserve Board (FRB) sets monetary policy without government intervention.

The FRB operates on a monetary theory that focuses on maintaining stable prices (low inflation), promoting full employment, and achieving steady growth in gross domestic product (GDP). The idea is that markets function best when the economy follows a smooth course, with stable prices and adequate access to capital for corporations and individuals.

In the U.S., it is the job of the FRB to control the money supply. The Federal Reserve (Fed) has three main levers:

-1. Reserve ratio: The percentage of reserves a bank is required to hold against deposits. A decrease in the ratio enables banks to lend more, thereby increasing the supply of money.

-2. Discount rate (bank rate): The Fed sets the discount rate, the interest rate at which banks can borrow directly from the central bank. Raising rates makes borrowing more expensive and slows down economic growth, while cutting rates encourages borrowing and investment on cheaper credit.   

-3. Open market operations (OMO): OMO consists of buying and selling government securities. Buying securities from large banks increases the supply of money while selling securities contracts money supply in the economy. The central bank buys government treasuries and other securities from its member banks and replaces them with credit. All central banks have this unique ability to create credit out of thin air. That’s just like printing money.

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Transition of Classical Monetary Theory to Modern Monetary Theory (MMT):

The core tenets of classical monetary theory have attracted plenty of support under the “Modern Monetary Theory” (MMT) banner. The likes of Alexandria Ocasio-Cortez and Bernie Sanders have been championing money creation, describing it as a useful economic tool, while disputing claims that it leads to currency devaluation, inflation, and economic chaos.

MMT posits that governments, unlike regular households, should not tighten their purse strings to tackle an underperforming economy. Instead, it encourages them to spend freely, running up a deficit to fix a nation’s problems.

The idea is that countries such as the U.S. are the sole issuers of their own currencies, giving them full autonomy to increase the money supply or reduce the effect of expansionary monetary policy through taxation. Because there is no limit to how much money can be printed, the theory argues that there is no way that countries can default on their debts.

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Monetarist theory of Inflation: 

According to the Monetarist theory of inflation, there is a direct link between the money supply and the inflation rate. Adherents of monetarism, called monetarists, argue that the demand for money is stable and is not very sensitive to changes in the rate of interest. Hence, expansionary monetary policies only serve to create a surplus of money that households will quickly spend, thereby increasing aggregate demand. Unlike classical economists, monetarists acknowledge that the economy may not always be operating at the full employment level of real GDP. Thus, in the short‐run, monetarists argue that expansionary monetary policies may increase the level of real GDP by increasing aggregate demand. However, in the long‐run, when the economy is operating at the full employment level, monetarists argue that the classical quantity theory remains a good approximation of the link between the supply of money, the price level, and the real GDP—that is, in the long‐run, expansionary monetary policies only lead to inflation and do not affect the level of real GDP. Milton Friedman was an important advocate of monetarist theory, pointing out many situations where government decisions to increase the money supply led to inflation

Some variants of the quantity theory propose that inflation and deflation occur proportionately to increases or decreases in the supply of money. Empirical evidence has not demonstrated this, and most economists do not hold this view.

A more nuanced version of the quantity theory adds two caveats:

-1. New money has to actually circulate in the economy to cause inflation.

-2. Inflation is relative—not absolute.

In other words, prices tend to be higher than they otherwise would have been if more dollar bills are involved in economic transactions.

Although a rise in the money supply can cause inflation, in practice, the link is not clear-cut – inflation can be determined by several factors other than the money supply.  

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Criticisms of quantity theory of money:

Prof. Fisher has explained that in short run, there are no or negligible changes in the economic factors, such as population, consumption, production, production techniques, technology, customer’s tastes and preferences, and circulation of money. Therefore, the demand for money is constant in short run. With respect to the supply of money, the circulation of money and credit is dependent on the habit of people and bank policies. Therefore, these factors also remain constant in short-run. The quantity theory is criticized on a large scale due to its static nature. In quantity theory, most of the factors remain constant, which is not true as real world conditions are dynamic in nature. Therefore, all the factors in this dynamic world keep on changing with time. The theory also considers that money is only used for the transaction purposes. However, it can also be held by individuals as idle cash and savings. So MV = PQ + saving. Apart from this, other factors, such as M and V are not independent factors. Among these factors, one factor can easily bring changes in other factors. For example, change in M can produce changes in V, which further make changes in the value of P.

Criticisms of classical Monetary Theory:

Not everyone agrees that boosting the amount of money in circulation is wise. Some economists warn that such behavior can lead to a lack of discipline and, if not managed properly, cause inflation to spike, eroding the value of savings, triggering uncertainty, and discouraging firms from investing, among other things.

The premise that taxation can fix these problems has also come under fire. Taking more money from paychecks is a deeply unpopular policy, particularly when prices are rising, meaning that many politicians are hesitant to pursue such measures. Critics also point out that higher taxation will end up triggering a further increase in unemployment, destroying the economy even more. Japan is often cited as an example. The country has run fiscal deficits for decades now, with mixed results. Critics regularly point out that continual deficit spending there has forced more people out of work and done little to boost GDP growth.

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Cash Balances Approach:

Cash balances approach is the modification of quantity velocity approach and is widely accepted in Europe. This approach is based on national income approach and considers the concept of liquidity. According to cash balances approach, the value of money depends on the demand and supply of cash balances for a given period of time. The demand for money is not only dependent on the quantity of goods and services that would be exchanged, but also on the time period at which the transaction takes place.

For example, an individual would not purchase food grains for the whole year at once, but he/she would purchase on monthly basis. Therefore, he/she is required to hold enough cash with him/her to buy food grains and other products from month after month.

Thus, if in economy individuals are habitual for holding money for overcoming their expenditure for a longer period of time, then the demand for money would be more. In such a case, only a small part of income is held by individuals and rest of the amount is invested.

This is because holding a large amount of cash as idle cash would be a loss or danger for the individual.  On the other hand, cash balances held by individuals should also not be very low, so that contingencies cannot be overcome.

Therefore, an individual should hold a particular amount of cash with him/her to fulfill his/her needs as well as overcome uncertainties.

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Income-Expenditure Approach:

The income-expenditure approach is given by Keynes. It is also termed as the modern quantity theory of money. Keynes was agreed with the concept that changes in quantity of money produces changes in the price levels, as given in the quantity theory of money. However, he did not agree with the view that determining relationship between quantity of money and price level is as easy as demonstrated by quantity theory.

According to the modern quantity theory of money, changes in price level are brought by the changes in national income rather than quantity of money. The main reason for the change in the price level is the changes that occur in the aggregate income or expenditure. Therefore, change in quantity of money can only bring changes in the price level when it can change the aggregate expenditure with respect to the supply of output.

If there is no rise in the expenditure, then the demand for goods would not rise and consequently, the price level would not increase. In case, the expenditure rises but the supply of output is fairly elastic, then also the price level would not rise.

Therefore, the impact of change in quantity of money would depend on the following factors:

-a. Effect of change in money supply on level of aggregate expenditure and volume of production

-b. Type of relation between aggregate expenditure and volume of production

The amount of expenditure depends on the consumption function, investment demand schedule, liquidity preference schedule, and supply of money. An increase in the quantity of money would decrease the rate of interest. However, in case the rate of interest is very low, then the increase in quantity of money would not be able to reduce rate of interest further.

The reduced rate of interest would help in increasing the rate of investment by individuals, which would further result in increase in income. The increase in income would increase the aggregate expenditure of a nation. However, when the increased quantity of money is not able to reduce the rate of interest as it is already very low, the investment would not show any increase.

Thus, the income and aggregate expenditure would simultaneously fail to show any type of increase. In such a case, the price level would not rise even with the rise of quantity of money. However, it is also not guaranteed that if the increase in quantity of money reduces the rate of interest, then price level would rise or not. This is because it may be possible that the proportional increase in price level is very less as compared to increase in money supply. Therefore, it is hard to determine relationship between changes in money supply and changes in price level. This is because they are indirectly related to each other and depend on aggregate expenditure and elasticity of supply of output.

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Quality of Money:

Much has been written about the quantity of money and its effects on money’s purchasing power. However, changes in the quality of money have been widely neglected. The changes in the quality of money can influence the purchasing power of money.

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Gresham’s Law:

Gresham’s law is a monetary principle stating that “bad money drives out good.” It is primarily used for consideration and application in currency markets. Gresham’s law was originally based on the composition of minted coins and the value of the precious metals used in them. When buying a good, a person is more likely to pass on less-desirable items that qualify as “money” and hold on to more valuable ones. For example, coins with less silver in them (but which are still valid coins) are more likely to circulate in the community. However, since the abandonment of metallic currency standards, the theory has been applied to the relative stability of different currencies’ value in global markets.

At the core of Gresham’s law is the concept of good money (money which is undervalued or money that is more stable in value) versus bad money (money which is overvalued or loses value rapidly). The law holds that bad money drives out good money in circulation. Bad money is then the currency that is considered to have equal or less intrinsic value compared to its face value. Meanwhile, good money is currency that is believed to have greater intrinsic value or more potential for greater value than its face value. One basic assumption for the concept is that both currencies are treated as generally acceptable media of exchange, are easily liquid, and available for use simultaneously. Logically, people will choose to transact business using bad money and hold balances of good money because good money has the potential to be worth more than its face value.

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In cases of hyperinflation, foreign currencies often come to replace local, hyperinflated currencies; this is an example of Gresham’s law operating in reverse. Once a currency loses value rapidly enough, people tend to stop using it in favor of more stable foreign currencies, sometimes even in the face of repressive legal penalties. For example, during the hyperinflation in Zimbabwe, inflation reached an annual rate estimated at 250 million percent in July 2008. Though still legally required to recognize the Zimbabwe dollar as legal currency, many people in the country began to abandon its use in transactions, eventually forcing the government to recognize de facto and subsequent de jure dollarization of the economy. In the chaos of an economic crisis with a near worthless currency, the government was unable to effectively enforce its legal tender laws. Good (more stable) money drove bad (hyperinflated) money out of circulation first in the black market, then in general use, and eventually with official government support. In this sense, Gresham’s law can also be considered across global currency markets and international trade, since legal tender laws almost by definition only apply to domestic currencies. In global markets, strong currencies, such as the U.S. dollar or the euro, which hold relatively more stable value over time (good money) tend to circulate as international media of exchange and are used as international pricing references for globally traded commodities. Weaker, less stable currencies (bad money) of less developed nations tend to circulate very little or not at all outside the boundaries and jurisdiction of their respective issuers to enforce their use as legal tender. With international competition in currencies, and no single global legal tender, good money circulates and bad money is kept out of general circulation by the operation of the market.

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The quantity theory of money is the heart of neoclassical monetary theory. In contrast, the quality of money is a subjective concept and should stand at the center of a monetary theory based on human action. Money serves people in attaining their subjective ends more efficiently and it fulfills certain functions for people. The better these functions of money are fulfilled in the eyes of actors the higher they value money. The quality of money is, consequently, defined as the capacity of money, as perceived by actors, to fulfill its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit. Hence, the theory of the quality of money maintains that the demand for money does depend on the quality of money. In fact, the quality of money is one of the important factors, along with uncertainty, financial innovations (credit cards, ATM machines, MMMFs), frequency of payment, etc. that affect the demand for money. The theory of the quality of money, thus, contrasts with a one-sided quantity theory of explaining the price level.

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The economic profession has largely neglected the quality theory of money concentrating mainly on money’s quantity. Changes in the quality of money are very important for the purchasing power of money and have an important explanatory power. The quality of money affects the purchasing power of money by first altering the demand for money, which reflects the changed valuation of a fixed quantity of money on the public’s value scales. The expected quantity of money is only one of many factors influencing the quality of money and derives its importance from its effects on the quality of money. Thus, an integrated theory of money must put emphasis on the quality of money and explain the importance of the expected quantity of money relating it to its effects upon money’s quality.

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Money’s quality is continuously changing. The changes in the quality of money can be slow but also abrupt. Consequently, they can have stronger effects for the purchasing power of money than changes in money’s quantity, which are seldom abrupt. Actually, increases in the quantity of money are increasingly less important the higher the quality of the money is. This is so, because with a money of high quality there will be a strong demand to absorb the additional amount of money as a store of value or for industrial or consumption purposes. If its quality deteriorates or is expected to deteriorate, it can have strong effects on the purchasing power of money. Furthermore, increases in the quantity of a money of high quality such as a 100 percent gold standard do not result in a deterioration of the integrity of the money. The integrity of the previously existing gold coins is not harmed by new gold production. In contrast, increases in the quantity of a money of lower quality, i.e., a fractional reserve paper money, can cause money’s quality to deteriorate by diminishing the average backing of the previously existing monetary units.

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In sum, it is time for economists to shift their focus onto the analysis of the quality of money and how it can be changed. For instance, the quality of different monetary and political regimes, the relevant properties of a good money, the role of expectations and the quality of media of exchange should be analyzed in more detail. We need a unified theory of money giving equal importance to quality and quantity of money. 

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Section-5

Purchasing power of money:

Purchasing power is the value of a currency expressed in terms of the number of goods or services that one unit of money can buy. Purchasing power boils down to this: It’s how much value your money has. In a sense, purchasing power and inflation are two sides of the same coin. Purchasing power measures what a unit of currency can buy, while inflation measures rising prices. Purchasing power is important because, all else being equal, inflation decreases the number of goods or services you would be able to purchase. You feel purchasing power in your daily life when prices and cost of living go up—but it doesn’t just stop there. Purchasing power plays into your future too. Things like savings and investments are all impacted by purchasing power.

In investment terms, purchasing power is the dollar amount of credit available to a customer to buy additional securities against the existing marginable securities in the brokerage account. Purchasing power may also be known as a currency’s buying power.

Inflation: 

Inflation is the increase in the prices of goods and services over time. Inflation makes your purchasing power go down by cutting back on the value of your money. Inflation tends to erode the purchasing power of a currency over time. Central banks try to keep prices stable through maintaining the purchasing power of the currency by setting interest rates and other mechanisms.

Deflation:

Deflation is when the prices for goods and services go down over time and the rate of inflation drops under 0%. In plain words, that just means you can get more for your buck (purchasing power) when you head out to the store or shop online. Cheaper prices might sound good at first, but don’t be fooled—deflation isn’t a good thing. It creates a whole bunch of new problems to deal with. Deflation can make unemployment rates spike, salary and hourly pay drop, and big-time assets like homes lose their value. And sometimes, it can even spur on a recession.

Consumer Price Index: 

The Consumer Price Index (CPI) measures the change in the prices of goods and services that consumers pay over time. In other words, CPI tracks how much your toothpaste costs today compared to three years ago. And when CPI is going in one direction up, your purchasing power goes in the opposite direction down. The Consumer Price Index (CPI) is a commonly used tracker of inflation. It uses quarterly survey data to gather the average prices for a market basket of consumer goods and services in urban areas. The basket includes common household purchases, such as cereal, milk, coffee, clothing, and medical care.

Purchasing Price Parity:

Purchasing Price Parity (PPP) is the exchange rate that a country uses to convert the currency of another country in order to buy the same amount of goods and services. Rather than focusing on a single currency, purchasing power parity (PPP) measures the purchasing power of currencies between countries. As an example, think of a gallon of milk that costs $3 in the US and 30 pesos in Mexico. The PPP exchange rate would be $1 to 10 pesos. If the market exchange rate is different, then it deviates from PPP. PPP estimates can be useful when comparing living standards and economic output from different countries.

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Understanding Purchasing Power: 

Inflation reduces the value of a currency’s purchasing power, having the effect of an increase in prices. To measure purchasing power in the traditional economic sense, you would compare the price of a good or service against a price index such as the Consumer Price Index (CPI). One way to think about purchasing power is to imagine if you made the same salary as your grandfather 40 years ago. Today you would need a much greater salary just to maintain the same quality of living. By the same token, a homebuyer looking for homes 10 years ago in the $300,000 to 350,000 price range had more options to consider than people have now.

Purchasing power affects every aspect of economics, from consumers buying goods to investors and stock prices to a country’s economic prosperity. When a currency’s purchasing power decreases due to excessive inflation, serious negative economic consequences arise, including rising costs of goods and services contributing to a high cost of living, as well as high interest rates that affect the global market, and falling credit ratings as a result. All of these factors can contribute to an economic crisis.  

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Purchasing power is a phrase to describe the quantity of goods or services that a dollar can buy. A decrease in purchasing power is called inflation. Let’s assume $1 bought 1.50 gallons of gas in 1987. Today, $1 buys about half a gallon. This is an example of the change in the purchasing power of the American dollar.

Two general theories explain decreases in purchasing power. The first, the demand-pull theory, says prices increase when demand for goods and services exceeds their supply. The second, the cost-push theory, says that companies create inflation when they raise their prices to cover higher supply prices and maintain profit margins.

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The purchasing power of money—or its reciprocal, the level of prices—depends on five definite factors: (1) the volume of money in circulation; (2) its velocity of circulation; (3) the volume of bank deposits subject to check; (4) its velocity; and (5) the volume of trade. Each of these five magnitudes is extremely definite, and their relation to the purchasing power of money is definitely expressed by an equation of exchange. Purchasing power doesn’t just relate to how much you can buy with your money. It also affects stock prices, as well as general economic health. That’s because if inflation causes purchasing power to decrease significantly, and the cost of living goes up, that will lead to more cash-strapped consumers. Interest rates also affect your individual purchasing power; for example, a 1% drop in interest rates can lead to a monthly savings of $167 on a mortgage of $200,000. A drop in mortgage rates means your dollars can go further since the total amount you’ll owe on your monthly mortgage payments will be lower. As Adam Smith noted, having money gives one the ability to “command” others’ labor, so purchasing power to some extent is power over other people, to the extent that they are willing to trade their labor or goods for money or currency.

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Purchasing power has a significant effect on investment returns and decisions. For example, let’s assume you invest $1,000 in a one-year XYZ Company bond. If the bond yields 5%, then at the end of the year you will collect $1,050. Your 5% return may not be as good as it looks, however, if your purchasing power decreases 4% during the year. Your real return is actually 1%. Some securities, such as Treasury Inflation-Protected Securities (TIPS), tie their principal and coupon payments to changes in purchasing power (the CPI) in order to compensate the investor for inflation.

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Importance of purchasing power:

Changes in purchasing power directly or indirectly affect nearly every financial decision, from consumer choices to lending rates, and from asset allocation to stock prices. Purchasing power also offers important clues about the state of an economy. Most economists agree, for example, that moderate decreases in purchasing power are a sign of a growing economy and that increases in purchasing power are a sign of stagnation.

Purchasing power can also distort a company’s financial performance. For example, a company that reports high revenue growth during a period of rising inflation could be misleading shareholders if those revenues were the result of inflationary pressure rather than managerial skill. For this reason, many analysts use inflation information to “deflate” or adjust certain financial measures so they can compare them accurately over time. Inflation can also influence a company’s choices in accounting methods. For example, in a rising cost environment, a company may be tempted to use the FIFO inventory method in order to increase paper profits; in a falling cost environment, LIFO may be better.

Purchasing power also affects securities values by way of the discount rate. When inflation is high or rising, the future dividends or interest payments from an investment are worth less. In broad terms, the higher inflation goes, the higher the discount rate goes, and the lower the value of the security goes. The reverse is also true.

Because the Federal Reserve’s job is to maintain long-term economic prosperity through the execution of monetary policy, it takes a keen interest in purchasing power when deciding whether to raise or lower the federal funds rate. This is one reason some analysts consider inflation a measure of the effectiveness of certain government policies.

Contracts and other obligations involving payments over time often consider purchasing power. For example, many labor contracts tie wage adjustments to changes in the CPI, as do some alimony, child support, rent, royalty, and other obligations affected by changes in purchasing power. People living off fixed incomes are particularly affected by changes in purchasing power, and this is why the government usually adjusts social security checks and food stamps as well as the wages of federal employees and members of the military on a regular basis.

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Inflation:

Inflation is defined as an increase in the average level of prices. When the supply of output is less, the rise in prices is described as inflationary. In Goulborn’s words, it is a case of “too much money chasing too few goods”. H.G. Johnson defines inflation as “a sustained rise in prices”. Inflation is generally associated with an abnormal increase in the quantity of money resulting in abnormal rise in prices. Inflation thus, represents a situation whereby the pressure of aggregate demand for goods and services exceeds the available supply of output.

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In economics, inflation is a general increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money.  The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index. As prices do not all increase at the same rate, the consumer price index (CPI) is often used for this purpose. The employment cost index is also used for wages in the United States.

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Through the Federal Reserve, the government tries to combat inflation on a large scale by raising the federal funds rate, which is the interest rate that commercial banks use to borrow and lend money to each other. When the cost of borrowing becomes more expensive, higher interest rates trickle down to consumer products such as loans and mortgages, making them more expensive. But higher interest rates may also apply to deposit accounts, meaning that banks start to offer higher interest rates on checking, savings and certificates of deposit.

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Causes of Inflation:

-a) Increase in demand and decrease in supply of goods cause inflation. Increase in demand is caused by increase in aggregate spending on consumption and investment goods. Decrease in output is due to deficiency of capital equipment, scarcity of factors of production and natural calamities like drought, flood, etc. 

-b) Inflation occurs during the war when the government creates additional money and circulates the same into the economy to meet war expenditures. 

-c) Also, when government resorts to deficit financing, inflation takes place. 

-d) Planning for rapid economic development is another cause of inflation. Huge investments are made which would yield results only after a period of five to ten years. This very long time lag between input and output results in inflation. 

-e) The activities of hoarders and speculators reduce the supply of goods to the market and push up prices.

-f) The prevalence of black money or unaccounted money and also the existence of counterfeit money lead to inflation.

-g) Demand-pull inflation: It refers to that rise in the price level, which takes place because consumers and investors with their rising income compete with each other for a relatively limited supply of available goods.

-h) Cost-push Inflation: It refers to that rise in the price level, which takes place because wages increase to a greater extent than labour productivity. These costs (wages) are passed on to the consumers in the form of higher prices.

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Types of Inflation:  

The classification of inflation is based on the speed with which the price increases in the economy.

-a) Creeping inflation: It is the mildest type of inflation, under which prices rise slowly, say, one per cent per annum.

-b) Walking inflation: When the rise in prices is more pronounced as compared to a creeping inflation, it is called walking inflation. Roughly, the prices rise five per cent annually under this situation.  

-c) When the movement of price accelerates rapidly, “Running inflation” emerges. Under this, prices rise by more than ten per cent per annum.

-d) Hyperinflation: This is an alternative term for run away or galloping inflation. There is such a tremendous expansion in the supply of money and eventually it becomes worthless. Hyperinflation results in a steep rise in prices (sometimes, the rise in prices is 100 per cent or more) and it disrupts normal economic relations.

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Economists believe that very high inflation and hyperinflation – which have severely disruptive effects on the real economy – are caused by persistent excessive growth in the money supply.  Views on low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities.  Moderate inflation affects economies in both positive and negative ways. The negative effects include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Positive effects include reducing unemployment due to nominal wage rigidity, allowing the central bank greater freedom in carrying out monetary policy, encouraging loans and investment instead of money hoarding, and avoiding the inefficiencies associated with deflation.

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Control of Inflation:

The following are the anti-inflationary measures:

(A) Monetary measures

-1) The central bank can increase the market rate of interest that will reduce the aggregate spending.

-2) If central bank can reduce the cash available to the banking system, the capacity of the banks to lend money to the borrowers will be reduced. 

-3) The central bank can sell the government securities to the banks or to the public so that cash available with bank or public can be reduced.

-4) Consumer credit control can reduce money supply.

(B) Fiscal measures 

-1) Reduction of government spending 

-2) Imposition of new taxes

-3) Encouragement of savings or introducing compulsory saving schemes

(C) Physical or Non-monetary measures 

-1) Increasing output, increasing imports and decreasing exports so as to increase the availability of goods which are in short supply.

-2) Controlling money wages to keep down costs. 

-3) Price control and rationing.

-4) Control over speculation, hoarding and black-marketing.

-5) Import of essential commodities and distribution of such goods through fair price shops. 

The monetary and fiscal measures will reduce the money supply in the country, whereas the physical and non-monetary measures will increase output and control prices of goods. Thus, inflation can be gradually controlled.

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Presently, most economists favor a small and steady rate of inflation. Small (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly to a recession, and reduces the risk that a liquidity trap (a reluctance to lend money due to low rates of interest) prevents monetary policy from stabilizing the economy.  However, money supply growth does not always cause nominal increases of price. Money supply growth may instead result in stable prices at a time in which they would otherwise be decreasing. Some economists maintain that with the conditions of a liquidity trap, large monetary injections are like “pushing on a string”.  The task of keeping the rate of inflation small and stable is usually given to monetary authorities. Generally, these monetary authorities are the national banks that control monetary policy by the setting of interest rates, by open market operations, and by the setting of banking reserve requirements. 

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Liquidity trap and inflation:

A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Among the characteristics of a liquidity trap are interest rates that are close to zero and changes in the money supply that fail to translate into changes in the price level.

Low inflation makes cash more attractive to investors as a store of value, everything else equal. Low inflation makes cash more attractive to investors, in turn making a liquidity trap easier to occur. Therefore, the correct monetary policy during a liquidity trap is not to further increase the money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate. … Only when financial assets become more attractive than cash can the aggregate price level increase.

Typically, an increase in the money supply (such as the increase generated through the Federal Reserve’s large-scale asset purchases) causes inflation to rise as more money is chasing the same amount of goods. During normal times, inflation increases 0.54 percent for each 1 percent increase in the growth of money. However, in a liquidity trap, investors choose to hoard the additional money resulting from an increase in the money supply rather than spend it because the opportunity cost of holding cash—the forgone earnings from interest—is zero when the nominal interest rate is zero. If this increase in money demand is proportional to the increase in the money supply, inflation will instead remain stable.

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In context of economic development, small and steady inflation is desirable for two reasons: These are:

-1) Inflation acts favorably upon the inducement of investment. The higher the price, the higher the expected price and the higher is the marginal efficiency of capital. As a result of this, the inducement to invest is higher too. Inflation thus boosts investment.

-2) Inflation generates the necessary resources for investment. It forces people to save.

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Effects of Inflation:

The effects of inflation are felt unevenly by different groups of individuals within the economy. Generally, inflation inflicts more harm on low and fixed income groups than high-income group of people. Some of the important effects of inflation are given below:

-a) Debtors gain and creditors stand to lose by inflation

-b) When prices rise, producers, speculators and entrepreneurs gain because prices rise at a faster rate than the cost of production. 

-c) Property owners are benefited on account of increasing property value.

-d) The hardest hit are those who earn fixed income. Persons who live on post office savings, fixed interest and rent, pensioners, government employees and so on suffer because their incomes do not rise in proportion to rise in prices.

-e) Distortion in production and allocation of resources take place since producers prefer to produce goods consumed by the rich people.

-f) Inflation results redistribution of wealth favouring businessmen and hurting consumers, creditors, small investors and fixed income earners.  

