1.
CHAPTER 1: MONEY
MONEY AND BANKING – B.COM PART 1

2.
DEFINITION
 Money has been defined differently by different economists.
1. Descriptive Definitions
2. Legal Definitions
3. General Acceptability Definitions

3.
DEFINITIONS
(1) Descriptive definitions
 “Anything that is generally acceptable as a means of exchange and that at the same time acts as a
measure and store of value.” – Crowther in his book: An outline of money
 “Money may be defined as a means of valuation and of payment” – Coulborn
 “Money is anything that is widely used as a mean of payment and is generally acceptable in settlement
of debts.” – Cole
These are considered narrow and partial definitions, because they focus on the functions of money and not
on what money is

4.
DEFINITIONS
(2) Legal Definitions:
 “Anything which is defined by the state as money is money” – Professor Knap
 Professor Hartley believes that money should be legal tender.
 These are narrow definitions based on “state theory of money.”
 The government can not force the people to accept money. e.g. German currency Mark

5.
DEFINITIONS
(3) General Acceptability Definitions:
 “Money is anything which is commonly used and generally accepted as a medium of exchange or as a
standard of value.” – Kents
 Money is described as “anything which is widely accepted in payment of goods or in discharge of other
kinds of business obligations,” by D.H. Robertson.
 “Money is anything that is generally accepted in payment of goods and services or in the repayment of
debts.” – E. Mishkin
Money here, is defined as anything which has general acceptability.

6.
“MONEY IS ANYTHING THAT IS REGULARLY USED IN
ECONOMIC TRANSACTIONS AND SERVES AS A MEDIUM OF
EXCHANGE, A UNIT OF ACCOUNT AND A STORE OF
VALUE.”
DEFINITION OF MONEY

7.
ORIGIN OF MONEY
Money has evolved through five different stages during history:
1. Commodity money
2. Metallic money
3. Paper money
4. Credit money
5. Electronic money

8.
ORIGINS OF MONEY
1. Commodity money:
 Commodity money has a value apart from its use of money.
 A large number of items such as cows, goats, sheep, rice, grains, etc were used
 However they lacked storage capability, durability transportability, divisibility, and homogeneity.

9.
ORIGINS OF MONEY
2. Metallic money:
 Coinage: gold and silver were used as coins, stamped by a competent authority.
 As time passed, transportation and storage of coins became inconvenient and dangerous

10.
ORIGINS OF MONEY
3. Paper Currency:
 Paper currency is made of paper and functions as a medium of exchange
 Initially paper currency carried a promise that it was convertible into a fixed quantity of precious metallic
gold and silver
 This promise was eliminated in 1914 in England and in 1933 in America.
 Fiat money: this newspaper money which is considered legal tender because the government says it is
money. It has no backing of gold, silver or government securities

11.
ORIGINS OF MONEY
4. Credit money or bank money:
 Bank money is the use of cheques as the medium of exchange.
 Cheques have made it possible an easier to make transactions for large amounts. They are easier to
transport.
 They are safe and provide receipts
 Checks are not legal tender. They cannot be enforced in payments of debts

12.
ORIGINS OF MONEY
5. Electronic banking stage:
 This is a modern system of transferring funds using Electronic Communications.
 Payments are now made through magnetic strip cards such as bank debit cards, credit cards, telephone
cards etc.
 This form of banking has reduced processing costs, lead times for payments and increasing flexibility.
 These are also not considered legal tender

13.
FUNCTIONS OF MONEY
Primary Functions of Money
•Money as a medium of Exchange
•Money as a unit of account
•Money as a standard of deferred payments
•Money as a store of value
Secondary Functions of Money
•Aid to specialization, production and trade
•Influence on income & consumption
•Money is an instrument of making loans
•Money as tool of monetary management
•Instrument of economic policy
Contingent Functions of Money
•Distribution of national income
•Basis of credit system
•Measure of marginal productivity
•Liquidity of property

14.
PRIMARY FUNCTIONS OF MONEY
1. Money as a medium of Exchange
 Used to pay for goods and services
 Overcame double coincidence of barter system
 Introduced time efficiency of exchanging goods and services
 Encouraged division of labour. People are now specializing due to easier payment of services
rendered..
2. Money as a unit of account
 Common measure of money.
 Used to compare goods in terms money
3. Money as a standard of deferred payments
 Money is useful in the purchasing goods on credit as it is easy to borrow-and lend
4. Money as a store of value
 Does not deteriorate and stores value

15.
SECONDARY FUNCTIONS OF MONEY
Money has the potential to influence an economy, by influencing interest rates, price levels, resources, etc.
1. Aid to specialization, production and trade
2. Influence on income & consumption
3. Money is an instrument of making loans
4. Money as tool of monetary management
5. Instrument of economic policy

