Unit 1

Money and Banking

1.1 DEFINITION OF 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 requirements. Money originates in the kind 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 crypto currencies.

Meaning:-

Money is also anything chosen as the medium of exchange. As per some economist money is anything that performs the function of cash . It's something which is widely accepted in payment for goods and services and in settlement of debts. During a modern society for commodities are expressed and valued in terms of money. During a wider sense, the term money includes all medium of exchange – Gold, Silver, Copper, Paper, Cheques, Commercial Bills of exchange, etc.

1.2 UNDERSTANDING MONEY

Money is usually stated as currency. Economically, each government has its own money system. Crypto currencies also are being developed for financing and international exchange across the world.

Money is a liquid asset utilized in the settlement of transactions. It functions based on the overall acceptance of its value within a governmental economy and internationally through foreign exchange. The present value of monetary currency isn't necessarily derived from the materials wont to produce the note or coin. Instead, value springs from the willingness to comply with a displayed value and believe it to be used in future transactions. This is often money's primary function: a generally recognized medium of exchange that people and global economies shall hold as and are willing to simply accept as payment for current or future transactions.

Economic money systems began to be developed for the function of exchange. The utilization of money as currency provides a centralized medium for purchasing and selling in a market. This was first established to exchange bartering. Monetary currency helps to supply a system for overcoming the double coincidence of requirements . The double coincidence of requirements is a ubiquitous problem during a barter economy, where so as to trade, each party must have something that the opposite party wants. When all parties use and willingly accept an agreed-upon monetary currency, they'll avoid this problem.

In order to be most useful as money, a currency should be: 1) fungible, 2) durable, 3) portable, 4) recognizable, and 5) stable. These properties make sure that the advantage of reducing or eliminating the transaction cost of the double coincidence of requirements isn't outweighed by other sorts of transaction costs related to that specific good.

Fungible

Units of the good should be of relatively uniform quality so that they're interchangeable with each other . If different units of the good have different qualities, then their value to be used in future transactions might not be reliable or consistent. Trying to use a non-fungible good as money results in transaction costs of individually evaluating each unit of the great before an exchange can happen .

Durable

The physical character of the good should be durable enough to retain its usefulness in future exchanges and be reused multiple times. A perishable good or a good that degrades quickly with use in exchanges won't be as useful for future transactions. Trying to use a non-durable good as money conflicts with money's essentially future-oriented use-value.

Portable

It should be divisible into small quantities in order that people appreciate its original use value highly enough that a worthwhile quantity of the good can be conveniently carried or transported. An indivisible good, immovable good, or good of low original use-value can create issues. Trying to use a non-portable good as money could produce transaction costs of either physically transporting large quantities of the low value good or defining practical, transferable ownership of an indivisible or immobile object.

Recognizable

The authenticity and quantity of the good should be readily ascertainable to the users in order that they will easily comply with the terms of an exchange. Trying to use a non-recognizable good as money produces transaction costs of agreement on the authenticity and quantity of the products by all parties to an exchange.

Stable

The value that people place on a good in terms of the opposite goods that they're willing to trade should be relatively constant or increasing over time. a good whose value varies widely up and down over time or consistently loses value over time is less suitable. Trying to use a non-stable good as money produces transaction costs of repeatedly revaluing the good in each successive transaction and therefore the risk that the exchange value of the good might drop below its other direct use-value or not be useful in the least , during which case it'll not circulate as money.

Money may be a generally accepted, recognized, and centralized medium of exchange in an economy that's used to facilitate transactional trade for goods and services.

The use of cash eliminates issues from the double coincidence of requirements which will occur in bartering.

Economically, each government has its own money system, defined and monitored by a central authority.

Crypto currencies represent a new type of money, with international exchange opportunities.

1.3 FUNCTIONS OF MONEY

As stated above, money primarily functions as a medium of exchange. However, it also has developed secondary functions that derive from its use as a medium of exchange. These other functions include: 1) a unit of account, 2) a store of value, and 3) a standard of deferred payment.

