11. Money- Meaning, Functions, Classification and

Gresham’s Law

Objectives:

After studying this lesson, you will be able to understand,

The meaning of money.

The different functions of money

The classification of money.

Meaning of Grasham’s law

11.1 Definition of money

11.2 Functions of Money

11.2.1 Main Functions

11.2.2 Secondary Functions

11.2.3 Contingent Functions

11.2.4 Other functions of money

11.3 Classification of money:

11.3.1 Legal Tender Money;

11.3.2 Optional money:

11.3.3 Metallic Money:

11.3.3.1 Standard Money:

11.3.3.2 Token money:

11.3.3.3 Subsidiary money:

11.4 Paper Money:

11.4.1 Representative Paper Money:

11.4.2 Convertible Paper Money:

11.4.3 Inconvertible paper money;

11.4.4 Fiat Money:

11.5 Gresham’s Law:

11.6 Summary

11.7 Check your progress

11.8 Key concepts

11.9 Self Assessment questions

11.10 Answers to check your progress

11.11 Suggested Readings

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11.1 Definitions of money:

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Money has been defined differently by different economists, as there is no unanimity

over its definition. Some definitions are too extensive while others are too narrow. For

example, Walker’s definition is too wide. In Walker’s words” Money is what money

does”. According to this definition, we can include all those things in money, which

perform the functions of money. Thus money does not comprise metallic coins and

currency notes only. It also includes cheques, hundies, bills of exchange, etc., because

they also perform the functions of money. On the other hand, Robertson’s definition of

money is rather narrow. According to him, Money is a “commodity, which is used to

denote anything which is widely accepted in a payment for goods or in discharge of other

business obligations”. According to this definition, metallic money alone deserves to be

called money in the strict sense of the term because it alone is generally acceptable by the

people, left to them. This definition unnecessarily narrows down the field of money.

Some economists define money in legal terms saying that ‘anything which the state

declares as money is money”. Thus, money possesses legal sanction to discharge debts

and perform other functions of money. But legal sanction alone is not a significant factor

in making money generally acceptable. The bank deposits or credit money are not legal

tender money but these are generally acceptable in payment and actually constitute a

major part of the circulating medium.

None of above definitions is satisfactory since they are either two wide or too narrow. A

suitable definition of money should emphasize not only the important functions of

money, but also its basic characteristic, namely, general acceptability. From this point of

view, Crowther; s definition appears to be ideal definition. He defines money as

‘anything that is generally acceptable as a means of exchange and that at the same time

acts as a measure and as a store of value”. This definition points out that money should

perform all the three important functions of being a medium of exchange, a standard of

value, and a store of value. Besides, money should be a commodity, which is generally

acceptable by the community in payment for anything. In other words, the commodity

chosen as money must be universally acceptable within community in exchange for

goods and services or in payment of debts.

11.2 Functions of Money:

The most general way to define money is to lay down its main functions. The various

functions of money can be classified into four groups.

1) Main Functions

2) Secondary Functions

3) Contingent Functions

4) Other Functions.

Let us now try to understand initially about the main functions of money.

11.2.1 Main Functions:

These are also referred to as original functions of money. Following are the two main

functions of money:

a) Money is a Medium of exchange:

b) Money is a measure of value

Money is a Medium of Exchange:

This may be considered as the most basic function of money. Money has the quality of

general acceptability. As such, all exchanges take place in terms of money. In ancient

times, commodities used to be exchanged for commodities. That was known as Barter

system. But, with the lapse of time, the barter system proved difficult and inconvenient

for the people. The main difficulty of the barter system was the lack of double

coincidence of wants. It was on account of the difficulties and inconveniencies of barter

that money came into existence. In the modern money exchange system, the prices of

goods and services are expressed in terms of money. On account of the use of money, the

exchange transactions have now come to be divided into two parts. One is purchases and

another one sale. Thus, in the modern society money acts as intermediary are sales and

purchases. It is on this account that money is referred to as the medium of exchange. The

difficulty of the lack double coincidence of wants no longer exists now on account of the

invention of money. Since money is generally acceptable, everyone accepts it in

exchange for goods and services and utilizes it for purchasing goods and services of his

choice. Money thus, promotes specialization among individuals, firms and regions.

Since money is a medium of exchange, it bestows upon the holder the power to command

marketable goods and services at his own option whenever he needs them. If the

individual concerned has no money, he may have to borrow it to acquire the necessary

command over marketable goods and services for his own benefit.

Money is a Measure of Value:

The second important function of money is that it measures the value of goods and

services. In other words, the prices of all goods and services are expressed in terms of

money. Since all values are expressed in terms of money, it is easier to determine the rate

of exchange between various types of goods and services in the community. But the

people enjoyed no such facility under the barter system. In view of its function as a

measure of value, money also serves as a unit of account. It means that all records are

kept and maintained in terms of the monetary unit, for instance in India Rupee.