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You’re actually losing money in a bank account due to inflation:

Despite the Federal Reserve’s increasingly hawkish stance, inflation continues to be a problem. The latest inflation report showed prices in May 2022 rose 8.6% from a year ago — the fastest rate in 40 years. Add to those declining stocks, climbing interest rates and global economic troubles caused by Russia’s invasion of Ukraine, and its understandable why people may not be feeling great about the economy.  Inflation erodes purchasing power. That means keeping large sums of money in a low-interest savings account is a big mistake. Right now, Indian banks give 3% interest in saving account. Annual inflation rate in India increased to 6.95% in March of 2022.  So you’re actually losing money every 12 months. Inflation is a time for investors and savers to re-evaluate their strategies. If you’re looking for ways to protect yourself financially, while also making the most of what you have, here are some options to consider. You must have three months of salary on hand in case of emergency. But after you’ve built that cushion, you ought to invest in index funds, which offer an easy and diversified way to get exposure to the stock market. Also, having two to four years in lower volatility investments like a short-term bond fund will help you ride out any market downturns and give your investments time to recover.  

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Deflation:

In common usage deflation is generally considered to be “falling prices”. But there is much more to it than that. Often people confuse deflation with disinflation. Note that deflation is not the same as disinflation, which is a decline in the positive rate of inflation from period to period. Deflation occurs when the annual inflation rate falls below 0% (a negative inflation rate). Deflation occurs when too many goods are available or when there is not enough money circulating to purchase those goods. As a result, the price of goods and services drops. Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time. Lower prices might sound appealing, making the cost of everything from cars to food to vacations cheaper. But prices decline because of a lasting drop in demand, which also means employers lower wages and consumers slow spending. It’s a combination that can drag down an economy for years.  Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy, exactly the opposite of inflation. For instance, if a particular type of car becomes highly popular, other manufacturers start to make a similar vehicle to compete. Soon, car companies have more of that vehicle style than they can sell, so they must drop the price to sell the cars. Companies that find themselves stuck with too much inventory must cut costs, which often leads to layoffs. Unemployed individuals do not have enough money available to purchase items; to coax them into buying, prices get lowered, which continues the trend.

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Actually, deflation itself is neither good nor bad. It depends on the cause of the deflation whether people will suffer or rejoice. If the cause is increasing supply of goods that would be good. An example of this is in the late 1800’s as the industrial revolution dramatically increased productivity. However, if deflation is caused by a decreasing supply of money as in the great depression, that would be bad. The stock market crash sucked all the liquidity out of the market place, the economy contracted, and people lost their jobs and then banks stopped loaning money because people were defaulting. The problem compounded as more people lost their jobs and money supply fell further causing more people to lose their jobs. Deflation can lead to an economic recession or depression, and the central banks usually work to stop deflation as soon as it starts.

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Inflation is a lesser evil than deflation:

Inflation is better than deflation. Deflation completely ruins the economy, whereas mild levels of inflation help in the growth of the economy, it leads to more investments, production and employment. Inflation, though it redistributes income and wealth in the community in an unjust manner, does not reduce the national income of the community. Deflation, on the other hand, reduces the national income of the community and pauperizes society as a whole.  Deflation increases the level of unemployment in the economy, whereas inflation at least implies that all factors are employed in some way or another.  It is easy to control inflation by a clear money policy, coordinated by appropriate fiscal policy, but it is difficult to recover from deflation. Once a deflationary tendency starts, it increases business pessimism, the marginal efficiency of capital diminishes, and investment is contracted, and ultimately a severe depression sets in. Monetary policy becomes helpless here, and no amount of increase in the money supply can revive the price level and business expectations or marginal efficiency or capital in the economy during depression. On the other hand, an inflationary spiral can be reflated by controlling credit and money supply.

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Section-6

Money and banks:

Somebody once asked the late bank robber named Willie Sutton why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.

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Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if everybody had to make all payments in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.

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Banks are a critical intermediary in what we call the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Transaction costs are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediaries—they bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in creating money.

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Banks as Financial Intermediaries:  

An “intermediary” is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but we will not include them in this discussion because they are not depository institutions, which are institutions that accept money deposits and then use these to make loans. All the deposited funds mingle in one big pool, which the financial institution then lends. Figure below illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.

The illustration below shows the circular transactions between savers, banks, and borrowers. Savers give deposits to banks, and the bank provides them with withdrawals and interest payments. Borrowers give repayment of loans and interest payments to banks and the banks provide them with loans.

Figure above shows Banks as Financial Intermediaries.

Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money). The amount banks pay for deposits and the income they receive on their loans are both called interest. Depositors can be individuals and households, financial and nonfinancial firms, or national and local governments. Borrowers are, well, the same. Deposits can be available on demand (a checking account, for example) or with some restrictions (such as savings and time deposits). 

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Bank assets:   

When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money.

Loans are the first category of bank assets. Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank’s perspective, because the borrower has a legal obligation to make payments to the bank over time.

The second category of bank asset is bonds, which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bonds—typically bonds issued by the government. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future.

The final entry under assets is reserves, which is money that the bank keeps on hand, and that it does not lend or invest in bonds—and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve,” which means either in their vaults or at the Federal Reserve Bank. This is called a reserve requirement. The level of these required reserves are one policy tool that governments have to influence bank behavior. Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required.

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Creating money by banks:

Banks create money. They must hold on reserve, and not lend out, some portion of their deposits—either in cash or in securities that can be quickly converted to cash. The amount of those reserves depends both on the bank’s assessment of its depositors’ need for cash and on the requirements of bank regulators, typically the central bank—a government institution that is at the center of a country’s monetary and banking system. Banks keep those required reserves on deposit with central banks, such as the U.S. Federal Reserve, the Bank of Japan, and the European Central Bank. Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it. The process of relending can repeat itself a number of times in a phenomenon called the multiplier effect. The size of the multiplier—the amount of money created from an initial deposit—depends on the amount of money banks must keep on reserve.

Banks also lend and recycle excess money within the financial system and create, distribute, and trade securities.

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How banks create money?

Money Multiplier:

When commercial banks lend money, they expand the amount of bank deposits. The banking system can expand the money supply of a country beyond the amount created or targeted by the central bank, creating most of the broad money in a process called the multiplier effect.

Money multiplier is a term in monetary economics that is a phenomenon of creating money in the economy in the form of credit creation, which is based on the fractional reserve banking system. Money multiplier is also known as the monetary multiplier. It is the maximum limit to which money supply can be affected by bringing about changes in the amount of money deposits. The money multiplier effect is seen in commercial banks as they accept deposits, and after keeping a certain amount as a reserve, they distribute the money as loans for injecting liquidity in the economy. Under cash reserve ratio (CRR), the commercial banks have to hold a certain minimum amount of deposit as reserves with the central bank. The percentage of cash required to be kept in reserves as against the bank’s total deposits, is called the Cash Reserve Ratio.

Mathematically, money multiplier formula can be represented as follows:

Money multiplier = 1/r

Where r = Required reserve ratio or cash reserve ratio

It means that if the reserve ratio is higher, then the money multiplier will be lower and the banks need to keep more reserves. As a result, they will not be able to lend more money to individuals and businesses. Similarly, a lower reserve ratio results in a higher money multiplier that allows a lesser amount of money to be kept as a reserve and more lending opportunities to the public.

Suppose the reserve requirement is 10%; so, the money multiplier in this case is (1/.10) = 10. The excess reserves resulting from the initial deposit of $100,000 are $90,000. Multiplying $90,000 by the money multiplier, 10, yields $900,000, which is the amount of additional deposits created by the banking system as the result of the initial $100,000 deposit.

How?

Consider what happens when the same bank receives a $100,000 deposit from one of its depositors. The bank is required to set aside 10% of this deposit, or $10,000, as reserves. It then lends out its excess reserves—in this case, the remaining $90,000 of the initial deposit. Suppose, for the sake of simplicity, that all borrowers redeposit their loans into the same bank. The bank thus receives $90,000 in new deposits of which it sets $9,000 aside as reserves and lends out all of its excess reserves. Suppose again that all borrowers redeposit their loans in the same bank, that the bank sets aside a portion of these deposits, and that the bank then lends out the remainder, which is again redeposited in the bank and so on and so on. If one were to follow this multiple deposit expansion process to its completion, the end result would be that the bank’s deposits would increase by $1 million, its loans would increase by $900,000, and its reserves would increase by $100,000, all due to the initial deposit of $100,000.

In reality, loan recipients do not deposit all of their loan funds into a bank. More typically, they hold a fraction of their loan funds as currency. If some loan funds are held as currency, then there is a leakage of money out of the banking system. In this case, the money multiplier will still be greater than 1, but it will be less than the inverse of the reserve requirement.

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How banks make money:  

Banks have several ways of making money besides pocketing the difference (or spread) between the interest they pay on deposits and borrowed money and the interest they collect from borrowers or securities they hold. They can earn money from:

• income from securities they trade; and
• fees for customer services, such as checking accounts, financial and investment banking, loan servicing, and the origination, distribution, and sale of other financial products, such as insurance and mutual funds.

Banks earn on average between 1 and 2 percent of their assets (loans and securities). This is commonly referred to as a bank’s return on assets.

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Transmitting monetary policy:

Banks also play a central role in the transmission of monetary policy, one of the government’s most important tools for achieving economic growth without inflation. The central bank controls the money supply at the national level, while banks facilitate the flow of money in the markets within which they operate. At the national level, central banks can shrink or expand the money supply by raising or lowering banks’ reserve requirements and by buying and selling securities on the open market with banks as key counterparties in the transactions. Banks can shrink the money supply by putting away more deposits as reserves at the central bank or by increasing their holdings of other forms of liquid assets—those that can be easily converted to cash with little impact on their price. A sharp increase in bank reserves or liquid assets—for any reason—can lead to a “credit crunch” by reducing the amount of money banks have to lend, which can lead to higher borrowing costs as customers pay more for scarcer bank funds. A credit crunch can hurt economic growth.

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Bank failure:

Banks can fail, just like other firms. But their failure can have broader ramifications—hurting customers, other banks, the community, and the market as a whole. Customer deposits can be frozen, loan relationships can break down, and lines of credit that businesses draw on to make payrolls or pay suppliers may not be renewed. In addition, one bank failure can lead to other bank failures.

Banks’ vulnerabilities arise primarily from three sources:

• a high proportion of short-term funding such as checking accounts and repos to total deposits. Most deposits are used to finance longer-term loans, which are hard to convert into cash quickly;
• a low ratio of cash to assets; and
• a low ratio of capital (assets minus liabilities) to assets.

Depositors and other creditors can demand payment on checking accounts and repos almost immediately. When a bank is perceived—rightly or wrongly—to have problems, customers, fearing that they could lose their deposits, may withdraw their funds so fast that the small portion of liquid assets a bank holds becomes quickly exhausted. During such a “run on deposits” a bank may have to sell other longer-term and less liquid assets, often at a loss, to meet the withdrawal demands. If losses are sufficiently large, they may exceed the capital a bank maintains and drive it into insolvency. We define net worth of a bank as its total assets minus its total liabilities. For a financially healthy bank, the net worth will be positive. If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money. A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities.

Essentially, banking is about confidence or trust—the belief that the bank has the money to honor its obligations. Any crack in that confidence can trigger a run and potentially a bank failure, even bringing down solvent institutions. Many countries insure deposits in case of bank failure, and the recent crisis showed that banks’ greater use of market sources of funding has made them more vulnerable to runs driven by investor sentiment than to depositor runs.

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The need for regulation:

Bank safety and soundness are a major public policy concern, and government policies have been designed to limit bank failures and the panic they can ignite. In most countries, banks need a charter to carry out banking activities and to be eligible for government backstop facilities—such as emergency loans from the central bank and explicit guarantees to insure bank deposits up to a certain amount. Banks are regulated by the laws of their home country and are typically subject to regular supervision. If banks are active abroad, they may also be regulated by the host country. Regulators have broad powers to intervene in troubled banks to minimize disruptions.

Regulations are generally designed to limit banks’ exposures to credit, market, and liquidity risks and to overall solvency risk. Banks are now required to hold more and higher-quality equity—for example, in the form of retained earnings and paid-in capital—to buffer losses than they were before the financial crisis. Large global banks must hold even more capital to account for the potential impact of their failure on the stability of the global financial system (also known as systemic risk). Regulations also stipulate minimum levels of liquid assets for banks and prescribe stable, longer-term funding sources.

Regulators are reviewing the growing importance of institutions that provide bank-like functions but that are not regulated in the same fashion as banks—so-called shadow banks—and looking at options for regulating them. The recent financial crisis exposed the systemic importance of these institutions, which include finance companies, investment banks, and money market mutual funds.

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Bank Reserves:

Currency held in bank vaults may be counted as legal reserves as well as deposits (reserve balances) at the Federal Reserve Banks. Both are equally acceptable in satisfaction of reserve requirements. A bank can always obtain reserve balances by sending currency to its Reserve Bank and can obtain currency by drawing on its reserve balance. Because either can be used to support a much larger volume of deposit liabilities of banks, currency in circulation and reserve balances together are often referred to as “high-powered money” or the “monetary base.”

Figure above shows High Powered Money in relation to Total Money Supply. Reserve balances and vault cash in banks, however, are not counted as part of the money stock held by the public.

For individual banks, reserve accounts also serve as working balances. Banks may increase the balances in their reserve accounts by depositing checks and proceeds from electronic funds transfers as well as currency. Or they may draw down these balances by writing checks on them or by authorizing a debit to them in payment for currency, customers’ checks, or other funds transfers.

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Although reserve accounts are used as working balances, each bank must maintain, on the average for the relevant reserve maintenance period, reserve balances at their Reserve (Central) Bank and vault cash which together are equal to its required reserves, as determined by the amount of its deposits in the reserve computation period.

From the standpoint of money creation, the essential point is that the reserves of banks are, for the most part, liabilities of the Federal Reserve Banks, and net changes in them are largely determined by actions of the Federal Reserve System. Thus, the Federal Reserve, through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities, influences banks’ decisions with respect to their assets and deposits. One of the major responsibilities of the Federal Reserve System is to provide the total amount of reserves consistent with the monetary needs of the economy at reasonably stable prices. Such actions take into consideration, of course, any changes in the pace at which money is being used and changes in the public’s demand for cash balances.

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Central banking:

Modern banking systems hold fractional reserves against deposits. If many depositors choose to withdraw their deposits as currency, the size of the banking system shrinks. A run on the bank—a sudden withdrawal of deposits as currency or, in earlier times, as gold or silver—can cause banks to run out of reserves and force their closure. Bank panics of this kind occurred many times. After 1866 in Great Britain, but not until 1934 in the United States, did governments learn to use the central bank (or some other government institution) to prevent bank runs.

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The Bank of England was the first modern central bank, serving as the model for many others, such as the Bank of Japan, the Bank of France, and the U.S. Federal Reserve. It was established as a private bank in 1694 but by the mid-19th century had become largely an agency of the government. In 1946 the U.K. government nationalized the Bank of England. The Bank of France was established as a governmental institution by Napoleon in 1800. In the United States, the 12 Federal Reserve banks, together with the Board of Governors in Washington, D.C., constitute the Federal Reserve System. The reserve banks are technically owned by their member commercial banks, but this is a pure formality. Member banks get only a fixed annual percentage dividend on their stock and have no real power over the bank’s policy decisions. For all intents and purposes, the Federal Reserve is an independent governmental agency. In making decisions about the money supply, a central bank decides whether to raise or lower interest rates and, in this way, to influence macroeconomic policy, whose goal is low unemployment and low inflation. The central bank is also responsible for regulating all or part of the nation’s banking system to protect bank depositors and insure the health of the bank’s balance sheet.

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The notes and coins issued by central bank are the monetary base; also known as base money, money base, high-powered money, central bank money etc. It represents all the physical coinage and paper money in circulation plus bank reserves. Each dollar, pound, or euro from base money becomes the base for several dollars, pounds, or euros of commercial bank loans and deposits. Earlier in the history of money, the size of the monetary base was limited by the amount of gold or silver owned. Today there is no longer a formal limit to the amount of notes in circulation and reserves that a central bank may have as liabilities.

The way in which a central bank increases the monetary base is, typically by buying government securities (open-market operations). The important point is that these bookkeeping operations simply record a process whereby the central bank has created, out of thin air as it were, additional base money (currency held by the public plus sums deposited with a reserve bank)—the direct counterpart of printing Federal Reserve notes. Similarly, if the central bank sells government securities, it decreases base money. If, for example, the Federal Reserve System purchases $1 million of government securities, it pays for these securities by drawing a check on itself, thereby adding $1 million to its assets and $1 million to its liabilities. The seller can take the check to a Federal Reserve bank, which will exchange it for $1 million in Federal Reserve notes. Or the seller may deposit the check at a commercial bank, and the bank may in turn present it to a Federal Reserve bank. The latter “pays” the check by making an entry on its books increasing that bank’s deposits by $1 million. The commercial bank may, in turn, transfer this sum to a borrower, who again will convert it into Federal Reserve notes or deposit it.

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The total quantity of money at any time depends on several factors, including the stock of base money, the public’s preference regarding the relative amounts of money it wishes to hold as currency and as deposits, and the preferences of banks regarding the ratio they wish to maintain between their reserves and their deposits. (The reserve ratio is, of course, dominated by legal reserve requirements, where they exist.) Banks hold treasury bills and other short-term assets to provide additional liquidity, but they also hold some reserves in the form of currency so that they may cash checks or pay withdrawals from their ATMs. On a much broader scale, it follows that a central bank can vary the total face value of money by controlling the amount of the monetary base and by other less important means. The major problem of modern monetary policy centres on how a central bank should use this power.

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Money has an “internal” and “external” price. The internal price is the price level of domestic goods and services. The external price is the nominal, or market, exchange rate. The principal responsibility of a modern central bank differs according to the choice of monetary standard. If the country has a fixed exchange rate, the central bank buys or sells foreign exchange on demand to maintain stability in the rate. When sales by the central bank are too brisk, the growth of the monetary base decreases, the quantity of money and credit declines, and interest rates increase. The rise in interest rates attracts foreign investors and deters local investors from investing abroad. Also, the increase in interest rates slows domestic expansion and reduces upward pressure on domestic prices. On the other hand, when the central bank’s purchases are too brisk, money growth increases and interest rates fall, thereby inducing domestic expansion and stimulating an increase in prices.

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If a country has a floating exchange rate, it must choose a policy to go with the floating rate. At times in the past, many countries expected their central bank to pursue several different objectives. Eventually, countries recognized that this was an error because it focused the central bank on short-term goals at the expense of longer-term price stability. After high inflation in Europe and the United States in the 1970s and the hyperinflation (inflation exceeding 50 percent) in Latin America and Israel in the 1980s, many central banks and governments recognized an old truth: the main objective of a central bank under floating rates should be to stabilize domestic price levels, thereby maintaining the internal value of money.

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Increased awareness of this primary responsibility led to lower rates of inflation in the 1980s and ’90s, although central banks continued to be concerned about employment and recession in addition to price stability. Several adopted rules or procedures to control money growth by adjusting interest rates in response to both inflation and deviations in output from the long-term growth rate. Following the examples of New Zealand and Great Britain, several countries adopted inflation targets, typically based on time frames of one or two years, and then adjusted policy to reach these targets. Under the Maastricht Treaty of the European Union, the European Central Bank has a mandate to maintain price stability. The ECB has interpreted this mandate to mean inflation of 2 percent or less.

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How Central Banks can Increase or Decrease Money Supply:

Central banks use several different methods to increase or decrease the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board—commonly referred to as the Fed—could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used, at least not in the United States. The Federal Reserve Board, which is the governing body that manages the Federal Reserve System, oversees all domestic monetary policy. They are often referred to as the Central Bank of the United States. This means they are generally held responsible for controlling inflation and managing both short-term and long-term interest rates. They make these decisions to strengthen the economy, and controlling the money supply is an important tool they use. Central banks use several methods, called monetary policy, to increase or decrease the amount of money in the economy.

-1. Modifying Reserve Requirements

The Fed can influence the money supply by modifying reserve requirements, which generally refers to the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks’ reserve requirements, the Fed is able to decrease the size of the money supply.

-2. Changing Short-Term Interest Rates

The Fed can also alter the money supply by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed is able to effectively increase (or decrease) the liquidity of money.

While the Fed can directly influence a market rise, it is more commonly held accountable for market downturns than it is lauded for upswings.

Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, and so the Fed must be careful not to lower interest rates too much for too long.

In the period following the 2008 economic crisis, the European Central Bank kept interest rates either at zero or below zero for too long, and it negatively impacted their economies and their ability to grow in a healthy way. Although it did not bury any countries in economic disaster, it has been considered by many to be a model of what not to do after a large-scale economic downturn.

-3. Conducting Open Market Operations

Fed can affect the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply.

Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system. Adjusting the federal funds rate is a heavily anticipated economic event.

-4. Extraordinary crisis measures:

In response to the 2008 financial crisis, the Fed created new policy tools that can be grouped into three broad categories:

-Quantitative easing: when the Fed creates bank reserves by a large scale open market operation at a low or possibly zero interest rate in the federal funds market.

-Credit easing: when the Fed buys private securities or makes loans to financial institutions to stimulate their lending.

-Operation Twist: when the Fed sells short-term securities and buys long-term securities in an attempt to lower long-term interest rates and stimulate long-term borrowing and investment. 

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Money creation in the economy, the correct view:

In the modern economy, most money takes the form of deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial rate making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.  Back in the 1930s, Henry Ford is supposed to have remarked that it was a good thing that most Americans didn’t know how banking really works, because if they did, “there’d be a revolution before tomorrow morning”.  Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system

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Two misconceptions about money creation:

-1. The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money.

-2. Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the central bank. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the central bank.  

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Money creation in reality:

Lending creates deposits — broad money determination at the aggregate level:

Broad money is a measure of the total amount of money held by households and companies in the economy. Broad money is made up of bank deposits — which are essentially IOUs from commercial banks to households and companies — and currency — mostly IOUs from the central bank.  Of the two types of broad money, bank deposits make up the vast majority — 97% of the amount currently in circulation.  And in the modern economy, those bank deposits are mostly created by commercial banks themselves. In comparison, banknotes and coins only make up 3%.

Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans. 

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Figure below shows money creation by the aggregate banking sector making additional loans affecting balance sheets of various actors:

(b)Central bank balance sheet only shows base money liabilities and the corresponding assets. In practice the central bank holds other non-money liabilities. Its non-monetary assets are mostly made up of government debt. Although that government debt is actually held by the Bank of England Asset Purchase Facility, so does not appear directly on the balance sheet.

(c)Commercial banks’ balance sheets only show money assets and liabilities before any loans are made.

(d)Consumers represent the private sector of households and companies.  Balance sheet only shows broad money assets and corresponding liabilities — real assets such as the house being transacted are not shown. Consumers’ non-money liabilities include existing secured and unsecured loans.

Figure above shows how new lending affects the balance sheets of different sectors of the economy. As shown in the third row of figure above, the new deposits increase the assets of the consumer (here taken to represent households and companies) — the extra red bars — and the new loan increases their liabilities — the extra white bars. New broad money has been created. Similarly, both sides of the commercial banking sector’s balance sheet increase as new money and loans are created. It is important to note that although the simplified diagram of figure above shows the amount of new money created as being identical to the amount of new lending, in practice there will be several factors that may subsequently cause the amount of deposits to be different from the amount of lending.

While new broad money has been created on the consumer’s balance sheet, the first row of figure above shows that this is without — in the first instance, at least — any change in the amount of central bank money or ‘base money’. As discussed earlier, the higher stock of deposits may mean that banks want, or are required, to hold more central bank money in order to meet withdrawals by the public or make payments to other banks. And reserves are, in normal times, supplied ‘on demand’ by the central bank to commercial banks in exchange for other assets on their balance sheets. In no way does the aggregate quantity of reserves directly constrain the amount of bank lending or deposit creation.

This description of money creation contrasts with the notion that banks can only lend out pre-existing money. Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out. A related misconception is that banks can lend out their reserves. Reserves can only be lent between banks, since consumers do not have access to reserves accounts at the central bank.

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Other ways of creating and destroying deposits:

Just as taking out a new loan creates money; the repayment of bank loans destroys money. For example, suppose a consumer has spent money in the supermarket throughout the month by using a credit card. Each purchase made using the credit card will have increased the outstanding loans on the consumer’s balance sheet and the deposits on the supermarket’s balance sheet. If the consumer were then to pay their credit card bill in full at the end of the month, its bank would reduce the amount of deposits in the consumer’s account by the value of the credit card bill, thus destroying all of the newly created money.

Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy. But they are far from the only ways. Deposit creation or destruction will also occur any time the banking sector (including the central bank) buys or sells existing assets from or to consumers, or, more often, from companies or the government.

Banks buying and selling government bonds is one particularly important way in which the purchase or sale of existing assets by banks creates and destroys money. Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw currency in large amounts. When banks purchase government bonds from the non-bank private sector they credit the sellers with bank deposits. And, central bank asset purchases, known as quantitative easing (QE), have similar implications for money creation.

Money can also be destroyed through the issuance of long-term debt and equity instruments by banks. In addition to deposits, banks hold other liabilities on their balance sheets. Banks manage their liabilities to ensure that they have at least some capital and longer-term debt liabilities to mitigate certain risks and meet regulatory requirements. Because these ‘non-deposit’ liabilities represent longer-term investments in the banking system by households and companies, they cannot be exchanged for currency as easily as bank deposits, and therefore increase the resilience of the bank. When banks issue these longer-term debt and equity instruments to non-bank financial companies, those companies pay for them with bank deposits. That reduces the amount of deposit, or money, liabilities on the banking sector’s balance sheet and increases their non-deposit liabilities.

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Limits to broad money creation:

Although commercial banks create money through their lending behaviour, they cannot in practice do so without limit. In particular, the price of loans — that is, the interest rate (plus any fees) charged by banks — determines the amount that households and companies will want to borrow. A number of factors influence the price of new lending, not least the monetary policy of the central bank which affects the level of various interest rates in the economy.

The limits to money creation by the banking system were discussed in a paper by Nobel Prize winning economist James Tobin and this topic has recently been the subject of debate among a number of economic commentators and bloggers. In the modern economy there are three main sets of constraints that restrict the amount of money that banks can create.

(i)Banks themselves face limits on how much they can lend. In particular:

-Market forces constrain lending because individual banks have to be able to lend profitably in a competitive market.

-Lending is also constrained because banks have to take steps to mitigate the risks associated with making additional loans.

-Regulatory policy acts as a constraint on banks’ activities in order to mitigate a build-up of risks that could pose a threat to the stability of the financial system.

(ii)Money creation is also constrained by the behaviour of the money holders — households and businesses. Households and companies who receive the newly created money might respond by undertaking transactions that immediately destroy it, for example by repaying outstanding loans.

(iii)The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the central bank’s monetary policy affects how much households and companies want to borrow. This occurs both directly, through influencing the loan rates charged by banks, but also indirectly through the overall effect of monetary policy on economic activity in the economy. As a result, the central bank is able to ensure that money growth is consistent with its objective of low and stable inflation.

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So, this is the real position and role of banks:

To get a sense of how radical the Bank’s real position is, consider the conventional view, which continues to be the basis of all respectable debate on public policy. People put their money in banks. Banks then lend that money out at interest – either to consumers, or to entrepreneurs willing to invest it in some profitable enterprise. True, the fractional reserve system does allow banks to lend out considerably more than they hold in reserve, and true, if savings don’t suffice, private banks can seek to borrow more from the central bank.

The central bank can print as much money as it wishes. But it is also careful not to print too much. In fact, we are often told this is why independent central banks exist in the first place. If governments could print money themselves, they would surely put out too much of it, and the resulting inflation would throw the economy into chaos. Institutions such as the Bank of England or US Federal Reserve were created to carefully regulate the money supply to prevent inflation.

