Role of Money

References: Samuelson’s Economics (pp 272-278), Handa’s Monetary Economics,

Mishkin’s The Economics of Money, Banking and Financial Markets, Suraj B Gupta’s
Monetary Economics, RBI’s Handbook of Monetary Statistics of India, RBI Bulletin

I.1 Functions of Money

Money is a stock concept as opposed to a flow variable like income that one earns per
month or year. A related stock concept is wealth. It consists of money and non-money
assets like share, bond, art, property, furniture, car, ornaments, etc which can store
value. Money is most commonly defined as currency consisting of notes and coins
that the citizens of a country use to pay for goods and services and to repay one’s
debts. However, this currency definition of money is too narrow. Checking account
deposits are also included in money since they can be easily converted into currency
whenever it is required to make payments for goods and services or repay debts.

Money is often described in terms of three functions it performs: medium of

exchange, unit of account, and store of value.

Medium of Exchange
Money serves as a ‘medium of exchange’ in economic transactions. The only
alternative is ‘barter’ where goods are exchanged against goods. Under barter, one
requires ‘double coincidence of wants’: a lecturer will have to have a farmer in his
class to be able to buy his food from the latter in exchange for his lectures. Barter
transactions usually involve high ‘transaction costs’ which are minimal if money is
used as a medium of exchange.

However, for money to function effectively as a ‘medium of exchange’ it must satisfy

several criteria:
it must be standardized so that it is simple to ascertain its value
it must be widely accepted
it must be divisible so that it is easy to make change
it must be easy to carry, and
it must not deteriorate quickly.
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Unit of Account
Money serves as a ‘unit of account’ in which we express value of economic
transactions measured in terms of money prices, just as we measure height of a person
in centimeter. These transactions may be current and future with or without deferred
payments. Money prices help to reduce some of the transaction costs of exchange. For
instance, in a barter system one has to remember many more prices and that too in
terms of quantity of goods. For instance, 3 shirts will exchange for a pair of shoes. If
there are 4 goods that are being exchanged, there will be 6 barter exchange rates.
Instead, if money can serve as a unit of account, four goods will have only 4 prices.
Therefore, a system with money prices is much simpler than a system with barter
exchange rates.

Store of Value
Money serves as a ‘store of value’. It serves as a repository of purchasing power;
income received today can be stored and spent gradually as needs arise till income is
received again in the next time period.

Money is not the only form of asset in which value can be stored. There are non-
money assets like property, ornaments, share, etc in which value can be stored as well.
However, it is argued that there are two distinct advantages in using money as a store
of value. First, money is the most liquid asset in the sense that it can be readily used
whenever the need arises. Other forms of assets like property or ornaments involve
‘transaction costs’ (both economic and non-economic) to convert them into money.
For instance, selling of an asset involves broker’s fee, time etc.

Second, value of money is assumed to be relatively stable compared to these other

forms of wealth whose prices can fluctuate unexpectedly. It is not necessarily true
always. Value of money is commonly defined in terms of the ‘purchasing power’ of
money or the ‘real value of money’: the amount of goods and services that money can
buy. The real value of a unit of money is obtained by deflating it by a price index like
the CPI. Therefore, it is affected by the fluctuations in the general level of prices. In
times of rising prices, value of money becomes more uncertain than non-money assets
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whose monetary value have a tendency to increase with rise in prices in a country,
thereby keeping their real value quite stable.

I.2 Motives for Holding Money and Demand for Money

There are three alternative motives to hold money and three related demand for
money functions.
Transaction Motive
The necessity to transact goods and services on a day to day basis motivates holding
transaction money balances. In demand for money theory, transaction demand for
money is mainly a function of the current income of an individual.

Precautionary Motive
Future uncertainties leading to unexpected or sudden expenses motivate individuals to
hold precautionary money balances. Demand for precautionary money balances is
also assumed to be proportional to an individual’s current income.

Speculative Motive
Speculative demand for money is mainly motivated by the profit motive of
individuals who wish to invest money in other forms of wealth like bonds. These are
so called speculative investments. For instance, one likes to invest in bonds when
their prices are down, and sell them when bond prices are high. Consequently,
individuals hold minimal speculative money when bond prices are low, vice versa.
Assuming that bond price and interest rate are inversely related, demand for
speculative money balances are assumed to be inversely related to interest rate.

