CHAPTER ONE

1. The Nature and Importance of Money

Before formally defining money, let’s do some brain storming. Throughout history in every
society barter was used as a means of exchange and always something has evolved to perform
the functions of money where people exchange goods and services directly without9 any
medium of exchange. In a barter economy people exchange their goods and services directly
without any medium of exchange and since this system was costly and inefficient each society
innovated something which could be used as a medium of exchange. For instance in America
before the Revolutionary war, money might have primarily consisted of Spanish doubloons
(silver coins that were also called pieces of eight).

Before the American Civil War (1861-1865) the principal forms of money is the United States
were not only gold and silver coins but also paper notes (banknotes) issued by private banks. Salt
(so called Amole) in Ethiopia and animal skins and furs in the cold regions of Alaska and Siberia
have served as money for a number of years.

Today we use money issued by governments. In general money has been different things at
different times; however it has always been important to people and to the economy.

To understand the effects of money on the economy, we must understand exactly what money is.

1.1 BARTER SYSTEM

In the beginning of the human existence, life was not as complex as it is today. Human needs
were simple and almost everybody satisfied them by producing whatever he/she required. The
individual himself to sustain life provided the bare necessities of life. He/she was self sufficient
in the sense that everybody engaged on hunting and gathering for his food, made his/her own
clothing, and own dwelling. Economic activities were, thus, confined to production and
consumption.

In course of time, man gained knowledge through learning by doing, formed family, and his
needs got increased. He realized that now it is not possible for him to satisfy his rising needs by

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producing everything himself. As a result self-sufficiency came to end and the process of
exchange started.

Initially, exchange was direct. That is it was exchange of goods for goods. Such exchange was
known as barter. Under the barter system the individual produces some goods in great quantity
than he could consume so as to exchange the surplus with another person for something he
needed in return. The economy based upon this system of exchange is called the barter
economy.

LIMITATIONS OF BARTER SYSTEM: This direct exchange of one good for another
without the mediation of money has a number of difficulties associated with it. These are:

1. Lack of double coincidence of wants: This is the most important problem of barter
system. The barter system requires that a person having a surplus of one commodity
should be able to find another person who not only wants that commodity but also has
something acceptable to offer in exchange. Unless the double coincidence of wants on the
part of those engaged in the barter is not matched exactly exchange will not take place.
2. Lack of common measure of value: Different commodities are of different values. There
is no common value under the barter system. For example, if a sheep is to be exchanged
for wheat it is difficult to decide in what proportion the two goods are to be exchanged.
Thus, it is difficult to settle the terms of exchange.
3. Indivisibility of commodities: There are many goods, which are indivisible. If someone
wants to exchange his horse for getting a pairs of shoes he will have to part with a portion
of his horse on the basis of the exchange ratio. In this process the horse loses its identity
of and value as a horse. Hence, the exchange is unthinkable.
4. Difficulty of storage and transfer of wealth: Most of the goods like rice, wheat, cattle,
skin etc deteriorate their values with the passage of time or involve heavy storage cost.
Further, the transfer of these goods from one place to another place involves huge
transportation cost.
5. Difficulty in differed payments: Under barter exchange system, several times payment is
not made then and there but after sometime. This is because there is absence of stability

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 in the prices of goods. Besides, there is absence of quality of general acceptability in
goods. In this way, it is very difficult to make differed payments in the form of goods

The existence of an efficient Medium of exchange (money) is essential to permit each of us to

specialize in what we are relatively most efficient in producing-that is, our “comparative
advantage” product-and then to exchange that product for the other things we want Money is
essential in the efficient functioning of markets and the price mechanism.

In its microeconomic role, money permits the society to achieve a more efficient allocation of
resources. Money facilitates the flow of resources in to their most efficient uses. The ultimate
result is increased efficiency of the economy and increased economics welfare for the society.

With specialization we can all become more efficient and enjoy higher standard of living. And
savings can flow smoothly- directly or through financial intermediaries-in to investment. The
high productivity of the modern world could not exist without a high degree of specialization.
And all this specialization could not exist without money.