It’s this understanding that allows us to continue to talk about money as if it were a limited resource like bauxite or petroleum, to say “there’s just not enough money” to fund social programmes, to speak of the immorality of government debt or of public spending “crowding out” the private sector. The crowding-out effect is an economic theory that argues that rising public sector spending drives down private sector spending. The government can boost spending by doing two things: raising taxes or borrowing. Higher taxes mean consumers and companies have less left over to spend. When governments borrow, they compete with everybody else in the economy who wants to borrow the limited amount of savings available. As a result of this competition, the real interest rate increases and private investment decreases.

However, none of this is really true. Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits. In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

In other words, everything we know is not just wrong – it’s backwards. When banks make loans, they create money. This is because money is really just an IOU. The role of the central bank is to preside over a legal order that effectively grants banks the exclusive right to create IOUs of a certain kind, ones that the government will recognise as legal tender by its willingness to accept them in payment of taxes. There’s really no limit on how much banks could create, provided they can find someone willing to borrow it. They will never get caught short, for the simple reason that borrowers do not, generally speaking, take the cash and put it under their mattresses; ultimately, any money a bank loans out will just end up back in some bank again. So for the banking system as a whole, every loan just becomes another deposit. What’s more, insofar as banks do need to acquire funds from the central bank, they can borrow as much as they like; all the latter really does is set the rate of interest, the cost of money, not its quantity. Since the beginning of the recession, the US and British central banks have reduced that cost to almost nothing. In fact, with “quantitative easing” they’ve been effectively pumping as much money as they can into the banks, without producing any inflationary effects.

What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow. Government spending is the main driver in all this. So there’s no question of public spending “crowding out” private investment. It’s exactly the opposite.

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Section-7

Monetary and fiscal policy:   

When gold and silver are used as money, the money supply can grow only if the supply of these metals is increased by mining. This rate of increase will accelerate during periods of gold rushes and discoveries, such as when Columbus travelled to the New World and brought back gold and silver to Spain, or when gold was discovered in California in 1848. This causes inflation, as the value of gold goes down. However, if the rate of gold mining cannot keep up with the growth of the economy, gold becomes relatively more valuable, and prices (denominated in gold) will drop, causing deflation. Deflation was the more typical situation for over a century when gold and paper money backed by gold were used as money in the 18th and 19th centuries.

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Modern-day monetary systems are based on fiat money and are no longer tied to the value of gold. The control of the amount of money in the economy is known as monetary policy. Monetary policy is the process by which a government, central bank, or monetary authority manages the money supply to achieve specific goals. Usually, the goal of monetary policy is to accommodate economic growth in an environment of stable prices. For example, it is clearly stated in the Federal Reserve Act that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

A failed monetary policy can have significant detrimental effects on an economy and the society that depends on it. These include hyperinflation, stagflation, recession, high unemployment, shortages of imported goods, inability to export goods, and even total monetary collapse and the adoption of a much less efficient barter economy. This happened in Russia, for instance, after the fall of the Soviet Union.

In the US, the Federal Reserve is responsible for controlling the money supply, while in the Euro area the respective institution is the European Central Bank. Other central banks with a significant impact on global finances are the Bank of Japan, People’s Bank of China and the Bank of England. When money supply is high, it boosts consumer spending and investments, which in turn spurs the economy. Vice versa, when the money supply is low, consumer spending and investments fall and, in the long term, can result in a declining economy.

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Monetary policy is a tool implemented by the central bank to maintain economic stability and growth. One of the biggest challenges monetary policy seeks to tackle is inflation. When spending (demand) is abnormally high and supply remains constant, it artificially pushes up the equilibrium price. Too much inflation can spell disaster, because when the prices of goods increase but wages do not, it erodes the purchasing power of consumers and can quickly lead to decreased overall spending and an economic downturn. On the other hand, not enough inflation will result in a stagnant economy, or even worse, deflation will create a cycle of high unemployment and bankruptcies.

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Monetary policy is referred to as being either expansionary or contractionary.

Expansionary policy occurs when a monetary authority uses its procedures to stimulate the economy. An expansionary policy maintains short-term interest rates at a lower than usual rate or increases the total supply of money in the economy more rapidly than usual. It is traditionally used to try to reduce unemployment during a recession by decreasing interest rates in the hope that less expensive credit will entice businesses into borrowing more money and thereby expanding. This would increase aggregate demand (the overall demand for all goods and services in an economy), which would increase short-term growth as measured by increase of gross domestic product (GDP). Expansionary monetary policy, by increasing the amount of currency in circulation, usually diminishes the value of the currency relative to other currencies (the exchange rate), in which case foreign purchasers will be able to purchase more with their currency in the country with the devalued currency.

Contractionary policy maintains short-term interest rates greater than usual, slows the rate of growth of the money supply, or even decreases it to slow short-term economic growth and lessen inflation. Contractionary policy can result in increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession if implemented too vigorously.

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Goals of monetary policy:

The goals of monetary policy are to promote maximum employment, stable prices and moderate long-term interest rates. By implementing effective monetary policy, the Fed can maintain stable prices, thereby supporting conditions for long-term economic growth and maximum employment.

Tools of monetary policy:

The Federal Reserve’s three instruments of monetary policy are open market operations, the discount rate and reserve requirements. Open market operations involve the buying and selling of government securities. The term “open market” means that the Fed doesn’t decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an “open market” in which the various securities dealers that the Fed does business with – the primary dealers – compete on the basis of price. Open market operations are flexible, and thus, the most frequently used tool of monetary policy. The discount rate is the interest rate charged by Federal Reserve Banks to depository institutions on short-term loans. Reserve requirements are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank.

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Classical view of monetary policy:

The classical economists’ view of monetary policy is based on the quantity theory of money (vide supra). According to this theory, an increase (decrease) in the quantity of money leads to a proportional increase (decrease) in the price level. The quantity theory of money is usually discussed in terms of the equation of exchange, which is given by the expression.

MV = PQ

In this expression, P denotes the price level, and Q denotes the level of current real GDP. Hence, PQ represents current nominal GDP; M denotes the supply of money over which the Fed has some control; and V denotes the velocity of circulation, which is the average number of times a dollar is spent on final goods and services over the course of a year. The equation of exchange is an identity which states that the current market value of all final goods and services—nominal GDP—must equal the supply of money multiplied by the average number of times a dollar is used in transactions in a given year. The quantity theory of money requires two assumptions, which transform the equation of exchange from an identity to a theory of money and monetary policy.

The classical economists believe that the economy is always at or near the natural level of real GDP. Accordingly, classical economists assume that Q in the equation of exchange is fixed, at least in the short‐run. Furthermore, classical economists argue that the velocity of circulation of money tends to remain constant so that V can also be regarded as fixed. Assuming that both Q and V are fixed, it follows that if the Fed were to engage in expansionary (or contractionary) monetary policy, leading to an increase (or decrease) in M, the only effect would be to increase (or decrease) the price level, P, in direct proportion to the change in M. In other words, expansionary monetary policy can only lead to inflation, and contractionary monetary policy can only lead to deflation of the price level.

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Keynesian view of monetary policy:

Keynesians do not believe in the direct link between the supply of money and the price level that emerges from the classical quantity theory of money. They reject the notion that the economy is always at or near the natural level of real GDP so that Q in the equation of exchange can be regarded as fixed. They also reject the proposition that the velocity of circulation of money is constant and can cite evidence to support their case.

Keynesians do believe in an indirect link between the money supply and real GDP. They believe that expansionary monetary policy increases the supply of loanable funds available through the banking system, causing interest rates to fall. With lower interest rates, aggregate expenditures on investment and interest‐sensitive consumption goods usually increase, causing real GDP to rise. Hence, monetary policy can affect real GDP indirectly.

Keynesians, however, remain sceptical about the effectiveness of monetary policy. They point out that expansionary monetary policies that increase the reserves of the banking system need not lead to a multiple expansion of the money supply because banks can simply refuse to lend out their excess reserves. Furthermore, the lower interest rates that result from an expansionary monetary policy need not induce an increase in aggregate investment and consumption expenditures because firms’ and households’ demand for investment and consumption goods may not be sensitive to the lower interest rates. For these reasons, Keynesians tend to place less emphasis on the effectiveness of monetary policy and more emphasis on the effectiveness of fiscal policy, which they regard as having a more direct effect on real GDP.

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Monetarist view of monetary policy;

Since the 1950s, a new view of monetary policy, called monetarism, has emerged that disputes the Keynesian view that monetary policy is relatively ineffective. Adherents of monetarism, called monetarists, argue that the demand for money is stable and is not very sensitive to changes in the rate of interest. Hence, expansionary monetary policies only serve to create a surplus of money that households will quickly spend, thereby increasing aggregate demand. Unlike classical economists, monetarists acknowledge that the economy may not always be operating at the full employment level of real GDP. Thus, in the short‐run, monetarists argue that expansionary monetary policies may increase the level of real GDP by increasing aggregate demand. However, in the long‐run, when the economy is operating at the full employment level, monetarists argue that the classical quantity theory remains a good approximation of the link between the supply of money, the price level, and the real GDP—that is, in the long‐run, expansionary monetary policies only lead to inflation and do not affect the level of real GDP.

Monetarists are particularly concerned with the potential for abuse of monetary policy and destabilization of the price level. They often cite the contractionary monetary policies of the Fed during the Great Depression, policies that they blame for the tremendous deflation of that period. Monetarists believe that persistent inflations (or deflations) are purely monetary phenomena brought about by persistent expansionary (or contractionary) monetary policies. As a means of combating persistent periods of inflation or deflation, monetarists argue in favor of a fixed money supply rule. They believe that the Fed should conduct monetary policy so as to keep the growth rate of the money supply fixed at a rate that is equal to the real growth rate of the economy over time. Thus, monetarists believe that monetary policy should serve to accommodate increases in real GDP without causing either inflation or deflation.

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Monetary policy versus Fiscal policy:

The economic decisions of households can have a significant impact on an economy. For example, a decision on the part of households to consume more and to save less can lead to an increase in employment, investment, and ultimately profits. Equally, the investment decisions made by corporations can have an important impact on the real economy and on corporate profits. But individual corporations can rarely affect large economies on their own; the decisions of a single household concerning consumption will have a negligible impact on the wider economy.

By contrast, the decisions made by governments can have an enormous impact on even the largest and most developed of economies for two main reasons. First, the public sectors of most developed economies normally employ a significant proportion of the population, and they are usually responsible for a significant proportion of spending in an economy. Second, governments are also the largest borrowers in world debt markets.

Government policy is ultimately expressed through its borrowing and spending activities. There are two types of government policy that can affect the macroeconomy and financial markets: monetary policy and fiscal policy.

When it comes to regulating the economy, a country has two main levers it can pull: monetary policy and fiscal policy. While they might sound similar—both involve words that suggest money or finance—they’re quite different and are enacted by distinct sectors of the government. Monetary policy is controlled by the Federal Reserve (central bank of any country); fiscal policy, on the other hand, is driven by the U.S. government’s executive and the legislative branches (finance ministry of any country). Practically speaking, this means fiscal policy deals with taxation and government spending.  In contrast, monetary policy involves effecting change by manipulating the monetary supply.  

Monetary policy refers to central bank activities that are directed toward influencing the quantity of money and credit in an economy. By contrast, fiscal policy refers to the government’s decisions about taxation and spending. Both monetary and fiscal policies are used to regulate economic activity over time. They can be used to accelerate growth when an economy starts to slow or to moderate growth and activity when an economy starts to overheat. In addition, fiscal policy can be used to redistribute income and wealth.

The overarching goal of both monetary and fiscal policy is normally the creation of an economic environment where growth is stable and positive and inflation is stable and low. Crucially, the aim is therefore to steer the underlying economy so that it does not experience economic booms that may be followed by extended periods of low or negative growth and high levels of unemployment. In such a stable economic environment, householders can feel secure in their consumption and saving decisions, while corporations can concentrate on their investment decisions, on making their regular coupon payments to their bond holders and on making profits for their shareholders.

The challenges to achieving this overarching goal are many. Not only are economies frequently buffeted by shocks (such as oil price jumps), but some economists believe that natural cycles in the economy also exist. Moreover, there are plenty of examples from history where government policies—either monetary, fiscal, or both—have exacerbated an economic expansion that eventually led to damaging consequences for the real economy, for financial markets, and for investors.

The concept of money neutrality is usually interpreted as meaning that money cannot influence the real economy in the long run. However, by the setting of its policy rate, a central bank hopes to influence the real economy via the policy rate’s impact on other market interest rates, asset prices, the exchange rate, and the expectations of economic agents.

Inflation targeting is the most common monetary policy—although exchange rate targeting is also used, particularly in developing economies. Quantitative easing attempts to spur aggregate demand by drastically increasing the money supply.

Fiscal policy involves the use of government spending and revenue raising (taxation) to impact a number of aspects of the economy: the overall level of aggregate demand in an economy and hence the level of economic activity; the distribution of income and wealth among different segments of the population; and hence ultimately the allocation of resources between different sectors and economic agents.

The tools that governments use in implementing fiscal policy are related to the way in which they raise revenue and the different forms of expenditure. Governments usually raise money via a combination of direct and indirect taxes. Government expenditure can be current on goods and services or can take the form of capital expenditure, for example, on infrastructure projects.

As economic growth weakens, or when it is in recession, a government can enact an expansionary fiscal policy—for example, by raising expenditure without an offsetting increase in taxation. Conversely, by reducing expenditure and maintaining tax revenues, a contractionary policy might reduce economic activity. Fiscal policy can therefore play an important role in stabilizing an economy.

Although both fiscal and monetary policy can alter aggregate demand, they work through different channels, the policies are therefore not interchangeable, and they conceivably can work against one another unless the government and central bank coordinate their objectives.

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Fiscal Policy:

Fiscal policy is carried out by the legislative and/or the executive branches of government. The two main instruments of fiscal policy are government expenditures and taxes. The government collects taxes in order to finance expenditures on a number of public goods and services—for example, highways and national defense.

Budget deficits and surpluses:

When government expenditures exceed government tax revenues in a given year, the government is running a budget deficit for that year. The budget deficit, which is the difference between government expenditures and tax revenues, is financed by government borrowing; the government issues long‐term, interest‐bearing bonds and uses the proceeds to finance the deficit. The total stock of government bonds and interest payments outstanding, from both the present and the past, is known as the national debt. Thus, when the government finances a deficit by borrowing, it is adding to the national debt. When government expenditures are less than tax revenues in a given year, the government is running a budget surplus for that year. The budget surplus is the difference between tax revenues and government expenditures. The revenues from the budget surplus are typically used to reduce any existing national debt. In the case where government expenditures are exactly equal to tax revenues in a given year, the government is running a balanced budget for that year.

Expansionary and contractionary fiscal policy:

Expansionary fiscal policy is defined as an increase in government expenditures and/or a decrease in taxes that causes the government’s budget deficit to increase or its budget surplus to decrease. Contractionary fiscal policy is defined as a decrease in government expenditures and/or an increase in taxes that causes the government’s budget deficit to decrease or its budget surplus to increase.

Classical and Keynesian views of fiscal policy:

The belief that expansionary and contractionary fiscal policies can be used to influence macroeconomic performance is most closely associated with Keynes and his followers. The classical view of expansionary or contractionary fiscal policies is that such policies are unnecessary because there are market mechanisms—for example, the flexible adjustment of prices and wages—which serve to keep the economy at or near the natural level of real GDP at all times. Accordingly, classical economists believe that the government should run a balanced budget each and every year.

Combating a recession using expansionary fiscal policy:

Keynesian theories of output and employment were developed in the midst of the Great Depression of the 1930s, when unemployment rates in the U.S. and Europe exceeded 25% and the growth rate of real GDP declined steadily for most of the decade. Keynes and his followers believed that the way to combat the prevailing recessionary climate was not to wait for prices and wages to adjust but to engage in expansionary fiscal policy instead. According to the Keynesians, budget deficit by increasing government expenditures in excess of current tax receipts would increase government expenditures sufficiently to cause the aggregate demand curve to shift to the right restoring the economy to the natural level of real GDP. Any increase in autonomous aggregate expenditures, including government expenditures, has a multiplier effect on aggregate demand. Hence, the government needs only to increase its expenditures by a small amount to cause aggregate demand to increase by the amount necessary to achieve the natural level of real GDP. Keynesians argue that expansionary fiscal policy provides a quick way out of a recession and is to be preferred to waiting for wages and prices to adjust, which can take a long time. As Keynes once said, “In the long run, we are all dead.”

Combating inflation using contractionary fiscal policy:

Keynesians also argue that fiscal policy can be used to combat expected increases in the rate of inflation.  The government can head off this inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand. Again, the government needs only to decrease expenditures or increase taxes by a small amount because of the multiplier effects that such actions will have.

Secondary effects of fiscal policy:

Classical economists point out that the Keynesian view of the effectiveness of fiscal policy tends to ignore the secondary effects that fiscal policy can have on credit market conditions. When the government pursues an expansionary fiscal policy, it finances its deficit spending by borrowing funds from the nation’s credit market. Assuming that the money supply remains constant, the government’s borrowing of funds in the credit market tends to reduce the amount of funds available and thereby drives up interest rates. Higher interest rates, in turn, tend to reduce or “crowd out” aggregate investment expenditures and consumer expenditures that are sensitive to interest rates. Hence, the effectiveness of expansionary fiscal policy in stimulating aggregate demand will be mitigated to some degree by this crowding‐out effect.

The same holds true for contractionary fiscal policies designed to combat expected inflation. If the government reduces its expenditures and thereby reduces its borrowing, the supply of available funds in the credit market increases, causing the interest rate to fall. Aggregate demand increases as the private sector increases its investment and interest‐sensitive consumption expenditures. Hence, contractionary fiscal policy leads to a crowding‐in effect on the part of the private sector. This crowding‐in effect mitigates the effectiveness of the contractionary fiscal policy in counteracting rising aggregate demand and inflationary pressures.

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Section-8

Monetization and demonetization:

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Monetization:

The term monetization refers to the coining of currency or the printing of banknotes by central banks, although broadly speaking, monetization refers to process of converting something into money i.e., to convert an asset into money or a legal tender.

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Why poorer nations can’t just print more money and become rich?

When a whole country tries to get richer by printing more money, it rarely works. Because if everyone has more money, prices go up instead. And people find they need more and more money to buy the same amount of goods. This happened recently in Zimbabwe, in Africa, and in Venezuela, in South America, when these countries printed more money to try to make their economies grow. As the printing presses sped up, prices rose faster, until these countries started to suffer from something called “hyperinflation”. That’s when prices rise by an amazing amount in a year.

When Zimbabwe was hit by hyperinflation, in 2008, prices rose as much as 231,000,000% in a single year. Imagine, a sweet which cost one Zimbabwe dollar before the inflation would have cost 231m Zimbabwean dollars a year later. This amount of paper would probably be worth more than the banknotes printed on it.

To get richer, a country has to make and sell more things – whether goods or services. This makes it safe to print more money, so that people can buy those extra things. If a country prints more money without making more things, then prices just go up, and people will stop using that money. Instead, people will swap goods for other goods, or ask to be paid in US dollars instead. That’s what happened in Zimbabwe and Venezuela, and many other countries that were hit by hyperinflation. Venezuela tried to protect its people from hyperinflation by passing laws to keep a low price on things people need most, like food and medicines. But that just meant that the shops and pharmacies ran out of those things. Printing more money is exactly what Weimar Germany did in 1922. To meet Allied reparations, they printed more money; this caused the hyperinflation of the 1920s. The hyperinflation led to the collapse of the economy.

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Why can’t governments just print money in normal times to pay for their policies?

The short answer is inflation.

Historically, when countries have simply printed money it leads to periods of rising prices — there’s too many resources chasing too few goods. Often, this means every day goods become unaffordable for ordinary citizens as the wages they earn quickly become worthless.

Printing more money doesn’t increase economic output – it only increases the amount of cash circulating in the economy. If more money is printed, consumers are able to demand more goods, but if firms have still the same amount of goods, they will respond by putting up prices. In a simplified model, printing money will just cause inflation.

Figure below shows money-supply-inflation

Suppose an economy produces $10 million worth of goods; e.g. 1 million books at $10 each. At this time the money supply will be $10 million. If the government doubled the money supply, we would still have 1 million books, but people have more money. Demand for books would rise, and in response to higher demand, firms would push up prices. The most likely scenario is that if the money supply were doubled, we would have 1 million books sold at $20. The economy is now worth $20 million rather than $10 million. But, the number of goods is exactly the same.

We can say that the increase in GDP is a money illusion. – True you have more money, but if everything is more expensive, you are not any better off. In this simple model, printing more money has made goods more expensive, but hasn’t changed the quantity of goods. Doubling the money supply, whilst output stays the same, leads to a doubling in price and inflation rate of 100%

How long can a central bank continue inflation?  Probably as long as people are convinced that the government, sooner or later, but certainly not too late, will stop printing money. When people no longer believe this, when they realize that the policymakers will go on and on without any intention of stopping, then they begin to understand that prices tomorrow will be higher than they are today. Then they begin buying at any price, causing prices to go up to such heights that the monetary system breaks down—that is the process of hyperinflation.

In a nutshell:

If the Money Supply increases faster than real output then, ceteris paribus, inflation will occur.

If a country prints money and causes inflation, then, ceteris paribus, the currency will devalue against other currencies. For example, the hyperinflation in Germany of 1922-23, caused the German D-Mark to devalue against the currencies that didn’t have inflation. The reason is that with the German currency buying fewer goods, you need more German D-Marks to buy the same quantity of US goods.

Too little money makes prices fall, which is bad. But printing more money, when there isn’t more production, makes prices rise, which can be just as bad. No wonder economics – the study of money, trade and business – is often called the “dismal science”. 

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Printing money and national debt:

Governments borrow by selling government bonds/gilts to the private sector. Bonds are a form of saving. People buy government bonds because they assume a government bond is a safe investment. However, this assumes that inflation will remain low.

-If governments print money to pay off the national debt, inflation could rise. This increase in inflation would reduce the value of bonds.

-If inflation increases, people will not want to hold bonds because their value is falling. Therefore, the government will find it difficult to sell bonds to finance the national debt. They will have to pay higher interest rates to attract investors.

-If the government print too much money and inflation get out of hand, investors will not trust the government and it will be hard for the government to borrow anything at all.

-Therefore, printing money could create more problems than it solves.

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The above analysis is something of a simplification:

On the other hand, it’s not true that a country can never get richer by printing money. This can happen, if it doesn’t have enough money to start with. If there’s a shortage of money, businesses can’t sell enough, or pay all their workers. People can’t even borrow money from banks, because they don’t have enough either. In this case, printing more money lets people spend more, which lets companies produce more, so there are more things to buy as well as more money to buy them with. In 2008, there was the Global financial crisis, when banks lost a lot of money, and couldn’t let their customers have it. Luckily, most countries have central banks, which help to run the other banks, and they printed extra money to get their economies moving again.

Printing money doesn’t always cause inflation:

In a recession, with periods of deflation, it is possible to increase the money supply without causing inflation.

This is because the money supply depends not just on the monetary base, but also the velocity of circulation. For example, if there is a sharp fall in transactions (velocity of circulation) then it may be necessary to print money to avoid deflation. In the liquidity trap of 2008-2012, the Bank of England pursued quantitative easing (increasing the monetary base) but this only had a minimal impact on underlying inflation. This is because although banks saw an increase in their reserves, they were reluctant to increase bank lending. However, if a Central Bank pursued quantitative easing (increasing the money supply) during a normal period of economic activity then it would cause inflation.

Government can print more money to tide over a financial crisis. Deficit financing happens when governments spend more by borrowing or minting more money to increase liquidity in the economy. The government may use the acquired cash to revive the economy by investing and spending.

Crowding-in is a phenomenon that occurs when higher government spending leads to an increase in economic growth and therefore encourages firms to invest due to the presence of more profitable investment opportunities. The crowding-in effect is observed when there is an increase in private investment due to increased public investment, for example, through the construction or improvement of physical infrastructures such as roads, highways, water and sanitation, ports, airports, railways, etc.

It may also be done by direct cash transfers to the poor who will then spend it, that will shoot up the demand, possibly increase the economic output, may reduce inflation and will definitely increase overall purchasing power. Although, for this to work, it absolutely is important that money pumped into the economy goes to those who need it and not those who already have a higher purchasing power.

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Modern monetary theory (MMT) supports money printing to finance expenditure:

Modern Monetary Theory (MMT) is an economic theory that suggests that the government could simply create more money without consequence as it’s the issuer of the currency. As part of this theory, the thinking is that government deficits and national debt don’t matter nearly as much as we think they do. Instead of relying on tax revenue or borrowing to support federal government spending, according to MMT supporters, the government can simply create more money instead. This is a big departure from how many economists think about government spending. The whole idea of MMT is that since a sovereign entity can borrow in its own currency, it can print more money when it needs to pay off all its debt. The central bank just needs to keep interest rates low. MMT is essentially a paradigm shift when it comes to economic theory and a new way of thinking about governments with fiat currencies. In essence, governments like the US, Japan, UK, and Canada that use fiat currencies are not constrained by their tax revenues when it comes to government spending and can perpetually run a budget deficit. This is due to the fact that the central banks in these counties have a monopoly on the supply of money.

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The main tenets of Modern Monetary Theory are:

-1. Government deficits aren’t inherently bad. According to the MMT theory, deficits don’t matter as much as we think they do and aren’t necessarily a signal of a shaky economy. If the government can simply create more money, then the government deficits can be easily fixed. This concept is a hallmark of MMT and one of the most controversial aspects of the theory.

-2. Governments can create more money without threat of economic collapse. Given the fact that money is no longer backed by gold and is more theoretical in the sense it can be created at any time, many MMT supporters believe that money can be created without tanking the economy. In 2005, former Federal Reserve Chairman, Alan Greenspan, followed that line of thought: “There’s nothing to prevent the federal government creating as much money as it wants.”

-3. Because the government is the creator of the currency, it doesn’t need to adhere to the same individual budgeting principles. As individuals we know that our expenses shouldn’t exceed our income or it’ll lead to debt. Proponents of MMT say that the government doesn’t need to abide by such standards since it’s also the creator of the money and theoretically can create more.

-4. A federal jobs guarantee program is possible. Again, given the core tenet that the government can create more money, MMT theorists support the idea of a federal job guarantee as a way to stabilize the economy and put money toward human capital.

-5. The Federal Interest rate should be at 0%. Many MMT supporters believe that the “natural rate of interest is zero” and there should be no bond sales. On top of that, MMT supporters want to do away with the increasing and lowering of interest rates as they’re ultimately not that relevant when it comes to growth and long-term business decisions.