It may however, be pointed out that money still presents a difficulty in its role as a

collective measure of values. The difficulty is that the value of money itself is subject to

changes from time to time.

11.2.2 Secondary Functions:

Money as a standard of Deferred Payments;

In the absence of money, borrowing and lending were difficult or borrowed and lending

amount could be returned only in terms of goods and services, but the modern money

economy has greatly facilitated the borrowing and lending process in terms of money. In

other words, money now acts as the standard of deferred payments for the following

reasons: the value of money is stable compared to the values of other commodities,

Money is more durable compared to other commodities: Money has the quality of general

acceptability. Hence it continues to be always desirable. But in its role as a standard of

deferred payments, money also suffers from certain drawbacks. They are; its own value is

not wholly stable. On the contrary, its value keeps on fluctuating from time to time. As a

consequence, debtors and creditors are differently affected at different times. For

instance, if the value of money depreciates on account of a price rise, the creditors lose

while debtors gain.

Money is a Store of Purchasing Power:

Money should have store of value character. Otherwise it is of no use in saving under

barter system. Because savings in terms of goods and services are not permanent and

some of which happened to be perishable. Thus savings done in terms of money under

modern money economy are more permanent and money made possible capital

accumulation, which is an essential, prerequisite of economic growth. Money also serves

as an excellent store of wealth, as it can be easily converted into other marketable assets,

such as, land machinery, plant etc., but money can perform this function satisfactorily

only if its own value is fairly stable.

As a store of value, people’s preference of money over other assets flows essentially from

the characteristic liquidity of money and the uncertainty about the future value of non-

money assets. By acting as a store of value, money provides a link between the present

and the future.

As mentioned earlier, though there are contingent and other functions of money, but as a

student of UG, it is sufficient to learn above stated important functions of money.

However, list out the contingent and other functions in brief in the following.

11.2.3 Contingent functions: money will act as the basis of credit to be created by

commercial banks, money also facilitates the distribution of social income among the

population in an economy, money helps to equalize marginal utilities and marginal

productivities and money increases productivity of capital.

11.2.4 Other functions of money: Money helps to maintain repayment capacity, money

represents generalized purchasing power and money gives liquidity to capital.

11.3 Classification of money:

Different economists on the basis of different criteria have classified money. On the

basis of legality, money can be classified under two heads:

11.3.1 Legal Tender Money;

It is that money which is accepted as a means of payment both by the Govt as well as the

people. This type of money has legal sanction behind it. No one refuse to accept it as a

means of payment.

Legal tender money can be further subdivided under two heads: a) limited legal tender, b)

unlimited legal tender.

Limited Legal Tender is that money which no person can be forced to accept beyond a

certain maximum limit. The Govt under statute fixes the maximum limit. For example

1,2,5,10,20 and 25 paise coins are legal tender only up to a sum of rupees twenty-five. If

some one is called upon to accept the small coins beyond the maximum limit of Rs 25/- is

perfectly free to refuse them. But up to the limit of Rs. 25/-, he cannot refuse the small

coins under the provisions of the law.

Un-Limited Legal Tender is that money which a person has to accept up to any limit,

because it is an unlimited legal tender. This type of money accepted by the people to an

unlimited extent. For example, one rupee coin’s, fifty paise coins and paper notes of all

denominations are unlimited legal tender in India.

11.3.2 Optional money:

It is that money, which ordinarily accepted by the people, but has no legal sanction

behind it. No one can be forced to accept this type of money against his wishes. It is

optioned money. If the persons is paying this money enjoys high credit in the market,

everyone will readily accept it. But as pointed out above, no one can be forced to accept

it. Different types of credit instruments like cheques, hundies and bills of exchange are

examples of optional money.

Money can be classified under two sub-heads on the basis of the commodity used in

making it.

1) Metallic money

2) Paper money

11.3.3 Metallic Money:

This money is made of a particular metal (i.e., Gold, Silver, Copper, Nickel, etc.,).

Metallic Money is further classified under three sub heads:

a) Standard Money

b) Token Money

c) Subsidiary Money

11.3.3.1 Standard Money:

This is also referred to as the principle money or full-bodied money. Standard coins are

made of gold or silver. These coins are made of a well-defined weight and fineness.

Standard money has the following characteristics:

1) Standard coin is the principal coin of the country. As such, it is the medium of

exchange and also the money of account. When the standard coin is made of one

metal, the monetary system is known as mono-mettalism. If this metal is gold, the

system is referred to as gold mono-metallism. In case, the standard coin is made

of silver only, the system is known as silver mono-metalism. Some times, the

standard coins are made of gold as well as of silver. In other words, two types of

standard coins are in circulation- one made of gold and the other of silver. Such a

monetary system is known as Bi-metalism.

