Money: Nature, Functions and Role

DIFFICULTIES OF BARTER SYSTEM AND INVENTION OF MONEY

• In the early history of man, money was not used and most families were self-sufficient.

• Exchanges were limited and took place through the barter system, that is, exchange of goods for other goods.

• In a barter economy, there was no generally acceptable medium of exchange to purchase goods and services.

• The absence of money created several serious difficulties.

• Double Coincidence of Wants was a major problem.

  • Exchange could occur only when two persons each wanted exactly what the other offered.

  • A person desiring a good had to find another person who both possessed that good and was willing to accept the good offered in exchange.

  • Trade was possible only when the wants of buyers and sellers coincided.

  • A great deal of time and effort was spent searching for such persons.

  • In a complex economy with millions of transactions, coincidence of wants is nearly impossible.

• There was a lack of a standard unit of account.

  • There was no common measure in which prices could be quoted.

  • Goods had to be expressed in terms of other goods.

  • This led to a large number of exchange ratios.

  • For example, cows in terms of horses, wheat in terms of cows, pens in terms of pencils.

  • The absence of a standard unit made calculation and comparison of values difficult.

• There was impossibility of subdivision of goods.

  • Some goods could not be divided without losing value.

  • For example, a cow cannot be divided to purchase a small quantity of wheat.

  • Division would destroy or reduce its value significantly.

  • This restricted smooth exchange and hindered trade.

• There was a lack of information in the barter system.

  • Traders needed detailed knowledge about the value of various goods.

  • Both parties had to assess the value of each other’s goods.

  • This required time and resources.

  • Without a medium of exchange, information costs were very high.

  • A commonly accepted medium with known characteristics would reduce these costs.

• Production of large and costly goods was not feasible under barter.

  • A producer of expensive goods like a car would struggle to find a buyer possessing goods equal in value.

  • The car maker needed food, clothing, and other daily necessities in exchange.

  • It was almost impossible to find one person who could provide all required goods in return.

  • This discouraged large-scale production.

• The barter system could function only in a primitive economy where life was simple and needs were limited.

• With economic progress, division of labour, specialisation, and large-scale production developed.

• The barter system failed to meet the growing needs of exchange.

• Due to its difficulties, barter economy:

  • Could not support large-scale production.

  • Could not take advantage of capital-intensive machinery.

  • Had no easy and cheap way to store wealth.

  • Produced a limited range of goods compared to modern economies.

• To overcome these problems, money was invented.

• Money serves as:

  • A generally accepted medium of exchange.

  • A standard unit of account.

  • A means to reduce transaction and information costs.

• The invention of money made modern economic development and complex exchange possible.

EVOLUTION OF MONEY

Use of Commodities as Money

• In modern economies such as India, United States and United Kingdom, money exists mainly in the form of paper currency like rupees, dollars and pound sterling.

• In early stages of human development, various commodities such as bows, sea shells, beads, arrows, furs and skins were used as money, particularly during the hunting stage.

• In the pastoral stage, animals like sheep, goats and cattle were adopted as a medium of exchange for trading goods.

• However, the use of animals as money had serious limitations; they lacked uniformity since animals were not identical in size, quality or value, making them unsuitable as a standard unit of account.

• The supply of animals fluctuated sharply due to disease, death or natural conditions, creating instability in the money supply.

• Ordinary commodities and animals were also poor store of value, as they could perish, lose weight or decline in quality over time.

Use of Metalic Money

• Due to the limitations of ordinary commodities and animals, precious metals such as gold and silver gradually replaced them as money with the progress of civilisation.

• Precious metals were superior because they were durable, easily portable and storable, did not deteriorate over time, and possessed a suitable degree of scarcity.

• Their supply changed only gradually, ensuring greater stability compared to animals or perishable commodities.

• With the invention of coinage, gold and silver coins became widely accepted as money, since coins had standardised weight and purity, making their value easier to determine than plain metal pieces.

• Precious metals were used as money not primarily because of their intrinsic value, but because of their scarcity, which is essential for any commodity to function effectively as money.

• In modern times, even paper currency serves as money not due to intrinsic value but because its controlled scarcity ensures public confidence and acceptability.

Use of Paper Money

• With the recognition that scarcity is more important than intrinsic value for sound money, precious metals were gradually replaced by paper money, which initially served as claims to metallic money.

• Early paper notes were representative money, fully backed by gold or silver reserves and convertible into coins on demand, functioning merely as substitutes for metallic currency.

• Over time, paper money became widely accepted as money itself, and note issuance became the monopoly of central banks such as the Reserve Bank of India.

• Under the full reserve system, paper currency was fully backed by gold or silver reserves of equal value, ensuring complete convertibility into precious metals.

• Later, the proportional reserve system required only 30–50% gold backing, based on the belief that people rarely demanded conversion; this system operated in India from 1927 to 1957.

• Eventually, the minimum reserve system replaced proportional reserves, requiring only a fixed minimum of gold and approved securities, allowing flexible expansion of currency to meet economic needs.

• Modern paper money is inconvertible fiat money, issued by government authority as legal tender and not exchangeable for gold or silver; its value rests on public confidence and acceptability.

• A major disadvantage is the temptation for governments to over-issue currency to finance expenditure, which can cause inflation and erode public confidence in money.

• However, instability arises from mismanagement rather than the system itself, since the elasticity of paper currency allows money supply to be adjusted to economic requirements.

• In extreme inflation, confidence in paper money may collapse and people may adopt substitutes (e.g., cigarettes in post-war Germany), demonstrating that money’s value depends on stability and trust rather than intrinsic worth.

Emergence of Bank Deposits as Money

• In modern developed economies, the dominant form of money is not paper currency but bank deposits, especially demand deposits held with commercial banks against which cheques can be drawn.

• In India, bank money or credit money has also become a significant component of the total money supply.

• Chequeable deposits function as money because they can be used to make payments for goods, services and assets through cheque transfers.

• The banking system not only holds deposited currency but also creates deposits through credit expansion based on reserve requirements, thereby increasing the money supply.

• It is the deposits themselves that constitute money, not the cheques; a cheque merely instructs the bank to transfer funds from one account to another.

• Similarly, a credit card is not money but a facility for short-term borrowing, since payments ultimately require settlement through currency or bank deposits.

• A fundamental requirement of money is general acceptability; people accept it in exchange because they trust others will also accept it in future transactions.

• When confidence in a currency collapses due to rapid depreciation in value, it ceases to function as money, as occurred with the German mark during the hyperinflation of the early 1920s.

Definition of Money

• Defining money precisely is difficult, and economists often describe it in terms of the functions it performs rather than its physical form.

• D.H. Robertson defined money as anything widely accepted in payment for goods and in settlement of business obligations.

• Crowther defined money as anything generally acceptable as a medium of exchange and simultaneously serving as a measure and store of value.

• These definitions highlight that money is identified by its functions; hence the view that “money is what money does.”

• A fundamental requirement of money is general acceptability, meaning it must be accepted by all members of society in exchange for goods, services and debt settlement.

• The usefulness of money depends on mutual confidence: a person accepts it because they believe others will also accept it in future transactions.

• General acceptability is not a physical property but a social institution, granted by law, custom or convention when society recognises a good as a medium of exchange.