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Table below summarises the main contrasts between MMT’s approach and mainstream economics.
What MMT deems wrong and right: 

	Wrong	Right
Explicitly
Govern­ment expen­diture is financed by…	taxes	issuing currency
Public debt sustain­ability…	can be an issue	cannot be an issue
Public bonds are issued…	to finance the public deficit	to distribute income as part of an interest rate main­tenance strategy
Access of govern­ment to central bank financing…	should be limited	is unlimited
Public debt pur­chased by the central bank…	should be paid off	is paid off
Crowding out…	can be an issue	cannot be an issue
Monetary policy…	has a role to play to stabilise the economy	has no role to play to stabilise the economy
Interest rates…	are a market variable	are set by the govern­ment
Inflation…	is a monetary policy issue	is a fiscal policy issue
Un­employment…	cannot be fully eliminated	can be fully eliminated
Conven­tional structural policies…	are positive	are negative
A sovereign economy…	should be competitive	does not have to be competitive
Skills…	are important determi­nants of income	are loosely linked to income
Social welfare…	has a cost	has no cost
Implicitly
Currency…	is both an asset and a liability	is an asset “manufactured” ad libitum by the state
Currency compe­tition…	exists	does not exist
Incentives and expec­tations…	play an major role in economic dynamics	play a minor role in economic dynamics
Competi­tion in the goods and services markets…	exists and is useful	can be ignored
Climate change…	can be address­ed primarily by setting a social price of carbon	necessitates primarily public investment

As Hartley (2020) notes, MMT “is not a falsifiable scientific theory: it is rather a political and moral statement by those who believe in the righteousness – and affordability – of unlimited government spending to achieve progressive ends”. Its meaning is more that of a political manifesto than of a genuine economic theory.

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Fundamentally, MMT argues the following three things:

-1. Sovereign currency-issuing governments are financially unconstrained;

-2. Taxes are not needed to finance government spending; and

-3. The role of taxes is to drain money out of the economy after the government has spent it, in order to manage aggregate demand and keep it in line with the available supply of resources.

In short, MMT says that a government can finance any budget deficit by de facto monetization and hence have no monetary limits. When a genuine national emergency arises, the government spends first, the central bank helps, and questions are asked later. MMT merely points out we don’t have to wait for genuine emergency to act in this manner. Modern Monetary Theory (MMT) proponents claim that money printing is s a useful economic tool, while disputing claims that it leads to currency devaluation, inflation, and economic chaos. MMT posits that governments, unlike regular households, should not tighten their purse strings to tackle an underperforming economy. Instead, it encourages them to spend freely, running up a deficit to fix a nation’s problems.

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How does MMT work?

MMT seems to generate some consternation among economists, and indeed people in general. They seem unable to grasp that governments, unlike households or businesses, are not balance-sheet constrained. They can just print money; there is a magic money tree (which has the initials MMT, of course!). Indeed, the mechanism by which MMT works is very simple (see figure below).

The government spends money into the economy – which in a sovereign-currency issuer comes before taxation. If there is not enough tax to cover the required spending (either because the economy is weak or because the government does not want to tax too much), then bonds are issued to make up the difference. This is the same as in normal economic ‘theory’. All that then changes is that the central bank either buys the bonds directly from the government (which is debt monetization), or if private banks buy the bonds it buys them from that secondary market. The latter is what we already see in QE – unless one believes that central banks will start running down their balance sheets again. Once the government has spent the money, the normal ‘money-multiplier’ effect works. Of course, in an economy that requires the government to take a radical step like embracing MMT, the likelihood is that banks will not be willing to lend freely. In which case, the argument is for more MMT, not less.

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It is important to understand that every country has three key surpluses/deficits accounting identities that interact in this regard:

• There is the fiscal/public-sector balance which is, of course, central to the MMT argument. MMT requires that a country runs a large fiscal deficit, which the central bank finances;
• There is the private-sector balance, which represents the sum of the household balance (saving/dis-saving) and the business sector balance (saving/dis-saving); and
• There is the current-account/external balance, which is always the sum of the public and the private-sector balances. For example, if the fiscal balance is -5% of GDP and the private-sector balance is -4% (households and businesses both -2%) then the country’s external balance with the rest of the world must be -9% of GDP (-5% and -4%).

This is of crucial importance to MMT because in order to have the power to create money domestically and to have it accepted on a stable basis internationally, a government needs to maintain a current-account surplus as seen in the figure below:

That does not mean that everything goes wrong immediately after a country embraces central-bank deficit financing. There is always a lag, similar to an eventual inflationary impact of a demand shift when supply is fixed. However, serious problems will still emerge over time.

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Current account deficit countries:

If you try MMT with a current-account deficit, in most cases it will not end well. After all, what you are seeing is government spending – with printed money – to such an extent that the overall economy is dis-saving (see figure below): the fiscal balance (in our example -5%) does not see an off-setting private sector surplus, but a deficit of -4%, meaning that the country is running a large external deficit.

Figure below shows current account deficit: big problem:

Perhaps inflation will already be too high in this case, as demand is clearly running ahead of supply, which will undermine the exchange rate. Yet even if inflation stays low, when the private sector is borrowing from the rest of the world (4% of GDP here) it is doing so with an excess supply of local currency due to money printing. The exchange rate will again depreciate – and in time lead to imported inflation if nothing else. In traditional economic theory, at this point interest rates should rise to compensate: but under MMT, interest rates are artificially depressed by central-bank bond buying so only the foreign exchange rates moves.

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Current-account surplus countries:

If a country runs a large fiscal deficit (-12% of GDP, for example), but runs huge household and business surpluses (for example, a private sector surplus of 14% of GDP in total), then internationally the country is a net lender not a borrower. So it can keep control of both (low) interest rates—as long as it faces no inflation problems domestically—and the exchange rate (see figure below).

Figure below shows current account surplus: no problem:

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Only those countries where economies consistently run a fiscal deficit and a current account surplus and are well-governed are strong enough for the MMT treatment. Only six in fact: Japan, Malaysia, China, Thailand, Uruguay, Israel (shown as the green countries in figure below). The Eurozone also could – but it chooses not to. The US could also adopt MMT.

Even though above mentioned six countries meet economic criteria, they still may not present as obvious candidates for MMT in terms of overall institutional quality given the heavy burdens involved. One could also question whether they can sustain a current account surplus if their fiscal deficits widen too far, too fast. Even assuming that these candidates are all viable, what does this show us? China, Japan, and the US collectively constitute 38% of world GDP, all of the other listed economies are relatively small. Asia is well represented, Africa has only one candidate, as does Latin America, and Europe has none, albeit this is a self-imposed political choice. Overall, this analysis does not suggest that the world can rely on MMT, despite the current hype about it.

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MMT advocates that there are real-world limitations on what any government can do. The government of a country can always spend a vast amount of printed money – and it can create huge inflation as a result. Indeed, turning on the taps after turning them off is the hard part – which is why nobody has done it in the recent past. Because of this fear, there are political limits to what a government can do: deficit spending past a certain level is prohibited in certain countries, no matter how it is financed. The government voluntarily accepts such limits on its power, or other pressure groups force it to. The Eurozone is obviously a key example of this self-imposed fiscal limitation.

Moreover, the government of a country with no natural resources, no industrial muscle, and no human capital cannot just print money to generate prosperity, even if there is local consensus. It has the power domestically to do that if it chooses, but it does not have the power internationally to force other countries to accept the newly-minted money, backed by no real economic value, in exchange for the goods and services, machinery and talent that it requires for development. The results are, again, usually inflation and huge economic problems, not solutions.

Indeed, consider the states that have tried MMT – and the results: Argentina – and hyper-inflation; Brazil – and hyper-inflation; Weimar Germany – and hyper-inflation (a case study most contemporary economists are aware of); and Zimbabwe – and hyper-inflation.

Present Sri Lankan economic crisis is mainly due to tax cuts and money creation. The Government of Sri Lanka made large tax cuts that affected government revenue and fiscal policies, causing budget deficits to soar. To cover government spending, the Central Bank began printing money in record amounts ignoring advice from the International Monetary Fund (IMF) to stop printing money and instead hike interest rates and raise taxes while cutting spending. The IMF warned that continuing to print money would lead to an economic implosion. It has led to unprecedented levels of inflation, near-depletion of foreign exchange reserves, shortages of medical supplies and an increase in prices of basic commodities.  

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Should Governments print Money to make it through the Pandemic?

The periodic lockdowns due to the Covid-19 pandemic since March of 2020 have taken a toll on several sectors. The promising signs of economic recovery after the first wave ran into a brutal second wave and a fresh round of curbs. As a result, there have been a raft of downgrades in growth estimates. Economists estimate that the coronavirus recession will cost the world’s governments more than $11 trillion. Central banks should consider bona fide debt monetization—money-printing—to help their governments cover some of those costs. Debt monetization or monetary financing is the practice of a government borrowing money from the central bank to finance public spending instead of selling bonds to private investors or raising taxes. The central banks who buy government debt, are essentially creating new money in the process to do so.  There have been calls from sections of India Inc for a large fiscal stimulus, including printing money, to nurse the economy back to health and help sectors flattened by the virus.

Monetisation is the third unconventional alternative for governments to raise funds other than borrowing and raising revenue through tax and divestment. Monetisation occurs when the central bank buys bonds directly from the government (debt monetization). It is called ‘money printing’ as new money is created (not necessarily banknotes) without a corresponding increase in real GDP. Governments often turn to printing money in order to increase the amount of cash or liquidity in the economy. The central bank buys bonds or other assets from the private sectors in exchange for reserves and account balances to print more money. Traditionally, printing money drives the demand for goods and services higher, in turn causing inflation. Hence the amount of money in circulation has to be in line with the economic output being produced by the country. 

Why are people calling for it?  

A huge economic stimulus & relief programme is required to combat the damage done by Covid. Since there is severe distress and destruction of demand, distributing money can alleviate pain. Monetisation is getting support because only the government is in a position to bring relief to distressed citizens & small businesses, but it does not have any room to raise funds. India is currently a ‘demand constrained’ economy, which means the factories in the country are producing below capacity, as the consumers do not have purchasing power in the wake of job losses and shutting down of business during the pandemic. But if more money is printed, it will stimulate demand, increase output, reduce inflation and also increase the purchasing power of consumers.

Who is supporting monetisation?

Even before the pandemic there has been a lot of debate on modern monetary theory (MMT), particularly in the US where it gained support among Left-leaning politicians. Proponents of MMT argue for expansionary fiscal policy, by monetising the deficit, until the economy reaches full employment. India has in the past used deficit financing when it had no other source of funds. Modern Monetary Theory (MMT) argues that the government can solve economic problems by printing money until it causes inflation, at which time taxes need to increase to rein in that money.

What are the risks?

Deficit financing leads to runaway inflation and risks loss of faith among foreign investors. Besides providing temporary relief, deficit financing is advocated to enable households and businesses get out of their funk, but if it gets out of hand it could lead to financial instability as seen in Zimbabwe and Venezuela. The central bank can directly print money and finance the government, but it should avoid doing so unless there is absolutely no alternative. For sure, there are times when monetisation despite its costs – becomes inevitable such as when the government cannot finance its deficit at reasonable rates.

Monetization only works if there is a respected and responsible central bank ready to turn off the taps when inflation threatens to exceed its targets and a responsible government.

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Demonetization:  

Demonetization is the act of stripping a currency unit of its status as legal tender. It occurs whenever there is a change in national currency. The current form or forms of money is pulled from circulation and retired, often to be replaced with new notes or coins. Sometimes, a country completely replaces the old currency with a new currency. The opposite of demonetization is remonetisation, in which a form of payment is restored as legal tender.

Removing the legal tender status of a unit of currency is a drastic intervention into an economy because it directly affects the medium of exchange used in all economic transactions. It can help stabilize existing problems, or it can cause chaos in an economy, especially if undertaken suddenly or without warning. That said, demonetization is undertaken by nations for a number of reasons. Demonetization has been used to stabilize the value of a currency or combat inflation. Some countries have demonetized currencies in order to facilitate trade or form currency unions. Lastly, demonetization has been tried as a tool to modernize a cash-dependent developing economy and to combat corruption and crime (counterfeiting, tax evasion). Governments of many countries across the world have taken this drastic measure to curb black money and stop the counterfeiting of currency notes. Some countries failed miserably while others were successful in their goals behind demonetization.

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The main benefit of demonetization is to curtail criminal activity as their supply of money is no longer legal tender. This affects counterfeiters as well as they cannot exchange their “merchandise” for fear of discovery. It can prevent tax evasion as those who were evading taxes must come forward to exchange their existing currency at which time the authorities can retroactively tax them. Finally, it can usher in the digital currency age by slowing down the circulation of physical currency.

The chief disadvantage is the costs involved in printing and minting the new currency. Also, demonetization may not have the intended effect of reducing criminal activity as these entities might be savvy enough to hold assets in other forms other than physical currency. Finally, this process is risky as it can plunge the nation into utter chaos if not handled with the utmost of competence.

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Demonetization has been used to stabilize the value of a currency or combat inflation. The Coinage Act of 1873 demonetized silver as the legal tender of the United States, in favor of fully adopting the gold standard, in order to stave off disruptive inflation as large new silver deposits were discovered in the American West. Several coins, including a two-cent piece, three-cent piece, and half-dime were discontinued. The withdrawal of silver from the economy resulted in a contraction of the money supply, which contributed to a recession throughout the country. In response to the recession and political pressure from farmers and from silver miners and refiners, the Bland-Allison Act remonetized silver as legal tender in 1878.

In a more modern example, the Zimbabwean government demonetized its dollar in 2015 as a way to combat the country’s hyperinflation, which was recorded at annualized rates of up to 231,000,000%. The three-month process involved expunging the Zimbabwean dollar from the country’s financial system and solidifying the U.S. dollar, the Botswana pula, and the South African rand as the country’s legal tender in a bid to stabilize the economy.

Some countries have demonetized currencies in order to facilitate trade or form currency unions. An example of demonetization for trade purposes occurred when the nations of the European Union officially began to use the euro as their everyday currencies in 2002. When the physical euro bills and coins were introduced, the old national currencies, such as the German mark, the French franc, and the Italian lira were demonetized. However, these varied currencies remained convertible into Euros at fixed exchange rates for a while to assure a smooth transition.

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Demonetization Example in India: 

Demonetization has been tried as a tool to modernize a cash-dependent developing economy and to combat corruption and crime (counterfeiting, tax evasion). In 2016, the Indian government decided to demonetize the 500- and 1000- rupee notes, the two biggest denominations in its currency system; these notes accounted for 86% of the country’s circulating cash. India’s Prime Minister announced to the citizenry on Nov. 8, 2016, that those notes were worthless, effective immediately—and they had until the end of the year to deposit or exchange them for newly introduced 2000 rupee and 500 rupee bills.

Chaos ensued in the cash-dependent economy (some 78% of all Indian customer transactions are in cash), as long, snaking lines formed outside ATMs and banks, which had to shut down for a day. The new rupee notes have different specifications, including size and thickness, requiring re-calibration of ATMs: only 60% of the country’s 200,000 ATMs were operational. Even those dispensing bills of lower denominations faced shortages. The government’s restriction on daily withdrawal amounts added to the misery, though a waiver on transaction fees did help a bit. Severe cash shortages were recurring even through 2018.

Small businesses and households struggled to find cash and reports of daily wage workers not receiving their dues surfaced. The rupee fell sharply against the dollar.

The government’s goal (and rationale for the abrupt announcement) was to combat India’s thriving underground economy on several fronts: eradicate counterfeit currency, fight tax evasion (only 6% of the population pays taxes in 2021), eliminate black money gained from money laundering, and terrorist financing activities, and to promote a cashless economy. Individuals and entities with huge sums of black money gotten from parallel cash systems were forced to take their large-denomination notes to a bank, which was by law required to acquire tax information on them. If the owner could not provide proof of making any tax payments on the cash, a penalty of 200% of the owed amount was imposed. The move also saw a significant increase in digital and cashless transactions throughout the country.

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Failure of Indian demonetization:

When a currency note of a particular denomination ceases to be legal tender, the central bank’s liabilities are reduced to that extent and also the amount of currency in circulation declines. On November 8, 2016 Government of India made Rs. 500 and Rs. 1000 notes invalid. This meant that Rs. 15.41 lakh crore worth of high-value legal tender was withdrawn from circulation. So, the entire liability of Rs. 15.41 lakh crore due to Rs.500 and Rs.1000 notes in circulation was nullified. If there was a lot of black money in the country, and people choose not to declare and surrender their high-denomination currency notes, then RBI would have gained to the extent that its currency liabilities are lowered. The gains it makes in the process could have been transferred to its reserves and then appropriated in its profit and loss account. This would have given it leeway to transfer higher amounts as dividends to the government.

However, this scenario didn’t happen. The RBI report after demonetisation had mentioned that 99.3% of all demonetised currency returned to the banking system. The figure was 15.31 lakh crore. As 15.31 lakh crore again became part of the RBI, now the net-liability of RBI = Rs.15.41 lakh crore – Rs.15.31 lakh crore = Rs.0.10 lakh crore. This figure (Rs. 10000 crore) was only a nominal reduction in liability, offset by printing and transportation cost of the new currency, which led many experts to point out that the demonetisation experiment was a failure to curb black money.

In 2012, the Central Board of Direct Taxes recommended against demonetisation, saying in a report that “demonetisation may not be a solution for tackling black money or shadow economy, which is largely held in the form of benami properties, bullion and jewellery.” According to data from income tax probes, black money holders kept only 6% or less of their wealth as cash, suggesting that targeting this cash would not be a successful strategy. Such a measure would only increase the cost as more currency notes which have to be printed. It could also harm the banking logistics.

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The announcement of demonetisation was followed by prolonged cash shortages in the weeks that followed, which created significant disruption throughout the economy. People seeking to exchange their banknotes had to stand in lengthy queues, and several deaths were linked to the rush to exchange cash. Over 100 lives were lost. The move reduced the country’s industrial production and its GDP growth rate. Indian economy lost 1.5% of GDP in terms of growth. That alone was a loss of Rs 2.25 lakh crore a year.  It is estimated that 1.5 million jobs were lost. Thousands of SME units were shut down. The cost to the people was high, and India lost about a year of economic growth. And to solve the jobs problem of India you need to grow at about 8% for about 20 years.  

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Section-9

Money vis-à-vis personality, society and culture:

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Money and Personality:

Money changes your personality:

Whether you have it or not, it’s hard to get away from the influence of money. Your education, your profession, your partner, and your health are all directly influenced by it. People care about what money does to our society, and what money and position does to individuals. Wealth creates these persistent social contexts that you live in throughout your life. Having money gives you more autonomy and control over your own life. Wealthy people tend to be more narcissistic and think they’re more able and skilled than the average person. Wealth can also make you selfish and unethical. Wealthy people may justify pursuing wealth as a good thing, and craft narratives of “pulling themselves up by their bootstraps,” even if they were born into privilege.  If someone isn’t wealthy, a wealthy person’s logic goes, it’s because they lack the talent or the drive to reach the same level.  Studies show that wealthy people are less good at reading others’ emotions, even though they might think they are.  Less wealthy people, conversely, have less control over their environments and have been found to be more empathetic, compassionate, and generous to others. This might be because, in lieu of wealth that would make them autonomous, they have to rely on one another to ensure that their needs are met. Also, poor people may need to be more vigilant to their environment if it’s not safe. Greater concern for others means the poor give a larger proportion of their wealth to charity. Poor people also don’t perform as well on cognitive tests, possibly because poverty-related concerns consume mental resources, leaving less for other tasks.  Money problems are also a key driver for divorce, and financial strain pushes couples away from reconciliation.

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Money personality:

We often stress about the importance of financial literacy, such as gaining a strong understanding of how money works and having the resources to make informed decisions. But when it comes to establishing financial health, one thing most people fail to consider is their money personality type — or their approach and emotional responses to money. We each have our own beliefs and emotions about money, and they are mostly shaped by our individual life experiences (e.g., passed down from our parents or influenced by our current situations). There are several money personality types, says psychology experts—how to tell which one you are is depicted in the figure below.

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Money and society: 

People often say that they can live without money. They define money as just one of the tools that enhances peoples living environment. However, in real life money is a very important matter in peoples lives. Although the people in history might have lived through the exchange of goods and not relying to the value of money itself, modern society today could not function without money. Money plays a huge role in the society in variety of ways such as in business, at peoples job, and even in education. Money helps people achieve a better quality of education, larger chance of business success, and higher work output. People value education highly in their lives and a quality education is dependent on the amount of money spent on this type of investment. The high quality of education brings oneself a higher possibility to succeed in the future society. Money also plays a significant role in worldwide business. In the business world, most interactions that people have involve a huge amount of money. One common example of a worldwide business is investment. In the field of investment, people put a lot of their money into a particular market and as the market gets bigger and builds a higher reputation, the worth of money invested grows larger. The money they gain from the investment is usually used to build up new business or even to invest in different markets. Money also affects quality of living. People who can earn their livings mostly live a life filled with what they want to have. They eat nutritious food which helps sustain body health and use cars to transport them to wherever they want to go. On the other hand, people who do not have a job and earn nothing often have hard times sustaining their life. They have nothing to support their health. They also do not have a permanent shelter where they could rest on. These people could not live properly because they could not afford any of it. These illustrate a contrasting example of people who earn wages and who do not. Wages are a hugely significant matter for one to maintain certain quality of life. Therefore, the importance of money in society cannot be doubted.

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Teach your kids the value of money:

By age 3, your kids can grasp basic money concepts. By age 7, many of their money habits are already set. That doesn’t mean you throw in the towel after first grade. Start wringing money lessons out of everyday life. One individual was in the market for a new car. He worried when his 10-year-old daughter asked to tag along — he didn’t want her to get the mistaken impression that they were rich just because he was shopping for such a big-ticket item. It turned out to be the best learning experience she could get. Car shopping offered the perfect excuse to discuss smart ways to save, how to see through clever marketing, how to negotiate prices, and how to avoid the pitfalls of loans. These are lessons that have a real impact on kids. Teach your kids the value of money. Start talking about money values. The same way you’d teach your kid to tell the truth or be kind to others, make sure they know what matters to your family when it comes to money. Yes, we could afford fancy jeans, but they’re not a priority for us. When it comes to day-to-day lessons, the best way to teach your kids the value of a dollar is to give them actual dollars. Use cash with your kids. Cash tells kids that money is finite, unlike plastic. A famous study out of MIT showed that people will spend twice as much money on the same item when they pay with credit cards instead of cash. While plastic can seem like play money, cash feels all too real. Always remember, you’re the parent. You set the rules. And the rules will determine how your kid values money in the future.

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Marry for money:

As unique and diverse as individuals are, so too are marriages. When you marry someone, it may often be viewed as a one-size-fits-all arrangement, complete with love, romance, a shared life. However, all relationships have different dynamics. One type of conscious coupling may involve the goal to marry rich or marry a millionaire.  As taboo as the idea of marrying for money may seem, unions based on financial connections have taken place throughout history. Kings and queens often united for the sole purpose of bringing their kingdoms together. A woman was often seen as “marriage-material” based on her dowry, the amount of money or property she (or her family) brought to the marriage. Even Jane Austen’s character Elizabeth Bennet, from the classic Pride and Prejudice, describes the turning point of falling in love with her beau when she visited his sizeable estate. But being drawn to his fancy estate, it turns out, was symbolic of having her heart won by a person she loved, not simply an attraction to being rich and fancy.  In Elizabeth Bennet’s 18th century, when women didn’t have today’s work opportunities, “marrying well” may have given wives a sense of financial security. Fast forward to the 21st century. Now, when women and men can both be employed, they can be financially independent and might not feel compelled to depend on anyone else for economic support. But does that mean it’s wrong to want a financially beneficial marriage? Not necessarily, but while financial stability is linked to emotional wellness, marrying for wealth alone may lead to emotional bankruptcy. Marrying just for money will likely not result in greater happiness for an individual or a couple. While financial stability can be good for mental health and, conversely, financial stress has negative impacts on well-being, there is virtually no indication that happiness and happy marriages come from financial wealth alone. If you don’t have a good connection with your spouse, you will likely feel less happy and less fulfilled, regardless of having the freedom to spend, buy, and save what you want.  

On the other hand, money is not the only deciding factor in pairing up but sense of financial stability can help with well-being and life satisfaction. For most of us, love transcends money. But we humans have the capacity to fall in love with lots of people. And there’s no shame in targeting your swooning on someone who can provide you with a higher standard of living. Put it this way: If two people are the same in most respects, except one earns twice as much as the other, don’t flip a coin. Go for the higher earner, and yes, marry for money. You won’t be the first to play the oldest financial trick in the book.   

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How governments control media using money:  

Governments often use funding mechanisms to control media, particularly to stifle critical journalism and advance the government agenda and the interests of its allies and supporters, either political groups or businesses. The media industry is in bad nick after nearly a decade of economic crises. Some media, particularly outlets focusing on tabloid fare and fast in adapting to digital channels, have gradually recovered. Others, launched with hefty investments, are thriving. But media outlets doing solely independent journalism, especially those serving audiences outside the Western world, have either succumbed to financial crises or are hardly surviving. Government is playing a major role in this problem by unfairly distributing public funding directly and indirectly, to capture the media. The phenomenon is widespread globally. An Open Society Foundations (OSF) study found that in 31 out of 55 countries worldwide, the government used state funding to manipulate media. In nine of them, there was no hard evidence showing that this was happening but that did not rule out government manipulation (Dragomir and Thompson, 2014). In particular, media outlets in countries from Eastern Europe, former Soviet Union, and the Middle East are the most affected by discriminatory use of public funds. But examples of countries where this is happening such as Argentina, Colombia, and Peru in South America, Guatemala and Nicaragua in Central America, and Indonesia and Malaysia in Asia indicate that the phenomenon has a much broader scope. Hard evidence on the use of public funding to capture media is thin in Africa mostly because it is hard to collect such information. But biased editorial coverage toward government-friendly media and lack of transparency of funding in media outlets give credence to suspicions that this is happening there as well (Dragomir and Thompson, 2014).

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Traditional Indian media is dependent on the Central government for several things. For instance, the central government spends Rs 1,200 crore per year (Rs 100 crore per month) on advertising. The Central Public Sector Units spend another Rs 1000 crore or so. So roughly about Rs 200 crore of money is given to media each month, an enormous sum which comes at a price. The various state governments and their budgets are separate from this. Then there are other things, such as licenses for TV stations, free or subsidised land allotment and customs and import duties on machinery and newsprint (the paper that newspapers are made of). Then there are the various ’summits’ that big media houses hold where they invite the prime minister and various ministers to attend and speak. When the PM is displeased with a headline or story, he has in the past cancelled his presence, leading other ministers to also cancel and leading event sponsors to complain that they did not get the full value of their sponsorship. All these make the traditional media vulnerable to government pressure in India.   

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Government-funded broadcasting such as Australian Broadcasting Corporation (ABC), the BBC in the United Kingdom or the Finnish Yle are held up around the world as models of impartial and balanced reporting and high-quality programming. Many transition countries have sought to emulate such models. But in too many countries, particularly in Eastern Europe or in countries with polarized political climates, governments have used funding as a way of ‘capturing’ the media and making it subservient to state aims. That was mainly the result of failed transitions to democracy.

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Regulation, legislation, physical attacks, and threats against journalists or media owners are effective methods used to capture the media. But funding is arguably the most effective method of all. By financing media and journalists willing to toe the government line and by not funding independent, critical media, authorities manage to suppress large parts of the media sector. In some countries, the entire media industry is controlled by governments, directly or indirectly.

There are four main categories of financial strategies and tactics that authorities use to dominate the media sector:

-1. Public funding for state-administered media;

-2. State (or official or public) advertising;

-3. State subsidies;

-4. Market-disruption measures.

The first three types of financial stratagems are in essence forms of direct funding. The last category encompasses strategies, financial in nature, aimed at distorting the market logic, hurting the financial health of unaligned, critical media or bankrolling media that are chummy with governments.