16.
CONTINGENT FUNCTIONS OF MONEY
Contingent functions are derived from primary & secondary functions
 Distribution of national income
 Basis of credit system in banks
 Measure of marginal productivity
 Liquidity of property

17.
QUALITIES OF A GOOD MONEY SYSTEM
The term monetary system refers to the type of standard money used for making payments. It refers to the value
of money, organization, arrangement, control and management system of money.
1. Simplicity
2. Elasticity
3. Economical
4. Price Stability
5. Legality
6. Liquidity
7. Full employment

18.
INFLATION
 Inflation is a continuous upward movement in the general (average) level of prices.
 Two causes:
1. Demand Pull Inflation
2. Cost Push Inflation

19.
DEMAND PULL INFLATION
 When aggregate demand increases faster than aggregate supply of goods and services, prices will
increase and inflation occurs.
 Also called aggregate demand inflation.
 Occurs when there is excess demand for output.
 Sources of rise in demand pull inflation
 Monetarist view: (Million Friedman)
 If central bank issues and prints more money into the economy than its demand.
 Non monetary view: (J.M. Keynes)
 Increase in purchases of goods and services due to increase in wealth.
 Higher business investments
 Increase in government expenditures
 Foreign demand for country’s goods.

20.
COST PUSH INFLATION
 Cost push inflation occurs when prices are forced upward by increases in the cost of factors of
production and not by excess demand.
 Sources of increased costs are:
1. Increase in money wage rates
2. Profit push inflation
3. Material push inflation
4. Higher taxes
5. Rise in import prices

21.
REMEDIES OF INFLATION
1. Monetary Policy
 It is a policy which influences the economy through changes in the money supply and
available credit.
2. Fiscal Policy
1. Change in taxation
2. Changes in government expenditure
3. Public borrowing
4. Balanced budget changes
5. Control of deficit financing

22.
REMEDIES OF INFLATION
3. Other measures
i. Price support program
ii. Provision of subsidies
iii. Arrangements of easy availability of goods on hire purchase to stimulate demand
iv. Imposing direct control
v. Rationing of essential consumer goods in case of acute emergency through holding of Friday
and Sunday markets

23.
INFLATION & DEFLATION
Inflation
Deflation

24.
DEFLATION
 Deflation refers to the situation where price level fall is causing major increase in unemployment,
reduction in output and decrease in the income off the people.
 “Deflation is that state of the economy where the value of money is rising or prices are falling.” --
Crowther

25.
CAUSES OF DEFLATION
 When the level of money income falls relatively to the current supply of goods and services.
 Deflationary process may occur due to:
 Fall in private investment
 Persistent unfavorable balance of payments
 Continued government-budgetary surplus
 Sudden increase in the total output
 By action of central bank to raise the discount rate or by selling securities
 All are due to the combined effect of all of these factors

26.
REFLATION
 A real Reflation is a sustained rise in the general level of prices.
 It is a situation all rising prices after the full employment is reached. This phenomenon is due to
increased in aggregation demand without any increase in production of goods and employment.
 The solution is the result of efforts made by the government to lift the economy out of depression.

27.
REFLATION
Similarities between inflation and reflation:
 The money supply increases
 Upward movement of general price level
Differences between inflation and recreation:
 Inflation causes a serious problem of rising prices without any increase in output and employment,
whereas reflation leads to more production and employment.
 Reflation is adopted by the government.
 It takes place below the level for employment
 Prices rise very slowly under reflation, but very rapidly under inflation.

28.
DEVALUATION
 Devaluation is the a reducing of value or exchange rate of national currency with respect to other foreign
currencies.
 Under the fixed exchange rate system, the exchange rate is determined by the demand for and supply of
foreign exchange.

29.
DEVALUATION
 Depreciation is the lowering of currency value in a free-floating exchange rate system.
 Devaluation is the lowering of currency value in a fixed exchange rate system.

30.
VALUE OF MONEY
 Value of money refers to its purchasing power: that is its capacity to command goods in exchange for
itself.
 Value of money is high if it buys more commodities. And vice versa.
 The value of money varies inversely with the general level of prices.

31.
VALUE OF MONEY
1. Quantity theory of money
2. Cash balance theory of money
3. Modern quantity theory of money

32.
QUANTITY THEORY OF MONEY
 In the 16th century, gold and silver inflows from the Americas into Europe were being minted into coins,
because of which there was a resulting rise in inflation.
 Changes in money supply will directly impact both prices and inflation rates.
 The quantity theory of money states that there is a direct relationship between the quantity of money in
an economy and the level of prices of goods and services sold.
 According to QTM, if the amount of money in an economy doubles, price levels also double and value of
money is halved.

33.
TOTAL MONEY SUPPLY SHIFT IN MONEY SUPPLY

34.
QUANTITY THEORY OF MONEY
 Irving Fisher studied and derived an equation to demonstrate this effect, based on:
a) Supply of money
• Total volume of money in circulation during a time period = MV
• M: quantity of money in circulation
• V: Velocity of money in circulation
b) Demand of money
a) People demand money for the means of exchange.