Unit of Account

Due to its use as a medium of exchange for both buying and selling and its use to assign prices to all kinds of other goods and services, money can be used to keep track of the money gained or lost across multiple transactions and to compare money values of various combinations of different quantities of different goods and services mathematically. This makes things such as accounting for profit and loss of a business, balancing a budget, or valuing the total assets of a company all possible.

Store of Value

Because money's usefulness as a medium of exchange in transactions is inherently future-oriented, it provides a means to store value obtained through current production or trade for use in the future, in the form of other goods and services. In particular trading their non-fungible, non-durable, non-portable, non-recognizable, or non-stable goods or services for money here and now, people can store the value of those goods to trade for goods at other times and places. This facilitates saving for the future and engaging in transactions over long distances possible.

Standard of Deferred Payment

To the extent that money is accepted as a general medium of exchange and serves as a useful store of value, it can be used to transfer value for exchange use at different times between people through the tools of credit and debt. One person can loan a quantity of money to another for a period of time to use and repay another agreed-upon quantity of money at a future date. The stored value represented by the loaned money is transferred from the lender to the borrower in exchange for an agreed quantity of stored value in the future. The borrower can then use and enjoy the value of other goods and services that they can now purchase in exchange for payment at a later date. The lender in effect is able to loan the current use of real goods and services, which he does not himself originally possess, to the borrower. The sellers of the goods are able to receive payment for their goods now instead of loaning the goods directly to the borrower in hope of future return or repayment.

Functions of Money:-

Money performs various functions. Mainly the functions of money can be classified into  three groups’ namely Primary functions               Secondary function Contingent functions

Primary function: Primary functions are basic or fundamental function of money. Infact, they are the original functions of money which ensure smooth working of the economy. Following are the primary functions:

Medium of exchange: Money acts as an effective medium of exchange. It facilitates exchange of goods and services. Everything is bought and sold with help of money. By performing as the medium of exchange, money removes the difficulties of barter system.

Measure of value: Money serves as a common measure of value. The value of all goods and services are measured in terms of money. In other words, pieces of all goods and services are expressed in terms money.The pricing system unable a compare the value of different goods and services and each the right choice.

Secondary function: Secondary functions are those functions which are derived from primary function.

Standard of deferred payment: Money acts as an effective standard of deferred payments. Deferred payments refer to payment to be made in future. Deferred payments have become the day to day activity in modern society. Money facilitates all kinds of credit transactions. Both, borrowings as well as lending are done in terms of money. All kinds of Hire purchase transactions are carried out in terms of money. As money enjoys the attributes of stability, Durability and General acceptability, it acts as a better standard of deferred payments.

Store of value: Money serves as a store of value. Savings were discouraged under the barter system due to lack of store of value. With inventions of money, it is possible to save. At present all savings are done in terms of money. Bank deposits represent the savings of the people. Moreover, money can be easily converted into any other Marketable assets like Land, Machinery, Plant, etc. Thus it facilitates capital accumulation. Money being the most liquid assets, it acts as a better store of value than any other assets.

Transfer of value: Money acts as a means of transferring purchasing power. Money facilitates transfer of value from one person to another person & one place to another place. As money enjoys general acceptability, a person can dispose of his property in Delhi and purchase new property at Mumbai. Instrument like cheques and bank drafts enable such transfer easy and quick.

Contingent function: In additions to the above functions, money has to performs certain special function known as contingent functions –

Basis of credit: The modern business system is entirely linked to the credit system of the country. The credit system, on the other hand, derives its strength from money. In the absence of money, the credit instruments like cheque, bill of exchange, etc. are of no use. It is the quantity of money supply which determines the supply of credit in the country.

Measurement & Distribution of national income: The national income is the result of efforts contributed by various factors of production. Money is helpful in measuring the contribution made by each factor of production and thus facilitates the distribution of national income between factors.

Equalization of marginal utility: Every consumer is interested in spending his limited income in such a manner as to achieve maximum satisfaction (utility) for this purpose of achieving maximum satisfaction; he has to equalize marginal utilities from different goods. Money helps the consumer in equalizing marginal utilities.