I.3 Kinds of Money

I.3.1 Traditional Money
The payments system and the form of money have evolved over time. There are three
kinds of traditional money:
metallic coins
paper currency, and
checkable bank deposits.
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Coins
Precious metals like gold and silver were used to produce one of the earliest forms of
money. Although this money was acceptable to everyone, it was difficult to transport
gold and similar money from one place to another since they were very heavy. The
fear of theft also threatened their day to day usage.

Later, the metallic content of coins was made less expensive and lighter with the use
of copper and nickel. Metallic coins are referred to as ‘token money’ or ‘symbolic
money’ because their metallic value is far less than their ‘face value’. Today, in India
and other countries these coins are mostly ‘fractional currency’, the total amount
being only a small fraction of the total value of money in a country. These coins can
be readily converted into other kinds of money.

Paper Currency
Gold and silver coins were not only replaced by more inexpensive metallic coins, an
important invention was the paper currency. Initially, paper currency simply carried a
promise that it could be converted into coins and precious metals. Later, paper
currency was made a fiat money: paper currency decreed (ordered as if having the
force of a law) by the governments of countries as legal tender whereby it must be
accepted as payment for debts but not convertible into gold coins or precious metals.

Presently, paper currency is far more important than coins in the sense their share in
total money is much bigger than coins. Any paper currency beyond Re 1 is paper
currency in India; for instance Rs2, Rs 5, Rs 20, Rs 50 and so on. Re 1 in paper form
or metallic form is classified as coin.

Checkable Demand Deposits

There are major drawbacks of paper currency and coins, such as they can be stolen
and difficult to transport from one place to another. With the development of the
banking system, checkable demand deposits have created another form of money.

Demand deposits with banks and post offices are payable on demand. These deposits
can be converted into cash on demand and used for economic transactions. Checkable
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demand deposit accounts can be used to pay for transactions by drawing cheques on
these accounts. Cheques are IOU type which allows transactions to take place without
carrying large amount of currency. These account balances and not the cheques are
considered as money.

Near-Money
Near-money is not as liquid as money, therefore one does not pay for his daily
transactions with near-money. Examples of near-money are bank and post office time
deposits, non-checking savings deposits, mutual funds (beyond their lock-in period),
and government bonds held by individuals and businesses (excluding banks,
insurance companies, etc). However, near-money can be converted into cash at a
price.

I.3.2 Modern Money: Cards and Electronic Money

There are two problems with traditional money. First, it is inconvenient to carry large
amount of cash for transaction purposes. Second, it takes time for cheques to travel
from one place to another particularly when one pays someone in a distant
geographical location. Third, the paper work involved in processing of cheques is
costly. With the advent of modern technology, various transaction and economic costs
of dealing with cheques have been significantly reduced. One can make use of credit
cards or the electronic means of payment (EMOP) system where payments can be
made without carrying cash or writing cheques. Some of these modern monies are
briefly described below.

Credit Cards
Companies like the VISA and Mastercard issue credit cards which allow the customer
to pay for their transactions without carrying either currency with them or by writing
cheques. Typically, these companies pay the amounts to the sellers of goods on behalf
of the customers and then recover the expenses from the latter at the end of a month.
The amount of expenses incurred by a customer with credit cards is usually not
constrained by the present bank balances of the customer.
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ATM Cards
These cards allow the customers to withdraw cash and make cheque payments
through automatic teller machines (ATM) of their respective banks. These cards also
reduce the burden of carrying currency for transaction purposes.

Debit Cards
These cards enable consumers to purchase goods by electronically transferring funds
from their bank accounts to a company’s account. Most charge card companies like
VISA and Mastercard and banks issue debit cards. Sometimes, ATM cards also
function like debit cards.

Stored-Value cards
These cards differ from credit and debit cards in that they contain a fixed amount of
digital cash. These cards are typically bought for a fixed amount of money that the
customer can spend. A sophisticated version of the stored-value card is the Smart
Card which has a computer chip that can be loaded with digital cash from the
owner’s bank account whenever required. Smart cards can be loaded from ATM
machines, personal computers and even specially equipped telephones.

These Smart Cards have become popular in Canada, some European countries
(France, Denmark, Italy, etc), a few Latin American countries (Chile & Columbia),
Australia and even in a few South-East Asian countries like Singapore and Taiwan.
The Mondex Smart Card from a London-based company can be used not only to
transfer funds between the customer and the retailer or between the customer and his
bank, it can also transfer money electronically between individuals.