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Money and culture:

Why cultures are different can be examined through the multifaceted lens of their currencies, their economic policies, and the very foundations of how money works. Anyone who has traveled abroad immediately senses the cultural differences, even before learning about the language, politics, or history of the people. The tourist is promptly faced with strangely priced goods and services, an unknown currency of dubious value, and an alien system of payment, trade, and exchange. An investigation into the origins and evolution of money explains much about the behavior of people and their culture.

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The collection of coins and money often begins with an inquiry into the history of a currency and other payment media used to resolve debts and exchange goods. Coin collecting can lead to a compelling interest in the study of cultural differences as numismatists have come to appreciate the semantic connection between numisma (coinage) and nomos (customs) with nonos (laws). Those interested in economics and business would find, through the study of numismatics, a wealth of information—the equivalent of a life-long education—not only in the study of coins and currencies, but also about people and their history.

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Viewing money through the lens of culture is a relatively new concept. Historically, the financial service world has focused on money as a fairly one-size-fits-all conversation. The truth is every aspect of your finances is directly impacted by your identity and culture. If cultural background is ignored, you’re less likely to step into making positive and impactful financial decisions for your life. Every culture has different ways of viewing personal finances. Even within one culture, you might find that there are different ways that money is discussed or used. Culture is defined by the values, norms, and beliefs shared among its members and supported by its cultural institutions. A symbiotic relationship exists between a currency and its culture and society. The extent to which cultural institutions encourage and reinforce their economic foundations indicates the degree of a culture’s success or failure. Cultural institutions can strengthen their citizens’ values and beliefs with that of their currency, and enhance the process of trade and exchange for the betterment and prosperity of its people.

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Hofstede (2001, p. 9) refers to culture as “the collective programming of the mind that distinguishes the members of one group or category of people from another.” Culture is the mind-set or mental framework resulting from shared values, beliefs, symbols, and social ideals (Triandis, 1995). This programming typically happens early in life (Barnouw, 1979; Hofstede, 1980; Minkov and Hofstede, 2011) and leads to behavioral patterns that continue over time, shaping the institutional environment (Hofstede, 1980; Mueller and Thomas, 2001). Culture influences a wide range of economic behaviors including the decision to become self-employed rather than to work for others (Audretsch et al., 2007; Stevenson and Lundstro¨m, 2001), entry choice of multinational firms (Kogut and Singh, 1988), the development of trust between employees (Doney et al., 1998) and control methods (Chow et al., 1999; Shoham et al., 2003).

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Anthropologists and sociologists tend to differentiate themselves from economists by placing their emphasis on the social relations that people bring to how they use money. Dodd calls this “relational monies.” The chief proponent of this approach is of course Viviana Zelizer (1997). Dodd claims that we should talk about monies, not money in the singular: “If people can and do differentiate their monies, money simply cannot homogenize everything it touches. . . . [According to Zelizer,] all forms of money are differentiated according to use and fungibility—primitive and modern, local as well as state fiat currencies, and cash alongside virtual money—all are shaped from the inside by the social practices and cultural values of their users” (Dodd 2014: 286). Seen in this way, far from being alienated from markets and money, most people bend the monies available to them to their own personal and differentiated purposes. Money then is not a thing, but a process through which people configure their human associations. One criticism of Zelizer is that she focuses on domestic and private relations that lie beyond the scope of the public sphere that economists study and write about.

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Culture affects financial decision-making around the world:

A growing literature documents differences in financial decisions taken by individual members of cultural groups. In a study of 80,000 individuals from 76 countries around the world, Falk et al. (2015) address national cultures with regard to preferences relating to risk and time that influence a wide range of individual-level behaviours including savings and labour market choices (see also Carroll, Rhee, and Rhee, 1994, 1999). National culture also affects individual behaviours related to indebtedness and mortgages (Guiso, Sapienza, and Zingales, 2013) and to shopping behaviours (Gentina, Butori, Rose, and Bakir, 2013; Parker, Hermans, and Schaefer, 2008) or individual financial market investment behaviours (Chui, Titman, and Wei, 2010; Eun, Wang, and Xiao, 2015; Grinblatt and Keloharju, 2001; Guiso, Sapienza, and Zingales, 2008). ‘It is therefore likely that culture influences business and financial decisions’ (Aggarwal, Faccio, Guedhami, and Kwok, 2016, p. 1), but it is nevertheless more difficult to know whether this influence is linked to different cultural attitudes towards money or the institutional, legal, political and social context specific to each country. Only a few, and recent, studies demonstrate the existence of different cultural attitudes towards money in a single national context (Medina, Saegert, and Gresham, 1996; Tang, Arocas, and Whiteside, 1997). As Kahneman, awarded the Nobel Prize in Economic Sciences in 2002, stated: ‘much remains to be learned about the ‘endowment effect’’ of cultural differences in attitude towards money (Kahneman, 2011: 299). Little is yet known about the way in which cultural differences in attitude towards money affect economic outcomes (Mitchell and Mickel, 1999; Tang et al. 2015).

Cultural finance – that is, viewing money through the lens of culture – is a relatively young discipline. Traditionally, the mainstream view has been that consumers around the world all share similar financial goals – which has led to a one-size-fits-all approach. But different cultures view money in different ways, which has implications for international finance marketers.

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Culture shapes financial attitudes:

Different countries have different rates of saving. For example, household savings in China have traditionally been high relative to other countries. China’s savings rate 52 percent is very high despite the fact that its average income is much lower than other nations. What marks China as unique is its levels of uncertainty avoidance and collectivism, which are much higher than the average. These cultural attributes are a major factor in explaining the high levels of savings in China. Another reason for this is thought to be the country’s one-child policy which was in place until 2015. This policy meant households had less need to spend on children, but also reduced ability to rely on children in retirement – incentivising household saving.

Singapore and South Korea also have relatively high household savings rates. Heng-fu Zou at the China Economics and Management Academy in Beijing believes that countries which have been influenced by Confucianism and Taoism – which prize frugality – are culturally more disposed to saving money.

Germans are famed for their love of cash – certainly pre-pandemic – summed up by the German expression Geld Stinkt Nicht (cash doesn’t stink). Before Covid, German restaurant visits and groceries were paid in cash more than twice as often as the European average. Coupled to this is a broad dislike of credit cards and personal debt. This has been attributed to a collective folk memory of painful historical events such as the severe inflation of the Weimar Republic era, as well as a strong desire for privacy and a distrust of surveillance of any kind.

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Symbolism and superstition matters:

The meanings that different cultures attach to symbols or dates can impact financial decision-making. An often-quoted example in the West is Friday 13th – when stock market returns are supposed to be lower, due to investor paraskevidekatriaphobia (the word for fear of Friday 13th). In the Gregorian calendar, Friday 13th takes place in any month which begins on a Sunday, which happens between 1-3 times per year.

A parallel in East Asian cultures, especially China, is fear which surrounds the number 4 – tetraphobia – leading to some investors avoiding trades on the fourth day of the month. This is thought to be because the Chinese word for four – in different varieties of Chinese – is similar to the word for death. The same is also true in the Korean and Japanese languages.

In India, gold is especially symbolic of wealth and success, and plays a leading role in many traditional rituals. As a result, there is high demand for gold as an asset class, whether it’s traded as physical gold or a CFD (contract for difference) for the precious metal. This cultural affinity is similar in China, where buying “something gold” is a long-standing tradition at lunar new year.

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Individualist and collectivist countries view money differently:

One of the axes in Hofstede’s theory of cultural dimensions is individualism/collectivism. As a broad generalisation, Western societies tend to be more individualist whereas Eastern societies tend to be more collectivist (although the extent to which this is true will vary by country). This may affect attitudes to risk – for example, in collectivist societies where people can rely on family members and friends in times of financial need, risk appetite for investing may be higher.

One example of collectivism in action is the tanda, a money-saving method in Latin America and the Caribbean. It’s known by different names around the world (for example, hui in China, or stokvels in South Africa) but the underlying premise is the same – a group of people saves an agreed upon amount to a collective pool on a specific day, which could be payday or the first of the month. The system works in turns – on the first turn, one member of the group receives the money as a pay-out, and on the second, the next member, and so on – until all members have had their turn. No new money is created, but it’s a collective way for a group to save. Apps like Twine use fintech to bring an old concept up to date.

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Religious influences are important:

Religion can also shape attitudes towards money, a key example being Islamic finance. Islamic finance is based on the belief that money shouldn’t have value in itself – it is simply a mechanism to exchange products and services which do have value. Linked to this is the idea that you shouldn’t make money from money – which means that where possible, the concept of interest (either paying it or receiving it) should be avoided.

Islamic finance encourages the idea of partnership – i.e., that both profit and risk should be equitably shared – which amongst other things, requires banks to have a clear understanding of what is being financed. It also avoids investing in categories like alcohol, tobacco or gambling.

Islamic finance has evolved from a fairly niche service offered by a small number of banks in the Middle and Far East in the 1970s, to an influential part of the global financial landscape with about 1.6 billion participants worldwide. As well as being the preferred method of banking in orthodox Islamic countries, it’s also having a positive impact on smaller businesses, particularly in emerging economies, who might otherwise have limited access to finance. Some global finance brands have created sub-brands specifically to cater to Islamic finance – an example being HSBC’s Amanah.

Most Shari’ah-compliant credit cards are issued by financial institutions located in the Middle East, Persian Gulf, and Southeast Asia. However, since they are often processed through the MasterCard and Visa networks, they can be used worldwide wherever credit cards are accepted. Issuing creditors often have Muslim advisory panels to ensure that their products and services are compliant with Islamic law.

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Every country is different:

Every country has a different economic climate, which inevitably acts as a backdrop to financial decisions made by its citizens. Countries differ on factors like demographics, availability of credit, income levels and expectations, and uncertainty. In addition:

• The role of family in decision-making varies from culture to culture
• The relationship of individuals within their community can differ from one demographic group to another
• Attitudes towards financial institutions, including levels of trust, can vary by demographic group (including within countries)
• Religious or spiritual beliefs can affect how an individual manages their money and how they make financial decisions

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Different cultures deal with money differently: 

Whether it’s saving, spending or lending, being able to manage one’s finances is an important life skill. But not everyone does it in the same way. Many cultures think outside the box and use creative practices to achieve the same results. The ways people around the world handle cash are as varied as the countries themselves.

-1. Caja de Ahorros (Panama)

Between presents, meals and travel, big celebrations like Christmas can be expensive for families. To make sure the holiday doesn’t break the bank, people in Panama pay monthly instalments into a caja de ahorros throughout the year. When the Christmas season arrives, they receive the full amount to spend on whatever makes their holiday special.

-2. Geld Stinkt Nicht (Germany)

By all accounts, Germany is a cash society. Germans use cash for about 80 percent of their purchases, shunning both credit cards and personal debt. While the reasons may be rooted in the country’s history, their “cash doesn’t stink” mentality lets them keep a physical connection with cash – and stay more aware of how they’re spending it.

-3. Zakat (Pakistan)

Zakat is a rather generous giving practice, and in Pakistan it’s mandated by law. The principle requires everyone to donate at least 2.5% of their income to charities and those who are less fortunate. It’s said to teach self-discipline and free those practicing it from becoming obsessed with accumulating material possessions.

-4. Harambee (Kenya)

In countries where getting loans to invest in a business can be next to impossible, communities have started to form their own systems of credit. In Kenya, this has seen the rise of harambee, a community-led initiative whereby participants pool their money together and use it for a project the community needs.

-5. Allowance (USA)

Often (though not always) linked to the completion of household chores, a child’s allowance is their first encounter with the concept of financial responsibility. While different parents take different approaches, the practice of giving an allowance helps teach children that they must work hard and save their earnings to get the things they want.

-6. Kuri Kalyanam (India)

Everybody loves a good party, and what better way to encourage people to donate money than by throwing a huge one? In south-western India, kuri kulyanam parties are thrown to raise money for big expenses, like hosting a wedding or building a house. Each invited guest is expected to make a cash donation – but there’s a catch. When it’s the host’s turn to attend the return party, they’re expected to give twice what they received.

-7. Harisma (Greece)

A wedding is a joyous occasion, as it marks the beginning of the happy couple setting out on the journey of life together. To help them on their way, Greek wedding guests take turns pinning cash onto the bride and groom’s clothes while they dance. It’s a potentially dangerous method of giving, perhaps, but worth it in the end.

-8. Susu (Jamaica)

Susu is practiced in many Caribbean countries, including Jamaica, and their emigrant communities in the USA and Canada. Built on a bond of trust, the money collected is given to one person to spend on a big purchase, like a car or investment in education. It allows people who might not have access to formal financial institutions to save and borrow money.

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Culture, money attitudes and economic outcomes, a 2019 study:

Using novel survey data, authors examine attitudes towards money and to what extent they affect economic outcomes in Switzerland. They find that three main types of attitudes towards money co-exist: the prestige and power attitude, the money management attitude and the goal-oriented attitude. The distribution of these attitudes differs across Switzerland’s linguistic regions; all of them are more significant in the French-speaking part, compared to the German- and Italian-speaking parts of Switzerland. In this study, authors document the link between cultural differences in attitude towards money and their potential impact on individual financial behaviours. They then examine the extent to which these attitudes affect economic outcomes.

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Section-10

Money and morality:

In late 1912, banker J.P. Morgan, at the height of his power, spoke at a U.S. Senate committee hearing investigating the “Money Trust,” the tightly knit network of bankers and industrialists who controlled much of the nation’s capital. This was a time in U.S. history with many parallels to today: Inequality was rising, corporations had stifled market competition and public discontent with the banks was growing. Having been asked how banks grant loans, Morgan provocatively asserted, “A man I do not trust could not get credit from me on all the bonds of Christendom.” Morgan was responding head-on to the accusation that personal relationships in the credit system only served the connected at the expense of outsiders and did little to improve public welfare. Instead of denying that social relationships were at the heart of banking, he gave a rationale as to why they should be: collateral (“all the bonds in Christendom”) was but a narrow indicator of the individual’s ability to pay back his or her debt. Through personal relationships, however, creditors could gain a better sense of the borrower’s creditworthiness. The potential for cheating would decrease – “character is everything,” Morgan was fond of saying.

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In today’s world, Morgan’s perspective may seem outdated. For most of us, access to credit is regulated by algorithms that produce quantitative indicators of creditworthiness. Personal connections do not seem to be as central to everyday citizens’ access to banking services as they used to be – though the proverbial handshake may still seal a deal when the parties to the transaction belong to a rarified and small social elite, raising important questions about how inequality operates in the world of credit. The larger point that still rings true, however, is that creditworthiness, no matter how quantified and automated, is a type of moral judgment: getting credit – whether a personal loan, funding for college, or a mortgage – requires us to undergo a process of evaluation with an eye to understanding whether we are the “sort of person” who can pay the creditor back. It’s not just about how much money we make: it’s also about our credit history, and specifically what kinds of “mistakes” we have made in our past that would raise a flag to potential creditors.

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We have come to accept that morality – a rather strict, even punitive kind of morality at that – is a way of governing credit – limiting or expanding access to it, regulating how it is used, and so on. And yet, when it comes to money – and it is money that passes hands in a credit transaction, after all – the idea that money and morality are just as intimately connected strikes us as dubious. We stand on the shoulders of giants when we take this position: Thinkers as different as Adam Smith, Karl Marx and Georg Simmel all made some version of the argument that whenever money is involved, that’s when morality stops. As Marx famously put it, with money, “all that is solid melts into air,” as money knows no boundaries; in fact, it transforms all relationships and experiences we consider to have intrinsic value into a quantitative metric, dissolving their distinctiveness and making them comparable. As sociologist Viviana Zelizer suggests, such views on money produce two perspectives on the relationship between the economy and our social world: first, a view whereby money “corrupts” anything it touches, lending credence to claims that money should be kept at bay from aspects of our lives we understand to have intrinsic or incommensurable value. Second, a view whereby money is “nothing but” money – once monetary evaluation takes root in a previously untouched sphere, its cold, rational logic will relentlessly take over.

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In 1991 an internal memo from the World Bank’s Chief Economist Lawrence Summers was leaked to the world’s press. Uproar followed, for in the memo Summers made certain policy recommendations concerning pollution based entirely on monetary considerations. In itself this might not be thought objectionable, but Summers was talking about the morbidity and mortality associated with high levels of pollution; the third world was under polluted and so he suggested that such pollution be exported to the less developed world where human life was ‘cheaper’ than in more developed nations. As he pointed out, people in the less developed world did not tend to live as long or earn as much as those in the developed world. In money terms the loss, and particularly the early loss, of a productive life in the developed world far outweighed the same loss in the less developed world. True, levels of morbidity and mortality would certainly increase in less developed nations as they became the repository for the world’s toxins, but such increases would hardly matter given the low monetary value of lives in these regions, and they would certainly be far outweighed by the monetary gains from healthier, longer lived people from developed nations. One of the central features of money is that it is a measure of value, indeed a measure of value that can be extended to absolutely anything we might care about including human lives no matter how immoral it becomes. 

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How Money impacts our sense of morality:

Research is uncovering how wealth impacts our sense of morality, our relationships with others, and our mental health. Psychologists who study the impact of wealth and inequality on human behavior have found that money can powerfully influence our thoughts and actions in ways that we’re often not aware of, no matter our economic circumstances. Although wealth is certainly subjective, most of the current research measures wealth on scales of income, job status, or socioeconomic circumstances, like educational attainment and intergenerational wealth.

-1. More money, less empathy

Several studies have shown that wealth may be at odds with empathy and compassion. As a person’s levels of wealth increase, their feelings of compassion and empathy go down, and their feelings of entitlement, of deservingness, and their ideology of self-interest increases. Through surveys and studies, Piff and his colleagues have found that wealthier individuals are more likely to moralize greed and self-interest as favorable, less likely to be prosocial, and more likely to cheat and break laws if it behooves them. Research published in the journal Psychological Science found that people of lower economic status were better at reading others’ facial expressions—an important marker of empathy—than wealthier people. While a lack of resources fosters greater emotional intelligence, having more resources can cause bad behavior in its own right. UC Berkeley research found that even fake money could make people behave with less regard for others. Researchers observed that when two students played Monopoly, one having been given a great deal more Monopoly money than the other, the wealthier player expressed initial discomfort, but then went on to act aggressively, taking up more space and moving his pieces more loudly, and even taunting the player with less money.

-2. Wealth can cloud moral judgment

A UC Berkeley study found that in San Francisco—where the law requires that cars stop at crosswalks for pedestrians to pass—drivers of luxury cars were four times less likely than those in less expensive vehicles to stop and allow pedestrians the right of way. They were also more likely to cut off other drivers. Another study suggested that merely thinking about money could lead to unethical behavior. Researchers from Harvard and the University of Utah found that study participants were more likely to lie or behave immorally after being exposed to money-related words. According to a new study, poor people are more likely to act ethically than the wealthy. The researchers suggest a number of reasons why upper-class individuals are more prone to unethical behavior, citing their relative independence from others and increased privacy in their professions, and the availability of resources to deal with the costs of unethical behavior.

-3. Wealth has been linked with addiction

Wealth has been linked with a higher susceptibility to addiction problems. A number of studies have found that affluent children are more vulnerable to substance abuse issues, potentially because of high pressure to achieve and isolation from parents. Studies also found that kids who come from wealthy parents aren’t necessarily exempt from adjustment problems—in fact, research found that on several measures of maladjustment, high school students of high socioeconomic status received higher scores than inner-city students. Researchers found that these children may be more likely to internalize problems, which has been linked with substance abuse. But it’s not just adolescents: Even in adulthood, the rich outdrink the poor by more than 27 percent.

-4. Money itself can become addictive

The pursuit of wealth itself can also become a compulsive behavior. As psychologist Dr. Tian Dayton explained, a compulsive need to acquire money is often considered part of a class of behaviors known as process addictions, or “behavioral addictions,” which are distinct from substance abuse. Process addictions are addictions that involve a compulsive and/or an out-of-control relationship with certain behaviors such as gambling, sex, eating, and, yes, even money.…There is a change in brain chemistry with a process addiction that’s similar to the mood-altering effects of alcohol or drugs.

-5. Wealthy children may be more troubled

Children growing up in wealthy families may seem to have it all, but having it all may come at a high cost. Wealthier children tend to be more distressed than lower-income kids, and are at high risk for anxiety, depression, substance abuse, eating disorders, cheating, and stealing. Research has also found high instances of binge-drinking and marijuana use among the children of high-income, two-parent, white families.

-6. We tend to perceive the wealthy as “evil”

On the other side of the spectrum, lower-income individuals are likely to judge and stereotype those who are wealthier than themselves, often judging the wealthy as being “cold.” Rich people tend to be a source of envy and distrust, so much so that we may even take pleasure in their struggles, according to Scientific American. University of Pennsylvania research demonstrated that most people tend to link perceived profits with perceived social harm. When participants were asked to assess various companies and industries (some real, some hypothetical), both liberals and conservatives ranked institutions perceived to have higher profits with greater evil and wrongdoing across the board, independent of the company or industry’s actions in reality.

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Section-11

Money and knowledge:

“An investment in knowledge pays the best interest.” – Benjamin Franklin

Knowledge is a skill acquired through experience or education. Every human on Earth is eventually learning and working each day to earn.

Two brothers set out to make their fortune. One of them joined a gurukula to get educated while the other became an apprentice to a rich merchant. Several years later, the two brothers met and decided to take home to their parents whatever they had acquired.

On the way the brothers were waylaid by dacoits who seized all the costly possessions that the merchant’s apprentice had collected. However, they found nothing of value on the person of the other brother. For what he was carrying was the knowledge he had acquired and it was stored in his mind. The merchant’s apprentice lost all his hard-earned wealth whereas the scholar-brother retained all the wealth of knowledge that he had acquired.

We need money to survive, to be comfortable, to indulge and enjoy ourselves. Even as children, though not earning ourselves, we seek pocket money from parents. Money also gives you power over others. The more the money, more the purchasing power. Not surprisingly, money is the single most sought after commodity today. To acquire wealth, however, one needs knowledge. The main purpose of education is to acquire knowledge that prepares you to face life and help build your character. If the only purpose of knowledge acquisition is to earn money, then education is narrowed down to the knowledge required for only a low level of subsistence.

Broader and deeper knowledge has several advantages over material wealth. Knowledge can be used to make money, but it cannot really be purchased with money; it is acquired by individual effort.

Worldly wealth is limited; knowledge is unlimited. Knowledge cannot be taken away or stolen, it is not burdensome to carry and it causes no anxiety.

Safeguarding one’s costly worldly possessions could be a source of immense anxiety. Wealth could diminish but knowledge increases when shared. A man of wealth is respected only till he possesses it; an erudite person is respected even long after he is no more.

Money can create some new money and some new knowledge but without knowledge of how to use it, it is pointless. However, knowledge can create new knowledge and new money without money to do so. You may inherit the money, but if you do not know how to safeguard that money and then grow it with knowledge, it will leave you.

Going forward, we know that a person can go bankrupt at any point in time due to any reason. There is no way a person can run out of knowledge. It shall always remain as a part of the person. Sharing money can aid someone momentarily, but sharing knowledge will aid the person who receives it for a life time. Knowledge is infinite, the world is based on the core of knowledge.

Why knowledge is better than money?

• One might be ‘born rich’, but if he/she doesn’t possess the right knowledge of how to maintain or double the riches, the person can become penniless. On the other hand, a poor person can gain riches via the application of his/her knowledge.
• Money can buy an object, but not the thought process (knowledge) that went into creating that object. Hence, knowledge is superior.
• It is better to be looked up to as a “knowledgeable person” rather than a “rich person”.
• We remember those who contributed their knowledge to the world, based on which new inventions and discoveries are being made. We seldom remember if they were wealthy or not.
• With knowledge one can acquire money, but money alone will not help in acquiring knowledge. It requires the need and hunger to know things.
• Money is an application of knowledge. This has lasted long and shall prevail until another application of knowledge takes over.

What knowledge gives that money can’t?

• Independence in finding solutions to problems one might face
• Creativity, intelligence and survival tactics
• Freedom from insecurity. With physical treasure (money), protecting it is an issue. But with knowledge forming an integral part of a person, there is no reason to worry about its security.
• Knowledge gives self-reliance and self-belief that money may not have

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Money and education paradox:

The amount spent on financing education doesn’t match the view that education is important. Nobody would argue that education isn’t important, but the money does not seem to add up. About $4.7 trillion is spent on education worldwide annually, with only 0.5% of that spent in low income countries, according to the 2019 edition of the GEM Report. For a long time, the GEM Report would show how the annual financing gap needed for basic education could be matched by like three days of military spending. In order to achieve universal completion of secondary education by 2030, low- and lower-middle-income countries would need to increase the amount they spend each year from $149 billion in 2012 to $340 billion in 2030, according to the GEM Report’s complement, Scoping Progress in Education. Approximately 771 million adults lacked basic literacy skills in 2020. Slow progress in raising literacy rates means that, in absolute terms, the number of illiterate people has hardly changed.

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Section-12

Money and happiness:

The big question is, “Can money buy happiness?” There’s no simple answer. Everyone knows the adage “money can’t buy happiness,” although few of us seem to believe it. It is clear that being wealthy does not guarantee happiness; there are many who are tremendously wealthy, yet entirely unhappy. Of course, anecdotal evidence is sometimes misleading. One finding does seem fairly conclusive across studies: financial poverty does result in lower happiness levels. For those above poverty levels, mindset plays an important role. Various studies and surveys suggest that money may help buy happiness when used to meet basic needs. Access to healthcare, nutritious foods, and a home where you feel safe can improve mental and physical health and may, in some cases, lead to increased happiness. Once basic needs are met, however, the happiness a person can gain from money may grow stagnant. 

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“It seems natural to assume that rich people will be happier than others,” write psychologists Ed Diener and Robert Biswas-Diener in Happiness (Blackwell Publishing, 2008). “But money is only one part of psychological wealth, so the picture is complicated.” There is a strong correlation between wealth and happiness, the authors say: “Rich people and nations are happier than their poor counterparts; don’t let anyone tell you differently.” But they note that money’s impact on happiness isn’t as large as you might think. If you have clothes to wear, food to eat, and a roof over your head, increased disposable income has just a small influence on your sense of well-being. To put it another way, if you’re living below the poverty line ($22,050 annual income for a family of four in 2009), an extra $5,000 a year can make a huge difference in your happiness. On the other hand, if your family earns $70,000 a year, $5,000 may be a welcome bonus, but it won’t radically change your life. So, yes, money can buy some happiness, it’s just one piece of the puzzle. And there’s a real danger that increased income can actually make you miserable—if your desire to spend grows with it. But that’s not to say you have to live like a monk. The key is finding a balance between having too little and having too much—and that’s no easy task.

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The Fulfilment Curve:

In their personal-finance classic Your Money or Your Life (Penguin, 2008), Joe Dominguez and Vicki Robin argue that the relationship between spending and happiness is non-linear, meaning every dollar you spend brings you a little less happiness than the one before it. More spending does lead to more fulfilment—up to a point. But spending too much can actually have a negative impact on your quality of life. The authors suggest that personal fulfilment—that is, being content with your life—can be graphed on a curve that looks like this:

This Fulfilment Curve has four sections:

• Survival.

In this part of the curve, a little money brings a large gain in happiness. If you have nothing, buying things really does contribute to your well-being. You’re much happier when your basic needs—food, clothing, and shelter—are provided for than when they’re not.

• Comforts.

After the basics are taken care of, you begin to spend on comforts: a chair to sit in, a pillow to sleep on, a second pair of pants. These purchases, too, bring increased fulfilment. They make you happy, but not as happy as the items that satisfied your survival needs. This part of the curve is still positive, but not as steep as the first section.