2) The Face value of standard money is equal to its intrinsic value. The face value of

standard money is always equal to its metallic or intrinsic value. In other words,

the standard coin comprises metal whose value is equal to its face value. If some

one melts down a standard coin and sells the bullion in the market, he suffers no

loss because the coin contains metal equivalent to its face value. That is why the

standard money is known as full-bodied money. For example, the Indian rupee

before 1893 was a standard coin. It had in it silver whose metallic value was equal

to its face value.

3) There is free coinage of standard money. A special characteristic of standard

money is that it is minted under free coinage. Under free coinage as is well

known, the mint is open to the public. Under the system, the people have the right

to take their gold or silver to the mint for getting it converted into coins. For this

service rendered to the citizens, the mint some times charges fee, but some times

it does not. The main advantage of this system is that there is no shortage of coins

in the country. Whenever the people experienced shortage of coins they can take

their gold or silver to the mint and get it converted into coins.

4) Standard money is unlimited legal tender money. An important characteristic of

standard money is that its unlimited legal tender, because it’s the principal

monetary unit of the country. All big payments can be made in terms of standard

money to an unlimited extent.

11.3.3.2 Token money:

The token money is used for making smaller payments. It serves as a subsidiary for

standard money. It is generally made of inferior and light metals, such as, copper,

nickel etc, Token money is different from standard money in several respects, I shall

then briefly in the following sentences:

1) There is no free coinage of token money. The government only mines this, the public

enjoys no right to take the metals to the mint and get them converted into token coins.

2) The face value of token money is higher than its intrinsic value.

3) Token money is limited legal tender money: Token coins can be used for making

payments only to a limited extent. No one can be forced to accept then coins

beyond a certain limit.

4) Token money is a subsidiary of standard money: Token coins are generally used

for making payments in smaller transactions. As such, they act as subsidiaries of

standard coins.

Let us see the merits and demerits of standard coins in brief:

Merits of Standard Coins:

a) Inspire grater confidence

b) Means of storing purchasing power

c) Easy acceptability in foreign countries

d) No fear of inflation

Demerits of Standard Coins:

a) Not economical

b) Standard money is not elastic

Now let us also study the merits and demerits of Token coins:

Merits of Token Coins:

a) Economical use of metals

b) Token currency is much more elastic

Demerits of Token Coins:

a) Inspire less confidence

b) Consistability

c) Fear or over-issue

d) Acceptability within the country

e) Limited legal tender

11.3.3.3 Subsidiary money:

Subsidiary coins are issued to facilitate smaller payments. The main characteristics of

subsidiary coins are:

a) The subsidiary coins are low-value coins and are made of lighter metals.

b) They facilitate the exchange of low-priced goods and services

c) There coins are not subject to free coinage, they are issued by the government

itself

d) All subsidiary coins are token coins

e) The relationship of subsidiary coins with the standard coins is defined and

determined under statute.

11.4 Paper Money:

Paper money has along history to its credit. China was the first in the world to make use

of this in the 9th century and it began in India in the 19th century.

Paper money can be classified under three heads:

1) Representative Paper Money

2) Convertible Paper Money

3) In-Convertible Paper Money

11.4.1 Representative Paper Money:

This type of paper money is fully backed up by fold and silver reserves. In the beginning

to avoid wastage of metals the paper currency was issued. Hence, the monetary authority

maintained metallic reserves equivalent to the value of paper notes issued. The demand

for converting paper notes into cash was met by making use of gold and silver kept in

reserves. Thus, under the system of representative paper money, gold and silver

equivalent to the value of paper notes issued were kept in reserves by the monetary

authority.

Main advantages and disadvantages of Representative money are as follows:

Advantages of Representative money :

a) No fear of inflation

b) Economy in use of valuable metals

c) Public confidence

Disadvantages of Representative money:

a) No saving in gold and silver

b) Lack of elasticity

c) Unsuitable for poorer countries

11.4.2 Convertible Paper Money:

It refers to that type of paper money, which is convertible into standard coins at the

option of the holder. The characteristics of convertible paper money give us a better

understanding of this.

a) The basic principle underlying this system is that the public for encashment does

not simultaneously present all the notes. Therefore, the value of gold, silver kept

in reserves is less that the value of notes issued by monetary authority.

b) The monetary authority assures the public that they can get their paper notes

converted into cash at their option.

c) The approved securities such as gold, and silver can be encashed at anytime.

d) Thus, gold and silver in the reserves are not kept equivalent to the value of the

paper currency issued, but they are some what less than that of currency under

this system the reserves comprise two portions:

i) Metallic portion- this portion contains gold, silver and standard coins and,

ii) Fiduciary potion – this portion contains only approved securities

e) Under this system, the people are given gold and silver in exchange for paper

currency for making payments abroad.

f) The government is ever ready to buy gold and silver at predetermined rates.