Electronic Cash
Electronic cash or e-cash is a form of electronic money that can be used on the
internet to purchase goods or services. A bank with links to the Internet can transfer e-
cash to the customer’s PC. The customer can then surf on the Internet and make a
purchase with e-cash which gets electronically transferred from the customer’s
account to the seller’s account. Once the e-money has been deposited in the seller’s
account, the goods are physically shipped to the customer.
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Electronic Cheques
Electronic cheques allow users to pay their bills on the Internet without writing or
mailing cheques. This system has shown to be far cheaper and more convenient than
writing and sending paper cheques.

I.4 Price of Money

The price of money is not the general price level in the country. It is defined in terms
of the opportunity cost of money or the cost of holding money. The nominal interest
rate is often considered the price of money. In an economy there are several interest
rates. The lending and the borrowing rates of the banks, the yield to maturity of
securities, and the coupon rate of bonds etc. We shall take up a few of these interest
rates for discussion.

I.4.1 Four Types of Credit market Instruments/Debt Instruments

(1) Simple Loan
A simple loan is one in which the lender provides the borrower with an
amount of funds which must be repaid to the lender at maturity along with
an additional payment for the interest. Examples are banks’ commercial
loans to businesses.

One Period Loan

Consider a loan of Rs 100 lent to a person by a bank at an interest rate of 10%. The
loan is to be returned to the bank by the borrower at the end of one year. Let us call
the loan the ‘principal’ (P) and the money returned with 10% interest cost the
‘amount’ (A). Therefore,
Amount = Rs100 + 10% of Rs 100 = Rs 100 (1 + .1) = Rs 110.
Alternatively, the simple interest rate can be defined as
A A P
1 i= 1 
P P
The principal P also represents the present discounted value (pdv) of A which the
bank will receive one year later. The notion of pdv can be explained as follows. Re1
paid to someone tomorrow is less valuable than receiving it today. Because, the
person receiving Re 1 today can deposit it in a bank and earn the simple interest
income before tomorrow arrives.
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The above calculation of the amount A is a forward calculation, where as the

backward calculation of A to P which deducts the interest income allows one to obtain
the present discounted value of A. Following our notations above
A
2 PDV 
1 i
This process of calculating the future in terms of the present is known as ‘discounting
the future’ or obtaining the present discounted value of the future.

Multi-period Loan
Suppose the loan is obtained for two periods that is, the maturity is at the end of the
second period. Two possibilities arise. First, if interest payments are made at the end
of each period, then the amount A will be
A  100  i  100  i 100  100 1  2i 

Second, if interest payments are made only at maturity, then the amount will be
A  100  i 100  i  100  i 100 
or
A  100 1  i   i 1  i 100
or
A  100 1  i 
2

In the first case, it is a ‘simple interest rate’ that the loan carries. The pdv of A will be
A
pdv 
1  2i
In the second case, the loan carries a ‘compound interest rate’ and the pdv of A will be
A
pdv 
1  i 
2

Depending upon the type of interest rate that one is considering, the present
discounted value of a ‘n’ period loan that fetches amount A at maturity, can be either
A A
3 pdv  or pdv  .
1  ni  1  i 
n

Mishkin talks about the second possibility only.

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(2) Fixed Payment Loan

A fixed payment loan (also known as fully amortized loan) is one in which the
borrower of a loan must repay a fixed amount every period that consists of a
part of the principal and interest, for a set number of years. Examples are
auto loans and mortgages.

(3) Coupon Bond

A coupon bond pays the owner of the bond a fixed interest payment (known
as coupon payment) every year until maturity when a specified final amount
(usually the face value or par value) is repaid. Examples are government
bonds and corporate bonds in India.

A coupon bond is identified by three pieces of information. First is the name of the
corporation or government agency that has issued the bond. Second is the maturity of
the bond. Third is the coupon rate that is, the yearly coupon payment expressed as a
percentage of the face value of the bond. For example, a bond with face value Rs
1000 and yearly coupon payment of Rs 100 has a coupon rate of 10%.

(4) Zero Coupon Bond

A zero coupon bond or discount bond is bought at a market price below its
face value, and the face value is paid at maturity. Unlike the coupon bond, a
discount bond does not make any periodic interest payments. Examples are
treasury bills etc.

I.4.2 Yield to Maturity

YTM is a method to calculate the interest rate on several credit market
instruments, like government bonds, treasury bills etc. It is the interest rate that
equates the present value of the cash flow payments received from a credit
instrument with its value today.