1.2 What exactly is Money?

As the word money is used in everyday conversation, it can mean many things but to economists
it has a very specific meaning.

Economists define money (also referred to as the money supply) as anything that is generally
accepted in payment for goods or services or in the repayment of debts when most people talk
about money, they are talking about currency. If for example, someone comes up to you and
says, “your money or your life” you should quickly handover all your life you should quickly
handover all your currency rather than ask, “what exactly do you mean by money?.”

To define money merely as currency is much too narrow for economists. Because checks are also
accepted as payment for purchases; checking account deposits are considered money as well. As
you can see, there is no single, precise definition of money or the money supply, even for
economists.

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However you need to keep in mind that the money (which is a stock-a certain amount a given
point in time) discussed in this refers to anything that is generally accepted in payment for goods
and services or (as a medium of exchange).

In the repayment of debts and is distinct from income (a flow of earnings per unit of time) and
wealth (total collection of pieces of property that serve to store value).

The one essential characteristic which money has is this: It is immediately exchangeable for all
other kinds of marketable assets-goods and services, real estate, stocks and bonds or whatever.
i.e. money is the most liquid asset (or money has liquidity advantage).

The term liquidity refers to the ease with which an asset can be exchanged for other assets. A
highly liquid asset is one which can be exchanged for other assets (or for money), quickly, and
without loss of value Different assets (houses, cars, government bonds, etc) have different
degrees of liquidity. But money is the only asset that has perfect liquidity.

What is money made of? How does it look? It makes no difference. As long as it is performing
the functions of money-as long as it is being used as a generally accepted medium of exchange-
it is money.

1.3 CHARACTERISTICS OF EFFICIENT MONEY

So far you have seen the gradual development of money. In this part you will study the
characteristics that efficient money should have.

During the course of the evolution of money, certain attribution of characteristics came to be
expected from the commodity acting as money or means of exchange. These characteristics of
efficient money are given below.

Acceptability
- It should be generally accept by virtue of its intrinc value
- Because of government decree
- Because of convention
- Because of convenience

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Reconcilability
- In order to avoid unfair practice of cheating it has to be recognizable by its size, color,
texture etc.

Divisibility
- It must be capable of being divided into the smallest fraction or unit without the loss in its
value.

Stability
The conditions of its supply and demand should remain stable so that its value (Purchasing
Power) remains stable.

Homogeneity
Each and every unit should be exactly the same as every other unit. Otherwise, people would
prefer to hold more valuable unit and would release the less valuable unit, thereby destabiling its
supply and demand conditions.

Portability
Each unit should have small weights compared to its value so that it could easily carried about as
necessary.

Durability
It should not be a wasting asset, either physically or in terms of its value. No one wants to hold
wasting or perishable asset. Most of the commodities used as money early days failed in
durability criteria. Example, salt bar cannot be durable money because it is sensitive to changes
in climate and its value also alter with the distance from the salt mining place.

1.4 THE BASIC FUNCTIONS OF MONEY

In every society, money performs four basic functions. All of these functions play significant
roles in the operation of the economy.

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1) The Medium of Exchange Function

The most basic function of money is to serve as the medium of exchange. In almost all market
transactions in our economy, money in the form of currency or checks is a medium of exchange;
it is used to pay for goods and services.

Although money has no power to satisfy human wants directly, it commands power to purchase
those things which have utility and satisfy human wants. The use to money as a medium of
exchange promotes economic efficiency by eliminating much of the time spent in exchanging
goods and services.

The time spent trying to exchange goods or services arecalled a transaction cost. In a barter
economy, transaction costs are high because people have to satisfy a “double coincidence of
wants” –they have to find someone who has a good or service they want and who also wants the
goods or services they have to offer.