• Luxuries.

Eventually your spending extends from comforts to outright luxuries. You move from a small apartment to a home in the suburbs, say, and you have an entire wardrobe of clothing. You drink hot chocolate on winter evenings, sit on a new sofa, and have a library of DVDs. These things are more than comforts—they’re luxuries, and they make you happy. They push you to the peak of the Fulfilment Curve.

• Overconsumption.

Beyond the peak, Stuff starts to take control of your life. Buying a sofa made you happy, so you buy recliners to match. Your DVD collection grows from 20 titles to 200, and you drink expensive hot chocolate made from Peruvian cocoa beans. Soon your house is so full of Stuff that you have to buy a bigger home—and rent a storage unit. But none of this makes you any happier. In fact, all of your things become a burden. Rather than adding to your fulfilment, buying new Stuff actually detracts from it.

The sweet spot on the Fulfilment Curve is in the Luxuries section, where money gives you the most happiness: You’ve provided for your survival needs, you have some creature comforts, and you even have a few luxuries. Life is grand. Your spending and your happiness are perfectly balanced. You have Enough.

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Money can buy happiness: a metanalysis:

Money is more strongly related to happiness than some people think — particularly when people compare their income with someone else’s. Writing in the journal Psychological Bulletin, researchers describe an association between people’s subjective socioeconomic status — how they perceive their own income, education, and occupation standing in comparison with others — and happiness. That association, they say, is significantly larger than the connection between people’s objective socioeconomic status — as measured by income and educational attainment — and their level of happiness. “There is a conventional wisdom in social science that relationships and experiences are more important than money in producing happiness,” said co-author Michael Kraus, associate professor of organizational behavior at the Yale School of Management. “But we found that when people consider their wealth relative to others, there is a stronger association between money and happiness.” The study, which was led by Jacinth Tan, an assistant professor of psychology at Singapore Management University, contradicts decades of social science research that shows a weak relationship between money and happiness, particularly in wealthy societies, the authors say. “The size of the relationship we observed in our study has policy implications in the sense that lawmakers must acknowledge that the relationship between money and happiness remains consequential and cannot be ignored,” said Kraus. “Policy considerations that help people obtain good jobs and protect people from financial ruin during this pandemic may have an added benefit of improving people’s happiness.”

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The new research was motivated by an apparent disparity in previous research that has showed weak links between income and happiness and the idea that many people actively seek out prestigious jobs and higher status, the authors say. Moreover, as inequality has increased in some societies (including the United States), overall happiness has declined. That outcome wouldn’t be expected if wealth and material resources were inconsequential, the researchers say. This gap between research findings and observation suggests the possibility that objective measures, such as income, do not adequately capture the influence of money on happiness, the researchers said. They wanted to test the idea that happiness is more dependent on what people think they have compared with others than how much they do have.

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For the study, the researchers performed a meta-analysis of 357 different studies that have examined questions related to associations between objective and subjective measures of socioeconomic status and people’s subjective wellbeing — their sense of happiness and life satisfaction. Collectively, those studies involved data from more than 2.3 million participants gathered in publicly available datasets, such as the World Values Survey, as well as in private datasets. In their analysis, the researchers applied the MacArthur Scale of Subjective Status — a 10-rung ladder in which people indicate their perceived social status — to test the association between comparative resources and happiness. Their findings suggest that that social comparison is an important driver of how much money or material resources will increase happiness. The researchers also found that the effect of social comparison was stronger in countries, such as Singapore, with high population density. This finding makes sense, the researchers say, since there often is greater competition for resources in places where population density is high.

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Tan pointed out that social comparison can lead to unhappiness when a person determines their status compares less favorably to others. She cited a quote attributed to Mark Twain: “Comparison is the death of joy.” “Our findings also suggest that improving from past levels of material resources alone is insufficient for increasing happiness,” she said. “Even if people today are earning higher wages or attaining higher educational levels than their parents or compared to 10 years ago, there is going to be limited impact on their happiness if they are not doing at least as well as, if not better than others at the present. In people’s minds, social mobility is not simply the ability to ascend one’s own socioeconomic ladder, but also to ascend the ladder of the broader, collective society.”

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Money can buy happiness, another study:

Financial stability helps people escape the everyday hassles of life, says research by Jon Jachimowicz.

When we wonder whether money can buy happiness, we may consider the luxuries it provides, like expensive dinners and lavish vacations. But cash is key in another important way: It helps people avoid many of the day-to-day hassles that cause stress, new research shows. Money can provide calm and control, allowing us to buy our way out of unforeseen bumps in the road, whether it’s a small nuisance, like dodging a rainstorm by ordering up an Uber, or a bigger worry, like handling an unexpected hospital bill, says Harvard Business School professor Jon Jachimowicz.

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The idea that money can reduce stress in everyday life and make people happier impacts not only the poor, but also more affluent Americans living at the edge of their means in a bumpy economy. Indeed, in 2019, one in every four Americans faced financial scarcity, according to the Board of Governors of the Federal Reserve System. The findings are particularly important now, as inflation eats into the ability of many Americans to afford basic necessities like food and gas, and COVID-19 continues to disrupt the job market.

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Higher income amounts to lower stress:

In one study, 522 participants kept a diary for 30 days, tracking daily events and their emotional responses to them. Participants’ incomes in the previous year ranged from less than $10,000 to $150,000 or more. They found:

-1. Money reduces intense stress: There was no significant difference in how often the participants experienced distressing events—no matter their income, they recorded a similar number of daily frustrations. But those with higher incomes experienced less negative intensity from those events.

-2. More money brings greater control: Those with higher incomes felt they had more control over negative events and that control reduced their stress. People with ample incomes felt more agency to deal with whatever hassles may arise.

-3. Higher incomes lead to higher life satisfaction: People with higher incomes were generally more satisfied with their lives.

“It’s not that rich people don’t have problems,” Jachimowicz says, “but having money allows you to fix problems and resolve them more quickly.”

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Why cash matters:

In another study, researchers presented about 400 participants with daily dilemmas, like finding time to cook meals, getting around in an area with poor public transportation, or working from home among children in tight spaces. They then asked how participants would solve the problem, either using cash to resolve it, or asking friends and family for assistance. The results showed:

-1. People lean on family and friends regardless of income: Jachimowicz and his colleagues found that there was no difference in how often people suggested turning to friends and family for help—for example, by asking a friend for a ride or asking a family member to help with childcare or dinner.

-2. Cash is the answer for people with money: The higher a person’s income, however, the more likely they were to suggest money as a solution to a hassle, for example, by calling an Uber or ordering takeout.

While such results might be expected, Jachimowicz says, people may not consider the extent to which the daily hassles we all face create more stress for cash-strapped individuals—or the way a lack of cash may tax social relationships if people are always asking family and friends for help, rather than using their own money to solve a problem. “The question is, when problems come your way, to what extent do you feel like you can deal with them, that you can walk through life and know everything is going to be OK,” Jachimowicz says.

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Breaking the ‘shame spiral’:

In another recent paper, Jachimowicz and colleagues found that people experiencing financial difficulties experience shame, which leads them to avoid dealing with their problems and often makes them worse. Such “shame spirals” stem from a perception that people are to blame for their own lack of money, rather than external environmental and societal factors, the research team says. “We have normalized this idea that when you are poor, it’s your fault and so you should be ashamed of it,” Jachimowicz says. “At the same time, we’ve structured society in a way that makes it really hard on people who are poor.” For example, Jachimowicz says, public transportation is often inaccessible and expensive, which affects people who can’t afford cars, and tardy policies at work often penalize people on the lowest end of the pay scale. Changing those deeply-engrained structures—and the way many of us think about financial difficulties—is crucial.

After all, society as a whole may feel the ripple effects of the financial hardships some people face, since financial strain is linked with lower job performance, problems with long-term decision-making, and difficulty with meaningful relationships, the research says. Ultimately, Jachimowicz hopes his work can prompt thinking about systemic change. “People who are poor should feel like they have some control over their lives, too. Why is that a luxury we only afford to rich people?” Jachimowicz says. “We have to structure organizations and institutions to empower everyone.”

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Quantum of money and happiness correlation: 

-1. The best-known theory on this topic is that money can buy happiness, but only up to a point. This comes from a study by two Nobel Laureates, Daniel Kahneman and Angus Deaton (2010), which found that emotional wellbeing rises with income. However, it rises logarithmically. That is, as an individual’s income increases, their wellbeing increases at a slower and slower rate. And after income surpasses about $75,000 per year, Kahneman and Deaton’s data suggests, wellbeing stops increasing altogether. This 2010 study found that, where wealth is concerned, a person’s satisfaction with their life no longer increases after about $75,000 a year. At this point, most people are better able to handle major life stressors like poor health, relationships, or loneliness than if they’re making less or are below the poverty line. Beyond that, daily habits and lifestyle are the main drivers of happiness.

-2. Results from a recent study that looked at happiness in European populations points to a much lower dollar amount being equated to happiness: 27,913 euros a year. That’s equivalent (at the time of the study) to about $35,000 a year. That’s half of the American figure. This may have to do with relative costs of living in the United States compared to Europe. Healthcare and higher education are often less expensive in Europe than in the United States. The researchers also mention several other cultural factors that may contribute to the lower correlation of money to happiness in these countries. Culture may affect this threshold. Depending on your culture, you may find happiness in different things than someone with different cultural values.

-3. A 2018 study by Trusted Source looked at what would happen over time if women in poverty-stricken households in Zambia were given regular cash transfers with no strings attached. The most notable finding was that, over a 48-month period, many women had a much higher sense of emotional well-being and satisfaction about their health, for both themselves and their children.

-4. In 2020, researchers analysed data from the Office for National Statistics and Happy Planet Index to find out how much money the average Briton would need to live a happy life. The answer: £33,864 or more. And it’s the ‘more’ part that’s key.

-5. New research by Matthew Killingsworth (2021) found that experienced well-being rises with income, even above $75,000 per year.

Figure below shows that money is correlated with happiness for incomes past $75,000 per year.

While it is true this paper find money is correlated with happiness for incomes past $75,000, we should be careful not to over-interpret this evidence. Remember, correlation does not imply causation.  Killingsworth’s study has advanced our state of knowledge on the link between money and happiness through the use of a clever research design. The new data suggests that increases in happiness don’t stop after an individual reaches an income of $75,000. Instead, the increases continue, and perhaps plateau, at a later point.

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Spending money right make you happy: 

Scientists have studied the relationship between money and happiness for decades and their conclusion is clear: Money buys happiness, but it buys less than most people think (Aknin, Norton, & Dunn, 2009; Diener & Biswas-Diener, 2002; Frey & Stutzer, 2000).  The correlation between income and happiness is positive but modest, and this fact should puzzle us more than it does.  After all, money allows people to do what they please, so shouldn’t they be pleased when they spend it?  Why doesn’t a whole lot more money make us a whole lot more happy? One answer to this question is that the things that bring happiness simply aren’t for sale. This sentiment is lovely, popular, and almost certainly wrong. Money allows people to live longer and healthier lives, to buffer themselves against worry and harm, to have leisure time to spend with friends and family, and to control the nature of their daily activities—all of which are sources of happiness (Smith, Langa, Kabeto, & Ubel, 2005).  Wealthy people don’t just have better toys; they have better nutrition and better medical care, more free time and more meaningful labor—more of just about every ingredient in the recipe for a happy life. And yet, they aren’t that much happier than those who have less. If money can buy happiness, then why doesn’t it? 

Because people don’t spend it right. Most people don’t know the basic scientific facts about happiness—about what brings it and what sustains it—and so they don’t know how to use their money to acquire it.  It is not surprising when wealthy people who know nothing about wine end up with cellars that aren’t that much better stocked than their neighbors’, and it should not be surprising when wealthy people who know nothing about happiness end up with lives that aren’t that much happier than anyone else’s.  Money is an opportunity for happiness, but it is an opportunity that people routinely squander because the things they think will make them happy often don’t.

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If Money doesn’t make you Happy then You probably aren’t Spending it: a study:

The relationship between money and happiness is surprisingly weak, which may stem in part from the way people spend it. Drawing on empirical research, authors propose eight principles designed to help consumers get more happiness for their money. Specifically, authors suggest that consumers should (1) buy more experiences and fewer material goods; (2) use their money to benefit others rather than themselves; (3) buy many small pleasures rather than fewer large ones; (4) eschew extended warranties and other forms of overpriced insurance; (5) delay consumption; (6) consider how peripheral features of their purchases may affect their day-to-day lives; (7) beware of comparison shopping; and (8) pay close attention to the happiness of others.  

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Counterpoint:

Money cannot make you happy:

Since 1972, the National Opinion Research Center has been polling Americans about their happiness. As you can see in the following graph, the numbers haven’t changed much over the past 32 years (up to 2004). About one-third of Americans consistently say they’re “very happy” with their lives, while a little less than one-third say they’re “pretty well satisfied” with their financial situations.

Figure below shows information from the National Opinion Research Center’s General Social Survey:

If Americans are earning more, why aren’t they happier? We’ve been led to believe that prosperity brings peace of mind, but it turns out your grandfather was right: Money isn’t everything. The bottom line: Money can’t make you happy if your increased wealth brings increased expectations. In other words, if you want more as you earn more, you’ll never be content; there will always be something else you crave, so you’ll need to work even harder to get the money to buy it. You’ll be stuck on the hedonic treadmill, running like a hamster on a wheel. The hedonic treadmill leads to lifestyle inflation, which is just as dangerous to your money as economic inflation; both destroy the value of your dollars. Fortunately, you can control lifestyle inflation. You can opt out, step off the treadmill, and escape from the rat race. To do that, you have to set priorities and decide how much is Enough.

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Section-13

Money and crime:

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Evils of Money:

Money is the basis of modern economy and it is a boon for human life. But sometimes it becomes a curse for the society as it gives rise to evil practices. Money is not an unmixed blessing. Money is also the cause of many evil practices. Keeping in view the evils of money, it has been said, “Money is a good servant but a bad master.”

Evils of money can be classified as follows:

-A. Economic Evils:

Economically, money has the following evils:

(1) Inflation and Deflation:

A big problem with money is that its value fluctuates. In this condition, the prices of commodities increase when the value of money reduces. Value of money is inversely proportional to price of commodity i.e., when the value of money increases then the price of the commodity decreases and vice versa. This leads to inflation and deflations. Both of these conditions are not good for the economy.

(2) Economic Inequalities: 

Money is a very convenience tool for accumulating wealth and of the exploitation of the poor by the rich. It has created an increasing gulf between the ‘haves’ and the ‘have-nots. The misery and degradation of the poor is, thus, in no small measure due to the existence of money.

(3) Class Struggle:

Everybody aspires to get money. The rich exploits the poor to get more and more money. As a result, the rich get richer and the poor get poorer. This leads to class struggle in the society. Money is the root of struggle between capital and labour. Prominent socialist like Marx and Lenin condemned money as it helps the rich to exploit the poor. When the communists came to power in Russia, they tried to abolish money. But they soon realized that to run a modern economy without money was impossible.  

(4) Trade Cycles:

Economy addresses ‘booms’ and ‘depressions’ due to inflation and deflation of money. This affects income, employment, prices, savings and investments. Sometimes, this effect is positive and sometimes negative. When the trade cycle is negative, there are many fluctuations in the economy.

(5) Over-Capitalization:

With a rise in the flow of money in the economy, there is an increase in savings and investments. A big part of investment is in the industrial fields. If there are over-investments then return on investment decreases. Also there is a problem of over-production. Over-production, too, leads to depression.

(6) Encouragement to Loan Tendency:

Individuals, society and nations try to show themselves prosperous. Money encourages loan tendency. People try to show themselves rich or prosperous even by taking loans. The wealthy are borrowing more than ever, using low-interest loans backed by their investments in a strategy known as “buy, borrow, die.”

(7) Economic Instability:

Several economists are of the opinion that money is responsible for economic instability in capitalist economies. In the absence of money, saving was equal to investment. Those who saved also invested. But in a monetized economy, saving is done by certain people and investment by some other people. Hence, saving and investment need not be equal. When saving in an economy exceeds investment, then national income, output and employment decrease and economy falls into depression. On the other hand, when investment exceeds saving, then national income, output and employment increase and that leads to prosperity. But if the process of money creation and investment continues beyond the point of full employment, inflationary pressures will be created. Thus inequality between saving and investment are known to be main cause of economic fluctuations.

The main evil of money lies in its liability of being over-issued in the case of inconvertible paper money. The over-issue of money may lead to hyper-inflation. Excessive rise in prices brings suffering to the consuming public and fixed income earners. It encourages speculation and inhibits productive enterprises. It adversely affects distribution of income and wealth in the community so that the gulf between the rich and poor increases.

-B. Social Evils:

Money has following social evils:

(1) Social Respect:

It is commonly seen that somebody is considered respectable if he has a lot of money. Due to abundance of money, many of their drawbacks remain hidden. Due to this reason, intellect, labour, honesty etc., don’t get proper place in the society. This reduces social values.

(2) Tendency of Exploitation:

It is commonly seen that a prostitute is condemned for her work, but there are many other contemptible work in the form of various kinds of exploitation in the society. People don’t hesitate to exploit their subordinate in order to get more and more money.

(3) Enmity:

In most cases, the root cause of enmity is money. There is a common visibility by enmity among brothers or relatives due to money. So, money reduces social peace and affection.

-C. Moral Evils:

Money has weakened the moral fiber of man.  Money is also the root cause of many crimes including theft, robbery, loot, murder, corruption, sex trafficking, drug trafficking etc.

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Counterfeiting money:

Counterfeit money is imitation currency produced without the legal sanction of the state or government. Producing or using counterfeit money is a form of fraud or forgery. Counterfeiting is almost as old as money itself. Plated copies (known as Fourrées) have been found of Lydian coins which are thought to be among the first western coins. Historically, objects that were difficult to counterfeit (e.g., shells, rare stones, precious metals) were often chosen as money.  Before the introduction of paper money, the most prevalent method of counterfeiting involved mixing base metals with pure gold or silver. A form of counterfeiting is the production of documents by legitimate printers in response to fraudulent instructions. During World War II, the Nazis forged British pounds and American dollars. Today some of the finest counterfeit banknotes are called Superdollars because of their high quality and likeness to the real U.S. dollar. There has been significant counterfeiting of Euro banknotes and coins since the launch of the currency in 2002, but considerably less than for the U.S. dollar.

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In the United States, money forgery is widespread. Between January and February of 2021, about $4,370,300 in counterfeit money was confiscated in the United States. This crime, if it is possible to produce such huge amounts of counterfeit money in only two months, would represent a significant danger to the US economy if the necessary safeguards are not put in place. Even in the earlier years, this kind of criminal activity was prevalent. The fact that $43 million in counterfeit money was distributed to the general population in 1998, out of a total of $500 billion in circulation, indicates that counterfeiting money has become a popular criminal enterprise throughout the years. In 2011, counterfeit notes totaling $70 million were found in circulation. According to the Federal Reserve of the United States, counterfeit money accounts for less than 0.01 percent of all money in circulation in the United States. This implies that the likelihood of encountering check fraud is 20 times greater than the likelihood of experiencing counterfeit money. In other words, although the odds of getting counterfeit money in the United States are very low, it is nevertheless conceivable.

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Counterfeit money has a number of negative consequences, including a decrease in the value of genuine money as well as inflation, economic losses, and a lack of trust in real money. In the event that counterfeit money is introduced into circulation, the amount of money in circulation rises, lowering the value of money and generating an increase in prices. In the event that counterfeit money is discovered and removed from circulation, traders in possession of counterfeit currencies suffer losses since the money taken away is not returned to them. In countries where paper money is a small fraction of the total money in circulation, the macroeconomic effects of counterfeiting of currency may not be significant. The microeconomic effects, such as confidence in the currency, however, may be large.  

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Money laundering:  

Money laundering is the process in which the proceeds of crime are transformed into ostensibly legitimate money or other assets. Money laundering is the conversion or transfer of property; the concealment or disguising of the nature of the proceeds; the acquisition, possession or use of property, knowing that these are derived from criminal acts; or participating in or assisting the movement of funds to make the proceeds appear legitimate. Money obtained from certain crimes, such as extortion, insider trading, drug trafficking, illegal gambling and corruption is “dirty” and needs to be “cleaned” to appear to have been derived from legal activities, so that banks and other financial institutions will deal with it without suspicion. Money can be laundered by many methods that vary in complexity and sophistication.

Reverse money laundering is a process that disguises a legitimate source of funds that are to be used for illegal purposes. It is usually perpetrated for the purpose of financing terrorism but can be also used by criminal organizations that have invested in legal businesses and would like to withdraw legitimate funds from official circulation.

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Let us discuss the real-life scenario of money laundering. Let’s say you just earned a couple of million rupees of cash by selling illegal drugs. Of course, you can spend it on small cash purchases and nobody would notice. However, you can’t really use the cash for purchasing a luxury car, real estate or a legitimate source without being reported. So, you buy a lottery ticket. This lottery ticket has won the prize of Rs. One million. You bought the ticket for Rs.1.05 million. Yes, you paid excess money. But since you are able to use the illegal money to invest, Rs. 50,000 is just the cost of service. With that pre-won lottery ticket, you now have one million rupees in your bank account. You can legally spend on anything you want. You just ran lucky with a lottery ticket.

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General process of money laundering:

Placing “dirty” money in a service company, where it is layered with legitimate income and then integrated into the flow of money, is a common form of money laundering.

Money laundering typically occurs in three phases as seen in the figure above:

-1. Initial entry or placement is the initial movement of an amount of money earned from criminal activity into some legitimate financial network or institution.

-2. Layering is the continuing transfer of the money through multiple transactions, forms, investments, or enterprises, to make it virtually impossible to trace the money back to its illegal origin.

-3. Final integration is when the money is freely used legally without the necessity to conceal it any further.

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Facts about Money Laundering:

-1. Banks almost hit an all-time high in fines of $10 billion in 2019 for violations of anti-money laundering policies. Banks are usually the ones hit the hardest by fines because of anti-money laundering violations. According to 2019 anti-money laundering statistics, 60.5% of the banks’ fines were due to anti-money laundering regulations violations.

-2. Criminals have included cryptocurrency in their money laundering techniques. Cryptocurrency is becoming one of the many destinations of illicit funds from criminals.

-3. In the fiscal year 2019, the United States Sentencing Commission reported that as many as 91.1% of those accused of money laundering were imprisoned, with an average length of 70 months sentencing.

-4. The anti-money laundering software market is projected to reach $1.77 billion by 2023.

-5. Identity theft has become one of the top money laundering trends. The number of cases of data breach and identity theft in recent years is alarming. What’s even more troubling is that criminals use some of the stolen identities for money laundering activities specifically. This relatively new scheme makes the know-your-customer (KYC) guidelines a crucial part of anti-money laundering initiatives.

-6. 400 times more money is laundered in fiat currencies than in cryptocurrency. Contrary to popular belief and what the media feeds the public, Bitcoin is not the usual arena for money laundering activities. Bitcoin accounts for only $2.5 billion of money laundered since its inception in 2009. This amount is significantly smaller than the annual $1 trillion money laundering statistics estimate we lose in fiat currencies.

-7. Anti-money laundering activities recover only 0.1% of criminal funds. The combined efforts of nations to combat money laundering seem to be ineffective, according to a study by Ronald F. Pol from La Trobe University in Melbourne, Australia. Using global statistics on money laundering, this researcher has found that only 0.1% of illegally gained funds are recovered from criminals.

-8. Money laundering activities cost the world 2% to 5% of its GDP. Determining the actual cost of money laundering to the nations is difficult due to the layering and integration processes funds go through. However, the United Nations believes that the estimated value of money laundering worldwide, according to recent statistics, is between 2% and 5% of the world’s GDP. That’s approximately $800 billion to $2 trillion laundered annually.

-9. 95% of system-generated alerts against money laundering resulted in false positives. Financial institutions have systems to monitor suspicious transactions, such as substantial cash deposits and frequent movement of funds from one bank to another. However, anti-money laundering statistics show that 95% of those system-generated alerts are false positives, costing firms billions of dollars every year in wasted investigation time.

-10. Global money-laundering statistics related to terrorist financing remained high in 2020. The Basel AML Index measures the world’s annual progress against money laundering and terrorist financing across 144 countries. In 2020, the report showed that the index is 5.22 out of 10, where 10 is the maximum risk. According to the report, only six countries had shown improvement in anti-money laundering.

-11. 30% of money mules in the UK are below 21 years old. One of the most troubling money laundering facts today involves individuals called money mules – people whom criminals use to transfer their illegally obtained wealth on their behalf. Law enforcers have reported that money mules are getting younger and younger. For instance, 30% of money mules reprimanded in the UK fell below 21 years old.

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Money Laundering and Financing of Terrorism:  

Money laundering is the process of concealing the illicit origin of proceeds of crimes. Terrorist financing is the collection or the provision of funds for terrorist purposes. In the case of money laundering, the funds are always of illicit origin, whereas in the case of terrorist financing, funds can stem from both legal and illicit sources. The primary goal of individuals or entities involved in the financing of terrorism is therefore not necessarily to conceal the sources of the money but to conceal both the funding activity and the nature of the funded activity.

Similar methods are used for both money laundering and the financing of terrorism. In both cases, the actor makes an illegitimate use of the financial sector. The techniques used to launder money and to finance terrorist activities/terrorism are very similar and, in many instances, identical.

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The Hawala Alternative Remittance System and its role in Money Laundering:

Hawala1 is an alternative or parallel remittance system. It exists and operates outside of, or parallel to traditional banking or financial channels. Hawala is illegal in many countries. The components of hawala that distinguish it from other remittance systems are trust and the extensive use of connections such as family relationships or regional affiliations. Unlike traditional banking, hawala makes minimal (often no) use of any sort of negotiable instrument. Transfers of money take place based on communications between members of a network of hawaladars, or hawala dealers. Hawala works by transferring money without actually moving it. In fact, money transfer without money movement is a definition of hawala that was used successfully, in a hawala money laundering case.

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An effective way to understand hawala is by examining a single hawala transfer. Abdul is a Pakistani living in New York and driving a taxi. He entered the country on a tourist visa, which has long since expired. From his job as a taxi driver, he has saved $5,000 that he wants to send to his brother, Mohammad, who is living in Karachi. Abdul calls the number, and speaks with Yasmeen. She offers him the following deal:

A fee of 6 rupees for each dollar transferred;

200 rupees for a dollar; and

Delivery is included.

Under these terms, Abdul can send Mohammad Rs 1,000,000. He decides to do business with Yasmeen.

The hawala transaction proceeds as follows:

Abdul gives the $5,000 to Yasmeen;

Yasmeen contacts Ghulam in Karachi, and gives him the details;

Ghulam arranges to have Rs 1,000,000 delivered to Mohammad.

The diagram below summarizes the transaction:

Even though this is a simple example, it contains the elements of a hawala transaction. First, there is trust between Abdul and Yasmeen. Yasmeen did not give him a receipt, and her recordkeeping, such as it may be, is designed to keep track of how much money she owes Ghulam, instead of recording individual remittances she has made. There are several possible relationships she can have with Ghulam; in any case she trusts him to make the payment to Mohammad. This delivery almost always takes place within a day of the initial payment (a consideration here is time differences), and the payment is almost always made in person. Finally, in some scenarios, he trusts her to repay him the equivalent of either $5,000 or Rs 1,000,000.