Examples
Simple Loan
Suppose A borrows Rs 100 from B and returns Rs 110 to B after one year. What is the
YTM? Using the formula in 2 above we know that
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A
PV 
1 i
Therefore
110
100 
1 i
or
110
i 1
100
or
i  0.1 or 10% where i is the YTM.

Fixed Payment Loan

Now, let us apply the concept to other forms of debt instruments. Consider a fixed
payment loan L with yearly payments FP for 25 years. The formula to compute the
YTM will be
FP FP FP
4 L   ... 
1  i 1  i  2
1  i 
25

A loan of Rs 1000 with yearly payments of Rs 85.81 has a YTM of 7% which can be
obtained from 4. Similarly, if the annual interest payment is known, one can also
obtain the yearly fixed payments from 4.

Coupon Bond
The YTM on coupon bonds is calculated in a similar manner. Consider a coupon bond
worth Rs F as face value, promises to pay Rs C every year for a n-year period. After n
years the bond issuer returns the face value of the bond. Therefore, the present value
of this coupon bond (also known as the current price of the bond P) will be
C C C F
5 P   ...  
1  i  1  i  2
1  i  1  i 
n n

One can use 5 to obtain either the YTM i or the current price of the bond P provided
all other variables are known. Consider an example where the face value of a coupon
bond is Rs 1000 with 10% coupon rate and 10-year maturity. The following table
explains the relationship between the current price of the bond and its YTM.
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Price of Bond (Rs) YTM (%)

1200 7.13
1100 8.48
1000 10.00
900 11.75
800 13.81

(i) When the bond is priced at face value, the YTM equals the coupon rate of
the bond, that is, 10%.
(ii) Otherwise, the price of the bond and YTM are inversely related. As the
current price of the bond rises, the YTM falls, vice versa.
(iii) The YTM is below the coupon rate if the price of the bond is above its face
value, vice versa.

Consol
A consol is a bond which promises to pay a fixed amount every year forever. The
formula to calculate the YTM on a consol is similar to 5 above. Since the face value is
never returned, we have the following infinite series

C C
6 P   ...
1  i  1  i 2
or
C
7 P
i

Discount Bond
The formula to calculate the YTM on a 1-period discount bond like a treasury bill is
similar to that of a simple loan.
F
P
1  i 
or
F P
8 i .
P
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I.4.3 Interest Rates and Returns

The YTM on a bond is the interest rate, where as the return on a bond is something
different. It is equal to the current yield on a bond plus the rate of capital gain.
Suppose, a bondholder has purchased a coupon bond at its face value of Rs 1000 with
a coupon rate of 10%. After one year he decides to sell it at the market price of Rs
1200. The rate of return R on this bond will be calculated as per the following
formula.
100  1200  1000 
R
1000
or
C   Pt 1  Pt 
R
Pt
or
C Pt 1  Pt
R 
Pt Pt
or
9 R  i  g , i 0 and g  or  0
i is the ‘current yield’ on the bond and g is the rate of capital gain or loss on the bond
due to change in the market price of the bond after one year. If there is no capital gain
or loss, then the interest rate and return will be the same. Otherwise, they will be
different.

I.4.4 Real Interest Rate

The discussion so far has not the considered the effect of inflation on interest rate. The
real interest rate is obtained by adjusting the nominal interest for inflation. In case of
the YTM that we discussed above, the real YTM can be calculated ex ante by
subtracting the expected inflation rate from YTM. Alternatively, the real rate can be
obtained ex post by subtracting the actual inflation rate from the nominal rate.
Therefore,
10 i  ir   , ir  or 0

where ir is the real interest rate and  is the inflation rate. 10 is known as the Fisher
equation following Irving Fisher who first defined this equation. In simple words, any
income in future will allow the recipient to purchase fewer goods if prices also
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increase in future. Hence, the real interest rate reflects the true income or the true cost
of borrowing. In times of inflation, a borrower typically gains since the real cost of
borrowing falls with inflation. However, the lender typically loses as his real income
from the interest payments that he receives falls with rising prices. Nominal interest
rate can never be negative or even zero. However, the real interest rate in an economy
can be even zero or negative!

Indexed Bonds
Some countries have indexed bonds which adjust both the interest payments and the
return payment of the face value at the time of maturity for changes in the price level.
This provides protection to the investment of the small savers.