Liquidity: Money being the most liquid asset, it can be converted into any other assets quickly. An entrepreneur has to keep capital in liquid form for various purposes, such as transaction, Precautionary and speculative motives. Money provides such liquidity.

Estimation of Macro Economic variables: Macro economic variables like Gross National Product, total savings, total investment etc. can be easily estimated in monetary terms. It also facilitates government tax collection, budgeting etc.

1.4 TYPES OF MONEY

There are several sorts of money.

Market-Determined Money

Money originates as a feature of the spontaneous order of markets through the practice of barter (or direct exchange), where people trade one good or service directly for another good or service. So as for a trade to occur in barter, the parties to the exchange must want the good or service that their counterparties need to offer. This is often referred to as the double coincidence of requirements , and it sharply limits the scope of transactions which will occur during a barter economy.

However certain goods during a barter economy will be generally desired by more people in trade for whatever they need to offer in barter. These tend to be goods that have the most effective combination of the five properties of cash listed above. Over time these special sorts of goods can come to be desired in trade partly for his or her wide acceptance, as a way to overcome the problem posed by the double coincidence of requirements in future transactions with others. Eventually, people can come to desire an honest mostly or solely for its use-value in reducing transaction costs in future exchanges.

Such a good can then be called money because it's generally recognized by participants within the economy as a valuable good for its use as a medium to indirectly exchange other goods and services between multiple parties. The physical commodity will still have another use-value, but the primary use of any source of value has within the market is for its use as money. Historically, precious metals like gold and silver were adopted as these types of market-determined moneys.

Legal Tender and fiat money

Sometimes market-determined money is officially recognized as legal money by a government. Under some circumstances, goods that don't necessarily meet the five properties of optimal market-determined money outlined above are often used to fulfill the functions of cash in an economy. Typically this involves a legal mandate to use a particular good as money (known as a tender law) or some quite prohibition on the utilization of money (such because the use of cigarettes as a medium of exchange among prison inmates). Tender laws specify a particular good as legal money, which courts will recognize as a final means of payment in contracts and therefore the legal means of settling tax bills. By default, the tender will typically be used as a medium of exchange by market participants within the political jurisdiction of the authority that declares it to be money.

The term fiat money or fiat currency is usually associated with a classification of money that has been authorized to be used by a country's government.

Legal tender laws don't always adopt market-determined money as legal tender. a new medium of exchange that doesn't serve any original non-money use as an economic good are often imposed to replace market-determined money by legal declaration. This sort of tender also can be called paper money . Fiat money becomes a medium of exchange through legal imposition on the market, instead of through the method of adoption by the marketplace for easing transactions. Fiat money often doesn't meet the overall characteristics of cash and therefore the market-determined money that it replaces. Because the fiat money tends to be less suitable to be used as money, market participants could also be reluctant to adopt it as money. Prohibitions (or even confiscation) of market-based money are sometimes enacted as a part of tender laws that impose fiat money on an economy.

Fiat moneys can cause increased economic transaction costs, market distortions, and unintended consequences to the extent that they are doing not meet the characteristics that make a specific good suitable to function money. For instance , in nowadays, most countries' legal tender moneys consistently lose value over time, sometimes rapidly, leading to the social costs related to inflation.

Governmental currencies fall into the category of fiat money. Internationally, the International monetary fund and world bank function global watchdogs for the exchange of currencies between countries. Governments establish their own money system which is monitored primarily by the financial institution and Treasury authorities. A governmental currency will have an intranational value and a world value. Established governmental currencies trade 24 hours every day seven days a week on the foreign exchange market, which is that the largest financial trading market worldwide. Governments can establish formal and informal trade relations to peg currency values to at least one another for reduced volatility. Governmental currencies can also be free-floating.