Connections are of equal importance. Yasmeen has to be connected to Ghulam in Karachi to arrange this payment. Hawala networks tend to be fairly loose, communication usually takes place by phone or fax (but email is becoming more and more common).

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When compared to a traditional means of remitting money, such as obtaining a check or ordering a wire transfer, hawala seems cumbersome and risky. The motivations for using the hawala system are as follows:

-1. The primary reason is cost effectiveness.

-2. The second reason is efficiency.

-3. The third reason is reliability.

-4. The fourth reason is the lack of bureaucracy.

-5. The fifth reason is the lack of a paper trail.

-6. The sixth reason is tax evasion.

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The following diagram summarizes hawala account behavior:

Certain businesses are also more likely than others to be involved in hawala. Once again, it is not possible to give an exhaustive list, but the following is a starting point:

Import/Export

Travel and Related Services

Jewellery (gold, precious stones)

Foreign Exchange

Rugs/Carpets

Used Cars

Car Rentals (usually non-chain or franchise)

Telephones/Pagers

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How is Hawala used to launder money?

Money laundering consists of three phases: placement, layering and integration. Since hawala is a remittance system, it can be used at any phase.

In placement, money derived from criminal activities is introduced into the financial system. In many money laundering schemes, the biggest problem is handling cash. Some jurisdictions, such as the United States, require reporting by financial institutions of cash transactions over a certain amount (in the U.S. it is US$ 10,000), and attempting to circumvent such reporting requirements by making smaller transactions is an offense. Hawala can provide an effective means of placement.

In the layering stage, the money launderer manipulates the illicit funds to make them appear as though they were derived from a legitimate source. A component of many layering schemes has been seen to be the transfer of money from one account to another. Even though this is done as carefully as possible, when it is done through the traditional banking system it presents problems to the money launderer. There is the possibility that a transaction could be considered to be suspicious and reported as such. Related to this is the paper trail created by these transactions. If any portion of the laundering network is examined, the related paper trails could lead a diligent investigator directly to the source of the criminal proceeds and unravel the money laundering network. Hawala transfers leave a sparse or confusing paper trail if any. Even when invoice manipulation is used, the mixture of legal goods and illegal money, confusion about valid prices and a possibly complex international shipping network create a trail much more complicated than a simple wire transfer. Even basic hawala transfers can be difficult to trace and tie to the original, criminal source of money. There is no reason, however, why hawala transfers could not be layered to make following the money even more difficult. This could be done by using hawala brokers in several countries, and by distributing the transfers over time.

In the final stage of money laundering, integration, the launderer invests in other assets, uses the funds to enjoy his ill-gotten gains or to continue to invest in additional illegal activities. The same characteristics of hawala that make it a potential tool for the layering of money also make it ideal for the integration of money. This is when money seems to become legitimate, and, hawala techniques are capable of transforming money into almost any form, offering many possibilities for establishing an appearance of legitimacy. Given hawalas close ties to business activities, there is no reason why money cannot be reinvested in a legitimate (or legitimate appearing) business.

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Section-14

Future of money:

Money changes societies, and societies change money. This is how it has always been and will continue to be. When money was “born,” the population of our planet was around 2 million. Today, there are over eight billion of us. The system is under pressure because of an increased demand for money. A massive demand for financing is created because of the current growth, and this growth has created a historical level of economic debt in the world, which in turn causes the increase of inequality. Money is printed by banks, and “economy” is created when the banks lend money, including loans to governments and countries. However, the “system” simply does not contain enough money to pay off all the debts in the world today.

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Everything has its own time. Everything sprouts, grows, withers, and disappears. This is the cycle of life – and the same process also applies to money and the way you obtain it. Our perception of money – how it is earned and its value – is undergoing a major change. You open your wallet and see a dime. The coin is physical, you can pick it up and hold it in your hand, and you are confident that it actually has a value of 10 cents. In a few years, you will most likely be holding a small plastic item shaped as a heart or a star, or you might not even have a wallet and only have access to a virtual currency, which you do not know what looks like. You have to be prepared for a financial revolution in the next 10 to 15 years. Money as we know it has only existed for a relatively few years – the first banknote was printed in France in the 17th Century. More, recently, however, currencies have started to disappear; more than 600 in the last 30 years, and the trend continues. Several leading experts point out that the current monetary system is bound to undergo significant changes in the years to come because it is compromised by issues such as inflation, the illicit economy and counterfeiting, to name a few. At the Shambala Festival, held in England, Jem Bendell offered courses on how to create your own currency. This situation offers up innovative ways to structure an economic system. The current monetary system might actually be a hindrance to people, countries, and governments to work together more optimally than they do today. The monetary system of the future does not depend upon politicians or bankers but will be managed by communities and lending platforms, such as capitalaid.com and lendingclub.com.

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Fairly often, discussions of the future of money get side-tracked by confusion over the definition of money – its many functions, various forms, and the multitude of mechanisms for effecting transactions. Without offering a systematic review of the numerous strands of thought and differences in vocabulary, it is worth covering three basic points that together provide a solid analytical foundation for approaching the subject. First, for most economists, money serves three classic functions – as unit of account, means of payment, and store of value. In the future there is little prospect of change in these basic attributes. Second, there are a range of forms of money, not all of which must serve all three of money’s primary functions. In the future there is a good chance that current forms of money will be joined by new ones, although it is difficult to ascertain the likelihood of widespread acceptance. And third, there will doubtless be a proliferation of monetary media or transaction methods, both physical and digital, over the next few decades.

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These points of departure are helpful for clarifying the issues at stake in the discussion. However, two additional concepts make it much easier to assess the many possible trajectories that monetary forms and means of payment might take over the coming decades. One is the idea of a “monetary space” which refers to a domain, understood both in the physical sense of a particular territory and in the virtual sense of a specific market, within which a particular money serves one, two or all three functions. For instance, the territory of Japan defines a territorial monetary space that uses yen, while oil markets define a virtual monetary space that uses American dollars. The second useful concept is that of a “monetary hierarchy” that exists within a monetary space. This notion helps to distinguish different forms of money and the relationships that exist among them.

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Dominating the hierarchy is the form of money that inspires the greatest confidence and can perform fully all of money’s primary functions. Here it is worth recalling that money is a form of credit, with state debt in the form of issued currency usually having the highest degree of credibility in terms of the expectation of future redeemability. Legitimate and stable political authority has two strong advantages when it comes to ensuring that its money constitutes the common denominator of the monetary hierarchy. First, the state can specify that the payment of tax liabilities must be in a specific currency. Second, in so far as a government maintains its fiscal balances within acceptable limits, respects the prevailing rules of political legitimacy and seems well positioned to maintain its territorial sovereignty, there is usually widespread confidence that the currency will be a generally accepted unit of account and means of payment in the future (often this acceptance is a legal requirement within a territorial monetary space).

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Other forms of money occupy a less dominant or less central position in the hierarchy, either because of less credibility or due to an inability to perform one or two of money’s general functions. For the most part, the position of a particular form of money in the monetary hierarchy is determined by two attributes: its liquidity, which means the ease with which it is redeemable into the dominant currency, and its effectiveness in performing money’s different functions. To take one example, the tokens stored on the smart cards used by some phone companies do not function at all as a generalised unit of account (no prices are posted in these units) and are limited as both a store of value (to the extent that they expire) and even as means of payment (no one else accepts them). Furthermore, these tokens are not at all liquid in that there is no redeemability back into the original currency. Frequent flyer miles and loyalty “dollars” are another example of a form of money with relatively narrow functionality. However, despite such limitations, these private tokens are a genuine form of money, while a credit card or other transaction mechanism, like a debit card, simply facilitates exchange using, in most cases, the dominant form of money.

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Looked at in terms of monetary spaces and hierarchies it becomes clear that most current discussions of “electronic money” are not about new forms of money at all but rather about new ways of executing transactions with existing forms. Genuinely new forms of money emerge when a person or institution offers to create a token which has no prior record and which they promise to redeem at a particular value in the future. In most circumstances this new token starts at a very weak position in the monetary hierarchy. By way of contrast, new tools or technological means for engaging and recording transactions often try to overcome the steep hurdles to widespread acceptance by using the most familiar and dominant form of money. So when credit cards were introduced there was no effort to compound the problems of gaining users’ confidence by attempting to introduce a new form of private money at the same time. Credit cards simply offer an easier way to use the currency that dominates the monetary hierarchy.

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Figure below uses these concepts to provide a graphical context for mapping possible directions for the future of money. The bottom left quadrant of the figure applies to situations where most transactions use the dominant currency of the monetary hierarchy, occur within a particular territory and are conducted using a physical medium. Historically, most societies have operated in this quadrant and even today this is the sphere of the majority of transactions involving individuals, retail merchants and small businesses. However, over time the weight of transactions measured in terms of value has moved more towards the bottom right quadrant. In specific markets such as oil, foreign currency and financial markets more generally, transactions have become less territorially circumscribed and more virtual, although for the most part the strongest currencies of the monetary hierarchy have continued to dominate.       

Figure below delineates possible paths for the future of money:

For the future, as figure above makes clear, the question is to what extent transactions will shift towards other quadrants – particularly the upper right, where conditions contrast the most with those that pertain today.

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Technology of Money in future:   

Over the past ten years there have been hundreds of electronic payment schemes – some representing new forms of money, others re-inventions of old – that have sought commercial acceptance. The list is long and notable for its successes and failures. Digital cash, digital wallets, stored value cards, micropayments have all, to date, failed to establish any significant beachhead or presence in the United States. Although P2P systems are emerging with interesting speed, 93% of all online transactions in the United States are still credit card-based.

Today, what do we have? Credit cards, cash and cheques dominate our money technologies. We do not expect any of them to disappear. In the coming few years some combination of today’s electronic payment instruments (card, chip, and PC based), cheques, and cash will continue to dominate, though perhaps in a different mix.

It is important to note that the non-cash technologies – when used online – are still principally linked to slow-moving book-entry clearing and settlement systems. When a consumer makes an online purchase using a credit card, for example, the only information actually moving over the Internet is the credit card information itself.

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Critical success factors:

New payment products are notoriously difficult to introduce. From a business perspective, the barriers to entry, acceptance, and ubiquity are high. As analysts point out, new payment products must be low margin to compete, high volume to build critical mass and be profitable, receive favourable press treatment, be well branded to gain customer confidence, achieve rapid uptake, and be differentiated from check and credit card so that consumers and merchants find reason to prefer and use them.

As a result, there is a great deal of risk in rolling out new payment products or infrastructures. Few of these business factors have in fact come together for new payment products, and consumers have shown a notorious reluctance to switch too far out of their preferred channels. One would surmise that products (such as smart cards) that have incremental roll-out benefits would ordinarily be more likely to attract investment and succeed in the marketplace.

Technically, the underlying attributes of new payment products also require certain factors to come together to succeed – if only because customers now enjoy these same attributes of financial transactions when they transact business face to-face, with third parties present:

• Integrity: transaction data are transmitted and received unchanged and as intended.
• Non-repudiation: transactions have the quality of non-deniable proof or receipts.
• Authentication: identities and attributes of parties engaged in commerce are established at some tolerable level of risk.
• Authorisation: individuals are established and recognised as entitled to receive, send or view transactions.
• Confidentiality: transactions can be protected from view except by those who are authorised.

Functionally, money technologies also need to achieve these operating characteristics:

• Privacy.
• Reliability: probability of failure in the transmission – send, receive, acknowledge – is low.
• Scalability: ability to raise capacity over time: technologies can be brought forward and replicate transactions thousands or millions of times, as necessary.
• Ease of use: probability of customer acceptance is high – predictors are comfort, convenience, confidence and cost, as well as technology interface.
• Vendor/device/mode agnostic: works no matter whether handheld, ear-borne, desktop, card-based.
• Personalise-able: device use, operations, interfaces can be tailored to individual preferences.
• Seamlessness: front-ground user interface operates with no impact from any vagaries of background infrastructure.
• Interoperability: distinct hardware/software infrastructures can communicate and exchange data as if they were identical.
• Write once, apply anywhere: interfaces, algorithms can be mapped to multiple modes, devices, systems with indifference.
• Cost-effective: risk/reward ratio is within tolerable business bounds.

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Recent efforts to introduce new money technologies – principally, digital currencies – have encountered resistance in the marketplace and have failed, in their initial run, to gather a critical mass of acceptance. Technologies in use today such as credit cards and cheques may use the Internet to send information securely, but they still rely on backend clearing and settlement systems that are derived from the requirements of book-entry protocols. It is expected that the move to electronic forms of payment will continue as computers, networks and the Internet become increasingly ubiquitous. With that, opportunities exist to create new payment products that solve problems associated with the established clearing and settlement systems. Immediate settlement of micro and macro trades, prepaid cards, and innovations in retail payment systems, for example, all hold promise against the cost and risk of e-commerce by credit card or cheque. In the near term, cash, credit card and cheque will continue to dominate. Yet emerging opportunities presage the possibility of new payment products that target inefficiency, cost, and risk in current payment products and systems. 

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Sure, there are plenty of new cryptocurrencies whose values fluctuate wildly from week to week. But if we’re worried about broader risks—to the economy, rather than just to speculators—maybe we should focus on stablecoins. Rather than promising overnight wealth, many stablecoins offer stability with the claim that each virtual coin will be worth exactly $1 today, tomorrow and forever. As more and more people trade a growing number of crypto-currencies, stablecoins such as Tether and USD Coin have exploded in popularity. And in the history of money, we often find the promise of boring stability is ultimately more risky than the promise of quick riches.

 

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Will cash disappear?

No.

It’s tempting to forecast the demise of cash. In fact, people have been predicting the end for physical money for nearly 60 years. With the rise of credit cards, contactless payments and cryptocurrencies like Bitcoin the death knells have only gotten louder. It may seem like physical money could soon be a thing of the past, but if you take a closer look at the evidence – and the intriguing psychological relationship we have developed with notes and coins – you’ll find that it’s a bit premature to predict cash’s disappearance.

Physical money has been with us for thousands of years for a reason. Cash is essentially untraceable, it’s easy to carry, it’s widely accepted and it’s reliable. If the power goes out, or there’s a blip in the electronic systems that make the online commerce world go round, cash is there. If someone wants to buy something without anybody tracing it back to her, cash is the way to do it. If someone wants to be certain that their form of payment will be accepted, cash is the best bet. Even with advances in technology, some of the aspects of cash simply aren’t reproducible with bits just yet.

There is simply no alternative system of payment that is as convenient, reliable and anonymous. Bitcoin is anonymous, but currently unstable and inconvenient. Credit and debit cards are widely accepted, but they instantly connect your purchases with your person. Peer-to-peer payment systems like Paypal or Venmo require apps and accounts, and are still easily traceable.

Then there’s the question of global reliability. In the case of American money, cash has value beyond the borders of the country. In fact, two thirds of cash holdings in American dollars exist outside the country. People store up cash for emergencies, to keep a safety net, and to ensure that whatever happens, their wad of cash will be there for them.

While technology is trying to design a system that has all the components that cash does, it’s simply not there yet. Which is why, when you look at the statistics we have on cash use around the world, paper and coin isn’t doing too badly after all.

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Cash in circulation:

It’s difficult to put a number on just how much cash is used day-to-day across the globe. One of cash’s key attributes is how hard it is to track. Still, the data that does exist gives us a glimpse.

The first way to estimate cash use is to calculate how much of it is in circulation. By this measure, cash is far from disappearing. In the United States, cash in circulation grew 42% between 2007 and 2012, and the amount of American money floating around in bills and coins is expected to grow by about 5% each year. The average growth globally is 7% per year, according to Eric Ziegler, President of the Security Technologies Group at Crane Currency, which manufactures notes.

However, that’s not the same as how much cash is actually changing hands in daily transactions. “Nobody has a way of going into the economy and counting how many bills are out there and the value of those bills,” says Daniel Wilson, an economist with the Federal Reserve Bank of San Francisco. “We don’t know exactly how many cash transactions are occurring on any given day.”

To get some sense of how cash moves, economists design models and surveys. In the Netherlands, for example, economist Nicole Jonker and her team at the Dutch National Bank conducted something called a diary study, in which they asked participants to write down a day’s worth of transactions, both cash and non-cash. From there, Jonker and her team built a picture of the how Dutch people were buying things. The Netherlands is an interesting case study to look at more closely, because their retail sector has recently embraced card payments in a big way. There are now 1,400 supermarkets in the Netherlands with registers that don’t accept cash. As a result, card payments in the Netherlands have been growing by about 8% annually over the past few years. And yet, cash is still king. In 2012, there were 2.7 billion card payments, but an estimated 3.5 to four billion payments were made with cash. “Even in supermarkets which all accept debit cards, cash is still used heavily,” Jonker says. “For the time being we think cash will keep on having an important role.”

Studies of other nations tie in with these findings. In the UK, half the transactions by consumers in 2013 were with cash, according to a report released by the UK Payments Council (now known as Payments UK).

And one study that rounded up surveys like Jonker’s from around the world found that, in the seven countries they looked at — Australia, Austria, Canada, France, Germany, the Netherlands and the United States, 46-82% of all transactions in 2012 were conducted using cash (a wide range that may reflect both the uncertainty in the survey methods, and the variability between nations).

Even countries that are often held up as the leaders of a cashless crusade, such as Sweden and Denmark, aren’t really getting rid of notes and coins.

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Relationship with cash:

Perhaps cash’s sticking power has something to do with our strange relationship with notes and coins. As with most of our decisions and preferences, our affinity for cash isn’t entirely rational. People value cash differently than they value electronic money, even though the two have the exact same value. Psychologist Eric Uhlmann, from the Paris School of Management, has done a handful of studies that picked apart how differently people feel about different kinds of money. “I’m interested in human intuition and economic irrationalities,” he says. “There’s this sort of irrational feeling that if money is physical, it’s more yours, and you feel like you own it more. If you touch a dollar more, then that particular dollar becomes yours.” This kind of thinking applies not to just dollars in a box, but larger questions of theft and justice as well. Another researcher has done studies showing that people feel less negatively about white-collar crime, where people aren’t stealing physical things, than they do about blue-collar crimes in which an object is taken. Another study found that people cheat more when they’re cheating for tokens, than when they’re cheating for actual money. If you leave a Coca-Cola out, people are far more likely to take it than if you leave a dollar.

Could that mean that we might resist giving up cash entirely?

There’s some evidence that suggests so. In the US, there has been a backlash against abolishing pennies – despite being worth less than they cost to produce, some Americans aren’t ready to part with the coin. Over in Australia, talk of abolishing the five cent coin was met with concern over the loss of income that charities receive from small change, and potential consumer backlash over rounded-up prices. History also suggests that there is a safety and security we feel about cash that digital currencies can’t quite match. When there’s a financial crisis, people would rather have their money in hand, than behind the teller’s window or in the cloud.

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The digital payment:

While most conversations about the future of technology might myopically focus on America and Europe, some of the greatest innovations in money aren’t coming from either place. In some developing countries, cash transactions are quickly being replaced by digital payments, powered by mobile phones. While in the US, you still might buy your coffee with cash in 2025, that might not be the case in Kenya. In 2007, Kenyans began to adopt a system called M-Pesa and in 2015 it is used by over 17 million Kenyans, over two-thirds of the adult population. Users top-up their accounts and transfer money by sending a text message; the recipient then takes their phone to a vendor to get their money. No banks are involved.

While tech evangelists might like to believe they can replace global use of cash with digital transactions or Bitcoin, the truth is a bit more complicated and the hurdles aren’t all fixable by technology alone. Our psychological attachment to money, the infrastructure available to banks, and the need to create systems that are compatible with lots of vendors and users, all make progress away from cash more of a slog than a sprint. What will happen when we will experience massive IT breakdowns that are expected to occur in the future? Future wars will not be fought by troops on land but rather by people sitting behind computer screens. Earlier, banks have not shown the capability of taking timely precautions, and IT companies still lack the evidence to prove that they respect privacy and are capable of protecting sensitive data. Thus, we are facing a completely new and challenging ethical and security-related problem with e-money and virtual payment methods.

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Money printing:

When you ask those who actually make currency whether they lose sleep over the looming cashless future, they say they’re not worried. “Frankly, based on the continued growth rate of cash, we don’t anticipate the disappearance of cash in the possible near term, or even medium term,” says Eric Ziegler at Crane Currency, a money design and manufacturing company. He doesn’t think Crane even has a cashless contingency plan, nor that they need one. Of course, saying that cash isn’t going away isn’t the same as saying cash is going to look the same forever. Banks and printers are constantly engaged in the fight against counterfeiters – a fight that goes all the way back to the 4th Century BC. And our future money will probably be a lot more digital than it is now.

Manufacturers like Crane are developing futuristic bills that involve large, easy to recognise security features. According to Ziegler, the best security features are the most obvious ones. “You want it to be technologically advanced, but so easy and obvious that if it’s missing the average cashier isn’t going to miss it,” he says. For that reason, he says, future money will likely continue to feature portraits and heads. Not just because we love to memorialise people, but because portraits are also a great way to challenge counterfeiters because as humans we’re good at recognising irregularities in faces. “If the hair is slightly different, or the glasses are off, we notice,” says Ziegler. “Portraits are a great security feature.”

Beyond creating new bills with advanced security features, others are toying with the idea of slapping the digital world right on top of the physical one. In 2001 the European Union considered adding an RFID chip to each bill, largely in response to a huge number of counterfeit euros discovered in Greece. They ultimately rejected the idea, as it would increase the cost of producing bills dramatically, but according to Nicolas Christin, a researcher at Carnegie Mellon University, future money might be full of these kinds of digital elements. In fact, it’s not the technology that’s missing, Christin says, it’s the infrastructure.  An RFID chip is only useful if someone has an RFID reader to scan it with. “Think about the guy on the beach in Thailand who wants to rent a surfboard,” says Christin. “Do you have all the infrastructure you need to use that technology there?” “It’s not that the technology doesn’t exist,” he adds, “it does, it would just cost a lot of money and be hard to deploy universally.” In other words, the exact challenges that face digital currencies are what make digital additions to cash so difficult.

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So where does that leave us?

“Until we have sufficient and reliable alternatives in place, it would be dumb to get rid of cash now,” says David Wolman, author of the book The End of Money. “Honest people and legit businesses still rely on it.” Instead of constant cheering or hand wringing about the word “cashless,” people should be examining the trends that are pushing cash away. “It would be foolish to conflate enthusiasm about the impact of that marginalisation with unthinking cheerleading for cash’s total demise,” he says. Many who think about cash like to use Mark Twain’s quote: “reports of my death have been exaggerated.” In one paper, the authors compare cash to a kind of Cinderella. “It doesn’t have a mom or dad to watch over it – just those horrible stepsisters that try to convince Cinderella that she is ugly. But she isn’t,” they write. Cash is with us, and it will stay with us whether Bitcoin and PayPal advocates like it or not.

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Moral of the story:     

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-1. Money is one of the most fundamental inventions of mankind. The invention of money belongs in the same category as the great inventions of ancient times, such as the wheel, the fire and the inclined plane. The creation of money is made possible because human beings have the capacity to accord value to symbols. Money is a symbol that represents the value of goods and services. Money is designed as a means of exchange and a measure of wealth. Money is indispensable in an economy, be it capitalist or socialist.  

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-2. There is no evidence about the first emergence of money; particularly the time and place concerned because the history of money is “lost in the mists of time,” as money’s invention probably predates writing.  

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-3. Human beings need money to pay for all the things that make their lives possible, such as shelter, food, healthcare, education, safety and security. Without money there can be no market.

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-4. Money is a concept which we all understand but which is difficult to define in exact terms. We are destined to fail if we try to define ‘money’ from the viewpoint of materials or forms. Money changed its materials and its forms in the course of the development of economic society; from gold & silver (commodity money), to paper on which some numbers and figures are printed (fiat money), to abstract number recorded in the computers (digital money). Therefore, we must define ‘money’ from the viewpoint of its function. For most economists, money serves three classic functions – as unit of account, means of payment, and store of value. In the future there is little prospect of change in these basic attributes. Money is a construct, used in societies to store, measure and transfer value. Money can be defined as anything that is generally acceptable by the people in exchange of goods and services or in repayment of debts; and that at the same time acts as a measure and a store of value. Money is not income, Money is not savings, Money is not wealth and Money is not capital.

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-5. Since the value of the money in use in any society is insignificant as compared with its total wealth valued in terms of money, it has been argued that the function of money as a measure of value is far more important than its function as a medium of exchange. All things capable of sale can be valued in terms of money. All credit operations depend upon this fact.  

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-6. Although money can take an extraordinary variety of forms, there are really only two types of money: money that has intrinsic value and money that does not have intrinsic value. Commodity money is created from precious metals such as gold and silver, while representative money represents a claim on a commodity that can be redeemed. Fiat money with no intrinsic value was introduced as an alternative to commodity money and representative money. For a fiat currency to be successful, the government must protect it against counterfeiting and manage the money supply responsibly.    

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-7. Currently, fiat money is generally centralized, traceable and unconstrained, but this is a relatively recent phenomenon. However, historically, money was open, decentralized, anonymous and supply constrained, and there is clearly important utility to this combination of attributes. Gold is the most ubiquitous commodity money and is fully anonymous, decentralized, open, supply constrained and physical. While gold is still used as money, its primary function is store of value.  

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-8. Economically, each government has its own money system, defined and monitored by a central authority. The money used by a community does not have to be a currency issued by a government. A famous example of community adopting a new form of money is prisoners-of-war using cigarettes as money to trade. What makes something money is really found in its acceptability, not in whether or not it has intrinsic value, or whether or not a government has declared it as such. For example, fiat money tends to be accepted so long as too much of it is not printed too quickly. When that happens, as it did in Russia in the 1990s, people tend to look for other items to serve as money. In the case of Russia, the U.S. dollar became a popular form of money, even though the Russian government still declared the rouble to be its fiat money. Money is whatever that is generally accepted as money within a society at a given time.    

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-9. A currency is a standardization of money in any form when in use or circulation as a medium of exchange for a particular country. Cash is money in the physical form of currency, such as banknotes and coins. American dollar is currency of America and dollar bill/note is cash. While early currency were backed by physical commodities such as silver and gold, today’s fiat money (fiat currency) is a currency that lacks intrinsic value and is established as a legal tender by government regulation. The United Nations recognises around 180 currencies as legal tender. Currencies may be traded between nations in foreign exchange markets, which determine the relative values of the different currencies.  The U.S. dollar is also the official currency in several countries and the de facto currency in many others, with Federal Reserve Notes (and, in a few cases, U.S. coins) used in circulation.   

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-10. Legal tender money is simply a third party’s promise to pay which we accept as full payment in exchange for goods & services. The two main third parties whose promises we accept are the government and the banks. Legal tender money is issued by the monetary authority of a country (central bank). It has legal sanction of the Government. Every individual is bound to accept legal tender money in exchange for goods and services, and in the discharge of debts. National currencies, such as the U.S. dollar, are legal tender. 

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-11. The domain of money is defined as comprising the users who adopt it, and the locale or context of use; money in one domain, even if intrinsically the same, may not be money in another. An object is money because it supports the triad of functions (unit of account, store of value and medium of exchange), alternatively, the object cannot be considered as money if it fails on at least one of the triad functions. The evaluation of new money proposals such as Bitcoin, Diem, DeFi tokens or central bank digital currencies (CBDCs) is not effective using this triad-based analysis, without this deeper contextualization of their domain of use. For example, the use of CBDCs is being considered carefully in the context of domain (e.g., retail vs. wholesale settings) and as a consequence its functionality as money will vary. This domain context is helpful in debate about whether new digital forms of currencies such as cryptocurrencies or CBDCs are or can act as a form of money.