35.
QUANTITY THEORY OF MONEY
Equation of Exchange:
𝑃 =
𝑀𝑉+𝑀1 𝑉1
𝑇
or
𝑃𝑇 = 𝑀𝑉 + 𝑀1 𝑉1
 P is the price Level
M is the quantity of money
V is the velocity of circulation
𝑴 𝟏 is the volume of credit money
𝑽 𝟏 is the velocity of circulation of 𝑴 𝟏
T is the total volume of goods and Trade

36.
QUANTITY THEORY OF MONEY
Assumptions:
 Full employment: The theory is based on the assumption of full employment in the economy.
 T and V are constant: The theory assumes that volume of trade (T) in the short run remains
constant. So is the case with velocity of money (V) which remains unaffected.
 Constant relation between M and M1. Fisher assumes constant relation between currency money M
and credit money (M1).
 Price level (P) is a passive factor. The price level (P) is inactive or passive in the equation. P is affected
by other factors in equation i.e., T, M, M1, V and V1 but it does not affect them.

37.
CASH BALANCE APPROACH
Fisher’s Transaction Theory Cash Balance Approach
Based on medium of exchange function of money Based on store function of money.
Demand for money Demand for cash balances
Focuses on demand/supply over period of time Focuses on demand/supply at particular point of
time.
Demand for money increases; Price level increases Demand for money increases; Price level decreases
because of decrease in expenditures

38.
CASH BALANCE THEORY OF MONEY
Cambridge Equations:
 Alfred Marshall’s Equation:
M = K P y
 Keyne’s Equation:
n = P k
M : quantity of money
P : price level
y: aggregate real income
K : fraction of real income which people wish to hold in money form
P : price level of consumption goods
n : total supply of money in circulation
K : total quantity of consumption units
which people wish to hold in cash

39.
MODERN THEORY OF VALUE OF MONEY
Wealth Theory of Demand:
 Money is a durable consumer good held for the services it renders
 The demand of money depends on volume of total demand, and relative returns on the different forms of
assets.
 Assets can be held in form of: money, bonds, equities, physical goods & human capital.
Money Demand Equation:
 𝑀 𝑑 = 𝑓 (𝑌𝑝)
 Demand for money is a function of permanent income ( resources available to individuals, and expected
returns on other assets)
 𝑌𝑝 𝑖𝑠 affected by yield of securities and wealth holdings.

40.
VALUE OF MONEY
• Irving
Fischer
• 𝑃𝑇 = 𝑀𝑉 +
𝑀1 𝑉1
Quantity Theory of
Money
• Cambridge
Economists:
Keynes,
Marshall
• M = K P y
• n = P k
Cash Balance
Approach to Money
• Milton
Friedman
• 𝑀 𝑑 = 𝑓 (𝑌𝑝)
Modern Theory of
value of money

41.
MONETARY POLICY
 Monetary policy is the process by which the monetary authority of a country controls the supply of
money, often targeting a rate of interest for the purpose of promoting economic growth and stability
 The official goals usually include relatively stable prices and low unemployment.

42.
MONETARY POLICY
Objectives:
1. Promoting high employment
2. Achieve a steady economic growth
3. Stable price level as a goal
4. Stability in interest rate
5. Promoting a more stable financial market
6. Stability in the foreign exchange markets

43.
MONETARY POLICY
Expansion
• increases the total supply
of money rapidly
• combat unemployment in
a recession by
lowering interest rates
Contraction
• expands the money
supply more slowly than
usual or even shrinks it
• slows inflation to avoid
the resulting distortions
and deterioration of asset
values.

44.
MONETARY POLICY
Quantitative controls Qualitative controls
Open market operations Varying margin requirements
Variation in the bank rates Consumer’s credit regulation
Credit rationing Use of moral persuasion
Varying reserve requirements Direct action

45.
KINDS OF PAPER MONEY
1. Representative paper money
 This type of money is fully backed by metallic money
 It possesses all the fundamentals qualities of a good money system
2. Convertible paper money
 It is money which Carries a promise by the issuer that the paper can be converted into the
standard money metal at some future date.
 In actual practice, the state bank never keeps a 100% metallic result. It is always less than
100%.
 State bank of Pakistan does not issue this kind of money
3. Inconvertible paper money
 This money cannot be converted into standard money metal
 It is regulated by the law of state, and is also called Fiat money

46.
PAPER MONEY
Advantages Disadvantages
Economical Danger of inflation
Elasticity of money supply Internal price instability
Promotes economic growth Exchange instability
Internal price stability Dangerous of mismanagement
Helpful in emergency Fear of demonetization
Regulation of exchange rates Use within the country
Uniform quality