Money Substitutes and Fiduciary Media

Physical units of currency (cash) can circulate from hand handy within the course of economic transactions or by being reassigned from person to person for accounting purposes while being persisted deposit at a bank or similar institution. Within the second case, tokens or paper notes that substitute for and represent the deposited money are passed from person to person in daily transactions and settled later by financial institutions. Paper notes and checks are samples of these sorts of money substitutes. The utilization of money substitutes can increase the portability and sturdiness of money, also as reducing other risks. Money substitutes enhance the function of cash by allowing people to simultaneously enjoy the utilization of their money in day-to-day transactions while also keeping the cash secure from theft or physical damage.

Normally, however, banks issue a bigger (often much larger) quantity of money substitutes than the amount of physical currency entrusted to them by depositors. By simultaneously issuing money substitutes like the same units of physical money to both the depositors and borrowers to whom the bank makes loans, during a process referred to as fractional reserve banking, banks can dramatically expand the availability of money available for transactions beyond the available supply of physical money. The new money substitutes that don't correspond to new units of physical money are called fiduciary media of exchange since they exist solely as entries within the accounting and financial system of the banks. Though widely accepted today, the

Use of fiduciary media has been controversial. Some economists believe that the (over)issuance of a fiduciary is accountable for business cycles and economic recessions, while others welcome it as a means to allow the expansion of money supply to suit the requirements of the economy.

In the U.S. The Federal Reserve System and the Department of the Treasury monetary several kinds of funds for the aim of regulating and mitigating monetary issues.

Crypto currencies

Crypto currencies are peer-based money, like bitcoin. This sort of cash is electronically supported electronic accounting entries which will be used as a medium of exchange. Crypto currencies share many characteristics of both market-determined money and paper money .

Crypto currencies are a kind of money which will be wont to facilitate international transactions.

Crypto currencies first originated as accounting units assigned to users as compensation in return for helping to process and verify transactions during a crypto currency block chain. They need also evolved to become a replacement sort of coin offering that helps to function financing for new technological business initiatives and corporations . Crypto currencies are becoming more widely used and adopted as a medium of exchange for daily transactions. However, crypto currencies do pose many risks. As such, they're being researched and controlled by authorities on an ongoing basis.

1.5 VALUE OF MONEY:

By value of cash is meant the purchasing power of money over goods and services during a country. What a rupee can buy in India represents the value of money of the rupee. Thus the phrase, “value of money” is a relative concept which expresses the connection between a unit of money and the goods and services which may be purchased with it.

This shows that the value of money is said to the price level because goods and services are purchased with a money unit at given prices. But the relation between the value of money and price level is an inverse one. If V presents the value of money and P the price level, then, V = 1/P. When the worth level rises, the value of money falls, and the other way around . Thus so as to live the value of money, we've to find out the general price level.

The value of cash is of two types: the internal value of money and the external value of money. The internal value of money refers to the purchasing power of money over domestic goods and services. The external value of money refers to the purchasing power of money over foreign goods and services.

Measurement of Changes in the Value of Money:

Changes in prices aren't uniform. Some prices rise, others fall; while still others remain stationary. They're like bees dashing out of a hive higgledy-higgledy, some buzzing off this manner , some that way, while others keep hovering at the spot. But there could also be a trend in a particular direction. A comparison of price changes would provides a very confusing picture. We have to find the extent of the overall changes within the value of money before suggesting a remedy. The seriousness of the disease must be known before a remedy is often suggested.

1.6 INDEX NUMBERS:

The device of index numbers comes to our aid in measuring changes in the value of money or price level. An index is a statement within the type of a table which represents a change in the general price level. Index numbers have great importance in lately . When it's desired to find bent what extent prices have risen or fallen, an index number is ready . In every advanced country, index numbers are being regularly prepared officially by the governments and also non-officially by other bodies interested in economic changes.

Preparation of Index Numbers:

The following steps are necessary for the preparation of index numbers:

(a) Selection of the base Year:

The first thing necessary is to pick a base year. It's the year with which we wish to compare this prices, so as to ascertain what proportion the costs have risen or fallen. The base year must be a normal year. It shouldn't be a year of famine, or war, or a year of outstanding prosperity.