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-12. To be able to perform the functions of money well, the money material must possess various properties like Durability, Portability, Scarcity, Divisibility, Cognizability, Malleability, Homogeneity, Elasticity, Stability of value, Storability, Fungibility, Countable and Noncounterfeitability.  So far not a single commodity has been discovered which possess all the properties in their entirety. The properties of money are not solely determined on the basis of the object or artefact used as money but in terms of the combined intrinsic attributes (those inherent to the object or artefact), and extrinsic attributes (those realised or provided within a domain). Intrinsic and extrinsic attributes in turn give rise to the differing capabilities of a particular manifestation of money to fulfil the functions of money in a particular domain.

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-13. Money is an asset to the person or firm holding it, but is also a liability for somebody else in the economy. Consumers carrying banknotes in their wallets hardly think of themselves as creditors; nonetheless, banknotes represent the central bank’s debt to banknote holders. Similarly, a bank deposit represents the bank’s debt to the customer. If the liability resides inside the private sector then the money is inside money. If the liability resides outside the private sector then the money is outside money. Bank deposit is a liability of the private bank that issues it. Bank balance is inside money, while gold coinage is outside money. 

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-14. Credit/debit cards and bank checks are not money. Checks can bounce and credit/debit cards can be declined. Credit/debit cards and checks are different ways to move money when a purchase is made. But having more credit cards or debit cards does not change the quantity of money in the economy, any more than having more checks printed increases the amount of money in your checking account.    

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-15. Basically, all your money in banks today is money (currency) represented digitally. They are digital money and not digital currency. Digital money is not about new forms of money at all but rather about new ways of executing transactions with existing forms. Transactions are digital but withdrawal from bank/ATM are still banknotes. All the digital money in all banks cannot be converted into cash as only 3-8% of M2 (broad money) globally is physical money and rest 92-97% of the world’s broad money is digital. Digital money as bank deposits makes up the vast majority of the amount currently in circulation. Money has now become a complete intangible concept that is represented by numbers in the computer system.

Digital currencies include cryptocurrency, virtual currency and central bank digital currency. Cryptocurrencies are not currencies as they do not have an issuer, are not an instrument of debt or a financial asset and do not have any intrinsic value. Anything that derives value based on make believe, without any underlying, is just speculation.    

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-16. In finance and accounting, cash refers to money (currency) that is readily available for use. It may be kept in physical form, digital form, or invested in a short-term money market product. In economics, cash refers only to money that is in the physical form i.e., fiat currency in physical form.

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-17. As of 2021 total tally of currency in circulation (notes and coins) from all over the world is about $5 trillion.  If you are looking for all the physical money (notes and coins) and the money deposited in savings and checking accounts worldwide, you could expect to find approximately $40 trillion. This figure represents only ‘narrow money’. However, if you add the ‘broad money’, the amount rises to over $90.4 trillion. This amount further increases when bitcoins and other cryptocurrencies are included. Money in the form of investments, derivatives, and cryptocurrencies exceeds $1.3 quadrillion. 

The top 26 billionaires of the world own as much money as the poor 3.8 billion people.  

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-18. Economists refer to the ease with which an asset can be converted into currency (cash) as the asset’s liquidity. Currency (cash) itself is perfectly liquid; you can always change two $5 bills for a $10 bill. Checkable deposits are almost perfectly liquid; you can easily cash a check or visit an ATM. An office building, however, is highly illiquid. It can be converted to money only by selling it, a time-consuming and costly process.  

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-19. A cash transaction is a transaction where payment is settled immediately and the payment for a credit transaction is settled at a later date. Try not to think about cash and credit transactions in terms of how they were paid, but rather when they were paid. The key difference between cash and credit is that one is your money (cash) and one is the bank’s (or someone else’s) money (credit). One of the benefits of using credit is that you can buy the thing you want now, even if you don’t have the cash saved up yet. For example, if you buy TV online and pay from your account, it is cash transaction even if no physical cash involved. However, if you pay from credit card, it is credit transaction as money is paid by bank at the time of transaction and you will pay bank at a later date.    

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-20. The relation between money and what it will buy has always been a central issue of monetary theory. Classical Monetary theory is based on the idea that a change in money supply is a key driver of economic activity. It argues that central banks, which control the levers of monetary policy, can exert much power over economic growth rates by tinkering with the amount of currency and other liquid instruments circulating in a country’s economy. According to monetary theory, if a nation’s supply of money increases, economic activity will rise too, and vice versa.

Quantity theory of money (neoclassical monetary theory) states that money supply and price level in an economy are in direct proportion to one another. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. Typically, an increase in the money supply (such as the increase generated through the central bank’s large-scale asset purchases) causes inflation to rise as more money is chasing the same amount of goods. During normal times, inflation increases 0.54 percent for each 1 percent increase in the growth of money.

A simple formula governs both classical monetary & neoclassical quantity theory: MV = PQ.  

M represents the money supply (nominal quantity of money over which central bank has some control), V is the velocity (number of times per year the average dollar is spent), P is the price of goods and services, and Q is the number of goods and services (real quantity of transaction or the level of current real GDP), so PQ represents current nominal GDP. The equation of exchange is an identity which states that the current market value of all final goods and services—nominal GDP—must equal the supply of money multiplied by the average number of times a dollar is used in transactions in a given year.

The classical economists believe that the economy is always at or near the natural level of real GDP. Accordingly, classical economists assume that Q in the equation of exchange is fixed, at least in the short‐run. Furthermore, classical economists argue that the velocity of circulation of money tends to remain constant so that V can also be regarded as fixed. Assuming that both Q and V are fixed, it follows that if the central bank was to engage in expansionary (or contractionary) monetary policy, leading to an increase (or decrease) in M, the only effect would be to increase (or decrease) the price level, P, in direct proportion to the change in M. In other words, expansionary monetary policy can only lead to inflation, and contractionary monetary policy can only lead to deflation of the price level. According to quantity theory of money, money is neutral and changes in money supply changes general price level.  

According to classical monetary theory, money is non-neutral and money supply is a key driver of economic activity, and changes in money supply changes real national income and labor employment. Assuming constant V, when M is increased, either P, Q, or both P and Q rise. The quantity of money in an economy has a large influence on its level of economic activity. So, a change in the money supply results in either a change in the price levels or a change in the supply of goods and services, or both. In addition, changes in the money supply are the primary reason for changes in spending. General price levels tend to rise more than the production of goods and services when the economy is closer to full employment. When there is slack in the economy, Q will increase at a faster rate than P under classical monetary theory.

Critics of the quantity theory argue that money velocity is not stable and, in the short-run, prices are sticky, so the direct relationship between money supply and price level does not hold.

Critics of classical monetary theory warn that excess money supply by money creation (printing banknotes and/or creating digital money) can lead to a lack of discipline and, if not managed properly, cause inflation to spike, eroding the value of savings, triggering uncertainty, and discouraging firms from investing, among other things. The premise that taxation can fix these problems has also come under fire. Critics also point out that higher taxation will end up triggering a further increase in unemployment, destroying the economy even more.   

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-21. The traditional functions of money, i.e., medium of exchange, measure of value, standard of deferred payments and store of value, all are the static or technical functions of money. In the static functions, money acts as a passive or technical tool to ensure a smooth working of the economic system. It does not have a causative influence on the economic activities. So here money is neutral in economic system.

The dynamic functions are those by which money actively influences the economic system through its impact on price level, interest rates, volume of production, distribution of wealth and income etc. In its dynamic role, money tends to influence the economic trends and a force driving economic and social change. So here money is non-neutral in economic system.   

In my view, the same money can perform static and dynamic functions as money comes into existence by performing static functions and then performs dynamic functions to influence economy. You take out static functions and money cease to exist, but once comes into existence, it performs dynamic functions influencing economic activities. I disagree with the concept of paradox of money in economics which states that money can’t be both static and dynamic at the same time because the states are mutually exclusive. It is just play of words. Instead of using words like static/dynamic or neutral/non-neutral; use words like ‘basic functions’ and ‘advanced functions’.    

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-22. Purchasing power is the value of a currency expressed in terms of the number of goods or services that one unit of money can buy. The values of all commodities are expressed in money as prices. Conversely, the prices of commodities express the value of money. We speak of prices as high or low, but we might as well speak of money as cheap or dear. Money is cheap when prices are high, and is dear when prices are low. Prices and the value of money are reciprocals. The value of money and the general price level are inversely proportional to each other. Violent changes in the value of money (or the price level) disturb economic life and do great harm.

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-23. Demand for money is the demand for money to hold. The demand for money is the desired holding of financial assets in the form of money: that is, cash or checkable bank deposits rather than investments. The demand for money is affected by several factors, including the level of income, wealth, interest rates, inflation, volume of exchange, rapidity of monetary circulation, use of credit as well as uncertainty about the future. Whatever increases the volume of exchanges increases the demand for money while credit minimizes the demand for money. The way in which these factors affect demand for money is usually explained in terms of the three motives for holding money: the transactions, the precautionary, and the speculative motives.   

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-24. The total quantity of money in the economy at any one time is called the money supply. The money supply is the total amount of money—cash, coins, and balances in bank accounts—in circulation. Since the money supply consists of various financial instruments (usually currency, demand deposits, and various other types of deposits), the amount of money in an economy is measured by adding together these financial instruments creating a monetary aggregate. Monetary supply aggregates (M1, M2, M3) are the formal breakdown and measurement of money supply in the economy based on liquidity. M1 is the most liquid category while M3 encompassing most illiquid assets. M1 is the total amount of M0 (cash/coin) outside of the banking system plus the amount of demand deposits, travelers checks and other checkable deposits. M2 is M1 plus most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits. M1 and M2 money have several definitions, ranging from narrow to broad money. Remember, the precise definition of M1, M2, M3 etc. may be different in different countries.

M0 is the base money (monetary base or high-power money), the amount of money actually issued by the central bank of a country. M0 is the most liquid category, as it represents all the physical coinage and paper money in circulation plus bank reserves; but bank reserves are not included in money supply as they are not in circulation with the public at a given point in time.   

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-25. Economists measure the money supply because it affects economic activity. Money supply’s possible impacts on economy includes price levels, interest rate, economic growth, inflation, and business cycle. An increase in the supply of money typically lowers interest rates, which in turn, generates more investment and puts more money in the hands of consumers, thereby stimulating spending. Businesses respond by ordering more raw materials and increasing production. The increased business activity raises the demand for labor. Increase in money supply boost economic growth but economy can grow even at reduced money supply; for example, when people took money out of their low-interest bearing savings accounts and invested it in the booming stock market, the M2 fell, but the economy grew.  It is the investment, production and spending that leads to economic growth rather than mere increase in money supply. If increase in money supply does not result in increase in real GDP, inflationary pressure is created.    

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-26. The value of money, as of any other commodity, is dependent upon its supply and demand. When money supply is more and demand for money less, value of money falls. When money supply is scarce and demand for money more, value of money rises. Assuming that no other influences are at work, it must be admitted that any increase in the money supply will lower its value and that any decrease will enhance it. Every increase in the world’s money supply has been followed by a rising in prices or a fall in the value of money.

The value of money also depends on demand and supply of commodities it exchanges. For example, scarcity of oil will increase oil prices and massive increase in oil prices may have cascading effects on prices of other commodities resulting in fall in value of money. 

The value of money also depends on perception of its value. The value of fiat money is dependent on how a country’s economy is performing, how the country is governing itself, and the effects of these factors on interest rates. A country experiencing political instability is likely to have a weakened currency and inflated commodity prices, making it hard for people to buy products as they may need.  

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-27. In economics, inflation is a general increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. Inflation is when the value of money steadily declines over time. Once people expect that prices will rise, they are more likely to buy now, before prices go higher. That increases demand, which tells producers they can safely pass on more costs. They drive prices up more, and inflation becomes a self-fulfilling prophecy. That’s why central banks watch inflation. They will reduce the money supply or raise interest rates to curb inflation. The monetary and fiscal measures will reduce the money supply in the country, whereas the physical and non-monetary measures will increase output and control prices of goods. Thus, inflation can be gradually controlled. The Consumer Price Index is the most common measure of inflation. Generally, inflation inflicts more harm to low and fixed income groups than high-income group of people. It adversely affects distribution of income and wealth in the community so that the gulf between the rich and poor increases. Changes in purchasing power directly or indirectly affect nearly every financial decision, from consumer choices to lending rates, from savings to investments, and from asset allocation to stock prices.

Deflation will certainly raise the value of money or its purchasing power. But it’s the fear of rapidly plunging prices that will make people hold on to their money, lessen aggregate demand for goods and services, and cause a serious slowdown in economic activity. 

Inflation is better than deflation. Deflation completely ruins the economy, whereas mild levels of inflation help in the growth of the economy, it leads to more investments, production and employment. Inflation, though it redistributes income and wealth in the community in an unjust manner, does not reduce the national income of the community. Presently, most economists favor a small and steady rate of inflation. Deflation, on the other hand, reduces the national income of the community and pauperizes society as a whole.  

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-28. Money today is worth more than money in the future because today’s money can be invested and grown. This is time value of money.

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-29. You’re actually losing money in a bank account due to inflation when inflation rate is significantly higher than interest paid by bank to you.

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-30. Much has been written about the quantity of money and its effects on money’s purchasing power. However, changes in the quality of money have been widely neglected. The changes in the quality of money can influence the purchasing power of money. Gresham’s law says that “bad money drives out good”. That is, when buying a good, a person is more likely to pass on less-desirable items that qualify as “money” and hold on to more valuable ones. For example, coins with less silver in them (but which are still valid coins) are more likely to circulate in the community. This may effectively change the money used by a community. In cases of hyperinflation, foreign currencies often come to replace local, hyperinflated currencies; this is an example of Gresham’s law operating in reverse. Once a currency loses value rapidly enough, people tend to stop using it in favor of more stable foreign currencies.  

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-31. Banks hold on reserve, and not lend out, some portion of their deposits by customers—either in cash or in securities that can be quickly converted to cash. Banks lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it. The process of relending can repeat itself a number of times in a phenomenon called the multiplier effect. The size of the multiplier—the amount of money created from an initial deposit—depends on the amount of money banks must keep on reserve. Under cash reserve ratio (CRR), the commercial banks have to hold a certain minimum amount of deposit as reserves with the central bank. The percentage of cash required to be kept in reserves as against the bank’s total deposits, is called the Cash Reserve Ratio. It means that if the reserve ratio is higher and the banks need to keep more reserves, then the money multiplier will be lower. As a result, they will not be able to lend more money to individuals and businesses. Similarly, a lower reserve ratio allows a lesser amount of money to be kept as a reserve resulting in a higher money multiplier and more lending opportunities to the public.

What I stated just now is popular misconception of how bank create money.

Money creation in practice differs from popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, nor do they depend on central bank money (M0) multiplier to create new loans and deposits. Bank deposits by savers are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out. Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits. New broad money is created when bank lends money. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. The majority of money in the modern economy is created by commercial banks making loans. This description of money creation contrasts with the notion that banks can only lend out pre-existing money. Banks create money out of thin air. It is unbelievable but true. Of course, you can say that commercial banks create private money by transforming an illiquid asset (the borrower’s future ability to repay) into a liquid one (bank deposits). Of course, bank can mortgage borrower’s assets as guarantee for repayment of loans. Banks create around 80% of money in the economy as electronic deposits in this way. New money is created when bank loan is extended and that money cease to exist when the loan is repaid in full.

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-32. Money creation (money printing/printing money) means either printing banknotes or creating digital money in bank accounts. Money creation leads to increased money supply. Replacing old/soiled/damaged notes by printing banknotes is not money creation. Printing banknotes accounts for only a tiny fraction of money creation. In contemporary societies, the great majority of money is created by commercial banks rather than the central bank and various procedures are used to create money:    

• 1. Legal tender is the cash created by a Central Bank by minting coins and printing banknotes at its discretion. The Nobel Prize winner in Economic Sciences, Maurice Allais believes that there is no difference between the money created by central banks and counterfeiters (punished by law). It is made out of nothing and leads to the same results. The only difference is that those who benefit from it are different. Printed money is distributed to public through massive tax cuts or spending programs.
• 2. Bank money (broad money/M2) is the money created by commercial banks through the recording of loans as deposits of borrowing clients as discussed in previous paragraph. Out of all broad money, about 80 % money is created by commercial banks digitally when they extend loans.
• 3. Central bank can create new money (digital/electronic money) by process of debt monetization, open market operations and quantitative easing.

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-33. The amount of money created in the economy ultimately depends on the monetary policy of the central bank. It is the central bank’s job to manage the money supply. The way in which a central bank can increase or decrease money supply are as follows:  

• 1. Could print paper currency at its discretion in an effort to increase the amount of money in the economy
• 2. Modifying Reserve Requirements of banks
• 3. Changing Short-Term Interest Rates (discount rate, funds rate) to banks
• 4. Conducting Open Market Operations by buying and selling government bonds & treasury bills in open market. The central bank buys government treasuries and other securities from its member banks and replaces them with credit. All central banks have this unique ability to create credit out of thin air. That’s just like printing money. The usual aim of open market operations is to supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks.
• 5. Extraordinary crisis measures:

-Quantitative easing: Quantitative easing (QE) occurs when a central bank buys long-term securities from its member banks. By buying up these securities, the central bank adds new money to the economy; as a result of the influx, interest rates fall, making it easier for people to borrow.  QE is an expansion of open market operations. QE technique is usually employed throughout a disaster and when open market operations have failed.  

-Credit easing

-Operation Twist 

Note:

It would be wrong to say that only central bank control money supply as majority of money is created by commercial banks by extending loans albeit interest rate is governed by central bank policy. In normal times, the central bank does not fix the amount of money in circulation.   

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-34. The control of the amount of money in the economy is known as monetary policy. Monetary policy is a tool implemented by the central bank to maintain economic stability and growth. The goals of monetary policy are to promote maximum employment, stable prices, economic growth and moderate long-term interest rates. The concept of money neutrality is usually interpreted as meaning that money cannot influence the real economy in the long run. However, by the setting of its policy rate, a central bank hopes to influence the real economy via the policy rate’s impact on other market interest rates, asset prices, the exchange rate, and the expectations of economic agents.  A failed monetary policy can have significant detrimental effects on an economy and the society that depends on it. These include hyperinflation, stagflation, recession, high unemployment, shortages of imported goods, inability to export goods, and even total monetary collapse and the adoption of a much less efficient barter economy.   

Fiscal policy is carried out by the legislative and/or the executive branches of government. Fiscal policy deals with taxation and government spending. In contrast, monetary policy involves effecting change by manipulating the monetary supply. Both monetary and fiscal policies are used to regulate economic activity over time. They can be used to accelerate growth when an economy starts to slow or to moderate growth and activity when an economy starts to overheat. In addition, fiscal policy can be used to redistribute income and wealth.  

Both fiscal and monetary policy work through different channels, so the policies are not interchangeable, and they conceivably can work against one another unless the government and central bank coordinate their objectives.  

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-35. The term monetization refers to the coining of currency or the printing of banknotes by central banks, although broadly speaking, monetization refers to process of converting something into money i.e., to convert an asset into money or a legal tender. Debt monetization means purchase of government bonds by the central bank to finance the spending needs of the government. Debt monetization is a type of ‘money printing’ as new money is created (not necessarily banknotes) without a corresponding increase in real GDP. Monetization is the third unconventional alternative for governments to raise funds other than borrowing and raising revenue through tax and divestment. Monetization only works if there is a respected and responsible central bank ready to turn off the taps when inflation threatens to exceed its targets and a responsible government.     

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-36. Poorer nations can’t just print more money and become rich. To get richer, a country has to make and sell more things – whether goods or services. This makes it safe to print more money, so that people can buy those extra things. If a country prints more money without making more things, then prices just go up, and people will stop using that money. Too little money makes prices fall, which is bad. But printing more money, when there isn’t more production, makes prices rise, which can be just as bad.  

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-37. If the Money Supply increases faster than real output then, ceteris paribus, inflation will occur. If a country prints money and causes inflation, then, ceteris paribus, the currency will devalue against other currencies.

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-38. In a recession, with periods of deflation, it is possible to increase the money supply without causing inflation. This is because the money supply depends not just on the monetary base, but also the velocity of circulation. For example, if there is a sharp fall in transactions (velocity of circulation) then it may be necessary to print money to avoid deflation. In the liquidity trap of 2008-2012, the Bank of England pursued quantitative easing (increasing the monetary base) but this only had a minimal impact on underlying inflation. Government can print more money to tide over a financial crisis. Deficit financing is practice in which a government spends more money than it receives as revenue, the difference being made up by borrowing or minting new funds. The government may use the acquired cash to revive the economy by investing and spending.    

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-39. Modern monetary theory (MMT) supports money printing to finance expenditure to achieve progressive ends as spending leads to money multiplier effect. According to the MMT theory, deficits don’t matter as much as we think they do and aren’t necessarily a signal of a shaky economy. If the government can simply create more money, then the government deficits can be easily fixed. In short, MMT says that a government can finance any budget deficit by de facto monetization and hence have no monetary limits. Modern Monetary Theory (MMT) proponents claim that money printing is s a useful economic tool, while disputing claims that it leads to currency devaluation, inflation, and economic chaos. Modern Monetary Theory (MMT) argues that the government can solve economic problems by printing money until it causes inflation, at which time taxes need to increase to rein in that money. Taxation will reduce the effect of expansionary monetary policy.

However only those countries where economies consistently run a fiscal deficit and a current account surplus, and are well-governed, are strong enough for the MMT treatment. Indeed, consider the states that have tried MMT – and the results: Argentina – and hyper-inflation; Brazil – and hyper-inflation; Weimar Germany – and hyper-inflation; and Zimbabwe – and hyper-inflation. So far evidence shows that MMT results in hyperinflation, currency devaluation, and economic chaos.     

Present Sri Lankan economic crisis is mainly due to tax cuts and money creation. The Government of Sri Lanka made large tax cuts that affected government revenue and fiscal policies, causing budget deficits to soar. To cover government spending, the Central Bank began printing money in record amounts ignoring advice from the International Monetary Fund (IMF) to stop printing money and instead hike interest rates and raise taxes while cutting spending. The IMF warned that continuing to print money would lead to an economic implosion. In fact, it has led to unprecedented levels of inflation (>50%), near-depletion of foreign exchange reserves, shortages of medical supplies and an increase in prices of basic commodities.      

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-40. Demonetization is a drastic intervention into the economy that involves removing the legal tender status of a currency. Governments of many countries across the world have taken this drastic measure to curb black money and stop the counterfeiting of currency notes. Demonetization can cause chaos or a serious downturn in an economy if it goes wrong. The RBI report after 2016 Indian demonetization mentioned that 99.3% of all demonetized currency returned to the banking system. which led many experts to point out that the demonetization experiment was a failure to curb black money. Indian economy lost 1.5% of GDP in terms of growth. That alone was a loss of Rs 2.25 lakh crore a year.  It is estimated that 1.5 million jobs were lost.

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-41. Thinkers as different as Adam Smith, Karl Marx and Georg Simmel all made some version of the argument that whenever money is involved, that’s when morality stops. Money impacts our sense of morality, our relationships with others, and our mental health. Several studies have shown that wealth may be at odds with ethics, empathy and compassion. Money was designed as a means of exchange and a measure of wealth but somehow that has changed and what was once solely a means to an end has become the end itself. Money is the root cause of many crimes. Keeping in view the evils of money, it has been said, “Money is a good servant but a bad master.” 

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-42. Money laundering is the process in which the proceeds of crime are transformed into ostensibly legitimate money or other assets. Money laundering activities cost the world 2% to 5% of its GDP. That’s approximately $800 billion to $2 trillion laundered annually. Anti-money laundering activities recover only 0.1% of criminal funds.

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-43. According to the Federal Reserve of the United States, counterfeit money accounts for less than 0.01 percent of all money in circulation in the United States. This implies that the likelihood of encountering check fraud is 20 times greater than the likelihood of experiencing counterfeit money. 

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-44. About ⅓ of married couples fight over cash each month. In fact, money is one of the leading causes of divorce for couples and financial strain pushes couples away from reconciliation.

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-45. Poor people don’t perform well on cognitive tests because poverty related concerns consume mental resources leaving less for other tasks and poverty related malnutrition & poor education affect brain performance. 

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-46. In many countries across world, governments have used money as a way of ‘capturing’ the media and making it subservient to state aims.   

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-47. Money allows people to live longer and healthier lives, to buffer themselves against worry and harm, to have leisure time to spend with friends and family, to control the nature of their daily activities; and allow them to fix & resolve problems more quickly—all of which are sources of happiness. Money does give you happiness. Various studies show that poverty does result in lower happiness levels.  

On the other hand, money is an opportunity for happiness, but it is an opportunity that people routinely squander because the things they think will make them happy often don’t. Also, money can’t make you happy if your increased wealth brings increased expectations. In other words, if you want more as you earn more, you’ll never be content; there will always be something else you crave, so you’ll need to work even harder to get the money to buy it.   

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-48. Culture affects financial decision-making around the world. Culture influences a wide range of economic behaviors including the decision to become self-employed rather than to work for others, entry choice of multinational firms, the development of trust between employees and control methods, indebtedness and mortgages, shopping behaviours, investment behaviours, saving behaviours and love for cash.   

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-49. Physical money has been with us for thousands of years for a reason. People store up cash for emergencies, to keep a safety net, and to ensure that whatever happens, their wad of cash will be there for them. Cash is essentially untraceable, it’s easy to carry, it’s widely accepted and it’s reliable. There is simply no alternative system of payment that is as convenient, reliable and anonymous. While technology is trying to design a system that has all the components that cash does, it’s simply not there yet. Which is why, when you look at the statistics we have on cash use around the world, paper and coin isn’t doing too badly after all. Cash is still the primary means of payment (and store of value) for unbanked people with a low income and helps avoiding debt traps due to uncontrolled spending of money. It supports anonymity and avoids tracking for economic or political reasons. In addition, cash is the only means for contingency planning in order to mitigate risks in case of natural disasters or failures of the technical infrastructure like a large-scale power blackout or shutdown of the communication network. Cash has proven to be secure in terms of cybercrime & fraud. People value cash differently than they value electronic money, even though the two have the exact same value. A famous study out of MIT showed that people will spend twice as much money on the same item when they pay with credit cards instead of cash. While plastic can seem like play money, cash feels all too real. People might resist giving up cash entirely. Cashless society may not emerge in near future.    

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-50. For centuries: prostitution, incarceration, literacy, crime, education, insanity, pauperism, life expectancy, and disease statistics were measures of wellbeing of population. Today, people’s wellbeing is best measured by people’s capacity to generate income. Today, people’s well-being is measured in terms of monetary earnings and economic output; i.e., per capita income and per capita GDP. Money has become the measure of wellbeing of people. 

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-51. Money has become measure of military effectiveness. Military effectiveness is primarily a function of economic development rather than political and social factors. Economically developed states have greater surplus of wealth, better technology base, efficient production techniques and in essence an ability to sustain larger investments in military without draining the economy of resources.

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Dr. Rajiv Desai. MD.

July 1, 2022  

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Postscript:

I am a student of science but I have ventured into the field of economics. Any shortcoming is regretted.     

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