Thus money promotes economic efficiency by

 Eliminating much of the time spent exchanging goods and service.
 Allowing people to specialize in what they do best
 Avoiding the problem of double coincidence by decomposing the single transaction of
barter in to two separate transactions of sale & purchase
 Allowing freedom of choice

Money is therefore a lubricant that allows the economy to run more smoothly by lowering
transaction cost, there by encouraging specialization and the division of labor.
However, the acceptance of money as a medium of exchange is a matter of social convention
each person accepts money as a means of payment because he/she is confident that other will
accept it in payment for him/her. The social convention could either be established through legal
or other means. And a commodity to be accepted as money, it must meet the following criteria.

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2) Money as a unit of account:

The second role of money is to provide a unit of account that is, it is used to measure value in the
economy. We measure the value of goods and services in terms of money. Just as we measure
weigh in terms of pounds or distance is terms of miles.

Money units serve as a unit of measurement in terms of which the values of goods and services
exchanged in the economy are measured and expressed. Money enables an orderly pricing
system which is essential for:-
 Rational economic calculation and choice
 Transmitting economic information among individuals

3. Money as a store of value (wealth holding)

Money also functions as a store of value; it is a repository of purchasing power over time. A
store of value is used to save purchasing power from the time income is received until the time it
is spent. This function of money is useful because most of us do not want to spend our income
immediately up on receiving it but rather prefer to wait until we have the time or the desire to
shop.
Money is not unique as a store of value; any asset, be it money, stocks, bonds, land, houses, art,
or jewelry, can be used to store wealth. Many such assets have advantage over money as a store
of value: they often pay the owner a higher interest rather than money, experience price
appreciation and provide service as a house. If these assets are a more desirable store of value
than money, why do people hold money at all?

The answer to this question relates to the important economic concept of liquidity, the relative
ease and speed with which an asset can be converted in to a medium of exchange. Hence money
is the most liquid asset of all because it is the medium of exchange it does not have to be
converted.

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In to anything else to make purchases other assets however, involve transaction costs when they
are converted in to money. The importance of money as a store of value depends on the rate of
increase of the general price level as compared to urgency for liquidity for example, if inflation
doubles, the value of money halves. That is value of money.
(VM) = 1/1+¶, Where ¶ is inflation rate

If ¶ increases by 100% then value of money?

(VM) = 1/1+¶,
=1/1+100/100=1/2=0.5=50%
Thus, doubling of all prices means that the value of money has dropped by half.

4. Money as Standard of Deferred payments

Money lets you buy now and pay later. Or It lets you lend now and collect later. When people
save money, that money can be borrowed and channeled in to investments it is the deferred
payments function of money which permits this transfer of spending power from earner – savers
to borrower – spenders. It permits the easy transfer of resources out of their less desired (less
productive less profitable) uses and in to their more desired (more productive, more profitable)
uses.

1.3 THE EVOLUTION OF MONEY

Money seems to have originated and developed in response to the urgent and inevitable needs of
human being in the various stages of growth of the economic system, till we come to this modern
age. In its earliest forms money was simply commodity money.

A. Commodity money

In the primitive society, things in common demanded like skins, salt, corn, utensils, and weapons
were used as money. The commodity chosen to serve as money was affected by the factors such
as location, climate, culture, and economic development. For instance, the communities living by
the seashore used shells as a medium of exchange, Salt and cattle were used as money in ancient

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Rome, while tobacco was used in the early American colonies, in Tibet ‘tea’, in Japan ‘rice’, in
ancient Greece ‘ox’, in India ‘cattle’, in ancient Ethiopia ‘salt’, Kent cigarettes in Rumania, and
Horses in new England region (during the colonial period) were the popular medium of
exchange. Some of the difficulties in using commodity as money are most of the commodities do
not possess the essential characteristics of money such as desirability, durability, portability,
scarcity, homogeneity, and variability. However, the use of commodity money was preferred to
barter.