(b) Selection of Commodities:

The next step is to pick the commodities to be included within the index number. The commodities will depend on the aim that the index number is ready . Suppose we want to understand how a particular class of people has been suffering from a change in the general price index. Therein case, we should always include only those commodities which enter into the consumption of that class.

(c) Collection of Prices:

After commodities are selected, their prices need to be ascertained. Retail prices are the simplest for the purpose, because it's at the retail prices that a commodity is actually consumed. But retail prices differ almost from shop to shop, and there's no proper record of them. Hence we've to take the wholesale prices of which there are a correct record.

(d) Finding Percentage Change:

The next step is to represent this prices because the percentages of the bottom year prices. The bottom year price is equated to 100, then the present year’s price is represented accordingly. This may be clear from the index given on subsequent page.

(e) Averaging.

Finally, we take the typical of both the base year and therefore the current year figures so as to seek out out the general change. In May 1985, the worth index was 355 which means that the price on the average were more than three-and a-half times as much or 255 per cent more than what they were in 1970-71.

Uses of Index Numbers:

Index numbers is used for a number of purposes:

(i) Index numbers are used not merely to live changes within the price index or changes within the value of cash . They can be accustomed measure quantitative change. Thus, we will prepare an index number of wages, imports, exports, industrial production, unemployment, profits, area under cultivation, enrolment during a college, etc.

(ii) Such quantitative changes as are measured by index numbers can indicate social and economic trends and help in framing policies with respect to them. As an example , an index number of cost of living can guide us within the adjustment of wages to changing prices.

(iii) we will also compare, with the assistance of index numbers, economic conditions of a category of people at two different periods.

(iv) Index numbers can be used as basis for, and equitable discharge of, contracts relating to borrowing and lending. We all know when prices rise, creditors lose. It's going to perhaps be considered more just to ensure that the creditor gets back the same purchasing power. Hence, when prices rise, the debtor may be asked to pay a correspondingly higher sum to discharge a debt.

Limitations:

It may, however, be noticed that index numbers aren't a faultless guide.

They suffer from variety of limitations, a number of which are given below:

(i) Approximations:

Index numbers are at best only approximations. They can't be taken as infallible guides. Their data are open to question and that they lead to different interpretations.

(ii) International Comparisons Difficult:

Use of index numbers for inter¬national comparisons presents several difficulties. The result's that such comparisons are difficult, if not impossible, on account of the various bases, different sets of commodities or differences in their quality, etc.

(iii) Comparisons between Different Times Difficult:

It is not easy to institute comparisons between different periods of time. Over long periods, some popular commodities are replaced by others. Entirely new commodities come to figure in consumption, or a commodity could also be vastly different from what’ it wont to be. Consider a contemporary railway engine and one among the first ones. Ford cat 1985 may be a different commodity from the 1950 Ford.

(iv) Measure Sectional Price Levels Only:

Index numbers measure only changes in the sectional price-levels. An index , therefore, prepared for a particular purpose, might not be useful for an additional . An index that helps us to review the economic conditions of mill-hands or railway coolies are going to be useless for a study of the conditions of college lecturers.

An entirely different set of commodities will have to be selected. Different people use various things and hold different assets. Therefore, different classes of people are affected differently by a given change within the price-level. Hence, the same index numbers cannot throw light on the effects of a price change on all sections of society.

(v) Weighting Changes Result:

One set of weights may yield quite different result from another, and weighting is all arbitrary.

Index number

Index number isn't an absolute measure, it measures the percentage change during a variable over time. It does so by comparing the worth of a variable at the present to its value at a base year. Index gives a quantitative foundation to qualitative statements like prices are falling or rising. Lastly, index numbers show changes in average. In effect, it means if the average change is 5% then some goods won't change exactly at 5%.

Why Use Index Numbers?

The most important use of index is that the determination of the value of money using price index number. It effectively displays the change in price levels and depicts inflation or deflation. As already mentioned index numbers are wont to calculate the standard of living in various areas. Price level numbers are extensively used by business communities as a tool to plan policies.