Merits and demerits of the type of money are as follows;

Merits of convertible paper money:

a) Economy in use of valuable metals

b) Flexibility

c) Inspire greater public confidence

d) Facility in foreign trade

Demerits of convertible paper money:

a) Fear of over –issue of paper currency

b) It does not inspire as much confidence as representative money

Though this system spread to many countries and is widely adopted, it’s the system of

inconvertible money, which is in force.

11.4.3 Inconvertible paper money;

This system prevails in a country when the monetary authority gives no guarantee to

convert the paper notes into coin or other valuable metals. Such a type of paper currency

circulation account of the high credit enjoyed by the monetary authority. The following

are its characteristics.

a) Under this system. The issuing authority keeps no metallic reserves behind paper

currency nor does it guarantee the convertibility of paper note into coins and

metals. It’s possible that the issuing authority backs up the note-issue with

government securities, treasury bills and even bonds.

b) Such type of paper currency can be issued at best only in limited quantity but if

need arises, the issuing authority may tissue more paper notes without metallic

cover.

11.4.4 Fiat Money:

Lastly, this is only a variety of in convertible fiat money and is issued generally at a time

of crisis. That is why it’s sometimes referred to as emergency currency. No reserves of

any type are kept behind and are neither backed up by the metallic and fiduciary cover.

The monetary authority gives no guarantee to convert fiat money into metallic coins. The

main characteristics of fiat money may be summed up as follows:

a) Fiat money is issued in limited quantities

b) Fiat money is issued at a time of crisis

c) There is no-cover (metallic or fiduciary) behind it

The fact of the matter is that fiat money is an extra-ordinary type of money and is issued

under special circumstances. Fiat money is however, is an unlimited legal tender.

At the outset, the above mentioned are the different types of money which have been and

are being used in the countries to carry on their daily transactions. The divisions and sub-

divisions made it easier, though money has undergone many changes from barter system

to the present day paper currency, however we may call it, it is highly essential.

11.5 Gresham’s Law:

Queen Elizabeth of England wanted to reform the currency system which was existed

during the time of her grandfather to have a single unified currency in order to strengthen

the trade and commerce in the country. She was introduced reform of the currency sytem

by issuing new coins of better weights and shape with the hope that public will deposit

the old debased coins in treasury and very soon the work of currency reforms would be

successfully accomplished. But to her utter dimay she found that the new coins

disappeared from the circulation no sooner these were issued from the mint. Upset by this

situation the queen on the advise of her minister consulted Sir Thomas Grasham who was

the master of the mint under queen Elizabeth. Grasham enquired about the phenomenon

in 1558 and came to the conclusion that bad money drives out good money. This has to

be come to known as Grasham’s law.

When two kinds of money in circulation the problem before the government is to keep

them concurrently in circulation. When the two currencies having the legal value have

different intrinsic or real value in the domestic or foreign market then the money having

higher market value is set to be under valued currency while other set to be over valued

currency. A money over valued by the government is that which has less purchasing

power in the market. In such a situation the over valued currency will tend to drive out

the under valued currency from circulation. The under valued currency is withdrawn

from monetary use melted and diverted to non monetary uses. Grasham’s law is based on

this observation.

A basic aspect of Grasham’s law is that the under valued money can remain in circulation

at home only if it will circuated at a premium. This conclusion follows from the fact that

people will not spend the under valued money at home on the same basis as the over

valued money when they can get relatively more for the under valued money in foreign

countries.

11.6 Summary

Money has been defined differently by different economists, as there is no unanimity

over its definition. Some definitions are too extensive while others are too narrow. And as

par as concerned with the classification of money, different forms of money and its

advantages as well as disadvantages also discussed in this lesson. We also covered what

is Grasham’s law and its importance. It is in this view money has been playing key role in

an economy. However, money no doubt, is a significant and important factor in the

operations of a modern economy, yet its limitations cannot be overlooked or ignored in

any fair evaluation of the role played by it.

11.7 Check your progress

Whether the following statements are true or false

1. “ Money is what money does” said by walker

2. Money is in the normal sense, means currency

3. Measure of value is an essential function of money

11.8 Key concepts

Medium of exchange

Measure of value

Store of value

Differed Payments

Representative Money

Fiat money

11.9 Self Assessment questions

1 Define money and explain its main functions

2. Explain the various types of money and briefly mention their characteristics

4. Distinguish between Convertible and inconvertible paper money

5. What is Grasham’s law

11.10 Answers to check your progress

1. false 2. False 3 True

11.11 Suggested Readings

Ackley Gardner : Macro economic theory

Ward R A: Monetary theory and policy

Rana & Verma : Macro economic analysis

Hajela TN: Monetary economics

Ghatak : Monetary economics in developing economies