B. Convertible paper money

Convertible paper money is paper money that can be redeemed for a specific commodity at a
rate specified on the money. While convertible paper money isn’t common today, it was once the
primary form of money. In many countries, for example, private banks accepted a specified
ounce of gold and issued bank notes in exchange. A bank note was a piece of paper printed in a
specific denomination ($1, $10 etc) that had a promise by the bank to pay to the bearer a specific
amount of gold on demand. Put differently, these convertible paper money or bank notes were
like the current Treasury-Bills form though a specific denomination T-bills is exchanged for
money today.

Currency, on the other hand, is paper money and coin issued by the government on regular basis.
The first U.S currency issued in 1879 was a form of convertible paper money. Until 1933,
exchange of gold for currency was at a rate of one ounce (approximately 28 g) for $21. The U.S
government eliminated the practice of dollar for currency exchange in 1933 when the official
rate was raised to $35 per ounce of gold1. The U.S government, however, continued to redeem
U.S currency to foreign central banks or governments at a rate of $35 per ounce of gold2.

C. Fiat money

Fiat is Latin for “by order of authority”. Fiat money is money that some authority, generally a
government, has ordered to be accepted as a medium of exchange. The money itself has virtually
no intrinsic value. That is the specific denomination of a bill (Birr 1 to Birr 100) is determined

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legally not because it has something that worth that much in it. Our currency Birr is fiat money.
You will notice the order on each bill: “Payable to the bearer on demand”. The problem with fiat
money is that it can be printed so fast that it causes inflation.

D. Debt money

Private debt money is a loan that the borrower promises to replay on demand. A checking
account, for example, is private debt money. The owner of a check account has in effect loaned
the money he or she deposit to the bank. The bank can use the proceeds in any time it wishes.
But, the bank promises to pay the depositor, in currency on demand-whenever the depositor
decides to cash a check.

Another form of private debt money is traveler’s check. When you have travelers check, you are
lending money to the issuer of the check. The issuer agrees to pay upon demand the amount
designated on the check to you or to anyone to whom you give the amount. In the mean time the
issuer is free to use the fund.

1.4 MEASURING MONEY

The total quantity of money at any time is called money supply. Economists measure money
supply because they know that it affects the level of economic activity. Money stock/supply or
simply money is measured as the sum of currency in circulation and the checkable deposits held
by non-bank sectors at commercial banks. This is because other forms of deposits are NOW
“negotiable orders of withdrawal” that are paid interest. Because, NOW are not easily
convertible or liquid to currency. Economists refer to the case with which an asset can be
converted into currency as assets liquidity. Checkable deposits are almost perfectly liquid. An
office building, however, is highly liquid. It can be converted to money only by selling it, a time
consuming and costly process.

Therefore, since it is difficult to determine what (and what not) to measure as money, the Fed
(Central or National Bank in our case) uses three different measures of money called M1
(Narrow money), M2 (Broad money), and M3.

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The definition of money as anything that is generally accepted in payment for goods and services
tells us that money is defined by people's behavior. What makes asset money is that people
believe it will be accepted by others when making payment. As we have seen, many different
assets have performed this role over the centuries, ranging from gold to paper currency to
checking accounts. For that reason this behavioral definition does not tell us exactly what assets
in our economy should be considered money.

The narrowest definition of money that the central bank reports is M1, which corresponds to the
definition proposed by the theoretical approach and includes currency, checking account
deposits, and traveler's checks. These assets are clearly money because they can be used directly
as a medium of exchange.

The M2 monetary aggregate adds to Ml other assets that have check-writing features (money
market deposit accounts and money market mutual fund shares) and other assets (small
denomination time deposits, savings deposits, overnight repurchase agreements that are
extremely liquid because they can be turned into cash quickly at very little cost. The M3
monetary aggregate adds to M2 somewhat less liquid assets such as large-denomination time
deposits, long-term repurchase agreements,
agreements, and institutional money market mutual fund shares.

The final measure, L, which is really not a measure of money at all, but is rather a measure of
highly liquid assets, adds to M3 several types of securities that are essentially highly liquid
bonds, such as short-term Treasury
Treasury securities, commercial paper, savings bonds, and the like.

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