To calculate the change in production of various sectors, index numbers of production are used. This, in turn, helps the govt to require necessary measures to increase production and growth. Export and import policies are formulated by pertaining to the index of imports and exports. Lastly, the govt plans its fiscal and monetary policies to increase growth, employment, productivity etc. with the aid of index numbers. By and enormous , an index is an important statistical tool.

The Negative Side

Index numbers deal with averages and are a rough estimate of the change in a variable. Consequently, they simply indicate temporal changes for the variable which aren't completely true or accurate. Also with changing times, consumptions patterns undergo a drastic change. As a result, comparison of previous index numbers to recent ones doesn’t seem viable.

Calculation of retail price index number isn't possible hence we calculate wholesale price index number although the former one displays the important scenario. Lastly, for every variable, we have to calculate different index numbers, which widens our calculations.

Simple Index Numbers

Before moving forward with construction of an index number, we shall discuss the 2 broad classifications of those numbers.

Simple index numbers grant equal importance to all or any items regardless of what share it's . In other words, it considers each item to be equal with reference to the given variable. Consequently, it's an easy average and is a smaller amount accurate in comparison to the other class of index numbers.

Simple Price Index:

To construct a simple price index, compute the price relatives and average them. Add the worth relatives and divide them by the number of things . Table 64.1 illustrates the construction of a simple index of wholesale prices.

TABLE 64.1

Using arithmetic mean, price index in 1980 = ∑R/N = 870/5 = 174

The preceding table shows that 1970 is the base period and 1980 is the year that the price index has been constructed on the idea of price relatives. The index of wholesale prices in 1980 comes to 174. This means that the price level rose by 74 per cent in 1980 over 1970.

Weighted Price Index:

Taking the example of Table 64.2 already given, we assign high weights to commodities of greater importance to consumers and low weights to commodities of lesser importance.

TABLE 64.2

Using arithmetic mean, the weighted price level in 1980 = 4680/24 = 195.

The weighted price level is more accurate than the simple price level . In the example given above, the weighted price level shows a rise of 91 per cent within the price level in 1980 over 1970 as against the rise of 74 per cent according to the simple price index.

(a) Simple index number and

(b) Weighted index number.

Simple index number again are often constructed either by – (i) Simple aggregate method, or by (ii) simple average of price relative’s method. Similarly, weighted index number can be constructed either by (i) weighted aggregative method, or by (ii) weighted average of price relative’s method. The choice of method depends upon the supply of data, degree of accuracy required and therefore the purpose of the study.

Construction of price index Numbers (Formula and Examples):

Constructions of price level numbers through various methods are often understood with the help of the subsequent examples:

1. Simple Aggregative Method:

In this method, the index number is equal to the sum of prices for the year that index number is to be found divided by the sum of actual prices for the base year.

The formula for finding the index number through this method is as follows:

2. Simple Average of Price Relatives Method:

In this method, the index is equal to the sum of price relatives divided by the number of things and is calculated by using the subsequent formula:

3. Weighted Aggregative Method:

In this method, different weights are assigned to the things consistent with their relative importance. Weights used are the number weights. Many formulae are developed to estimate index numbers on the basis of quantity weights

4. Weighted Average of Relatives Method:

In this method also different weights are used for the items according to their relative importance.

The price index number is found out with the help of the following formula:.

Difficulties in Measuring Changes in Value of Money:

Measurement of changes within the value of money through price index number isn't an easy and reliable technique. There are a number of theoretical also as practical difficulties within the construction of price index numbers. Moreover, the index number technique itself has many limitations.

Weighted Index Numbers

Unlike simple index numbers, weighted index numbers, because the name suggests, weigh items consistent with their importance with reference to the concerned variable. For example, when calculating the price index number if the worth of a unit of rice is twice the price of a unit sugar then the rice will be weighed in as ‘2’ whereas sugar will be weighed in as ‘1’.

Hence it's a comparatively average measure. In essence, it's more realistic in comparison to simple index number because it accurately reflects the change over time.