Nature and function of money

Legal tender

Is money for a specific country which must by law be accepted for the discharge of debts. Refers to the total stock of money and includes foreign currencies which are not generally acceptable for the discharge of debts.

Token money

Refers to the coins whose metal value is less than face value. Intrinsic value of money is the commodity value of materials used to make money.

Intrinsic value of money Is the value of money in terms of its ability to purchase goods and services.

Fiat money

Is issued at the directive of the government irrespective of the level of economic activity e.g. money printed to finance the car.

Fiduciary issue

Is the money which is issued and not backed by gold.

Quasi money/near money

Refers to risk-free assets which are easily converted into cash e.g. bonds, foreign currencies.

Liquidity

Refers to the ease with which an asset can be converted into cash. Liquid assets are those which are easily converted into cash with no risk of cash loss e.g. cash is the most liquid asset. Liquidity refers to the difficulty with which an asset is converted to cash. Liquid assets are less profitable than illiquid assets e.g. long-term bonds earn more interest than short-term bonds.

1. It must be generally acceptable in the society i.e. all the people in the country must be confident that it will be accepted by others.
2. It must be easy to transport e.g. it must not be heavy in relation to its value.
3. It must be divisible into smaller denominations to make smaller transactions possible e.g. Tanzania currency is divided into 50/=, 100/=, 1000/=, 5000/=, 20000/=, 50000/=, and 100,000.
4. It must be durable i.e. money must not be perishable so as to function as a store of value.
5. Must be relatively scarce as money must be relatively scarce in order to maintain its value otherwise it would lose its value if it is plentiful and people prefer to keep their wealth in the form of property.
6. Homogeneity: One piece of money should be similar, for instance a ten-shilling note should be similar to all other ten-shilling notes used in a country.

Money is classified according to how it evolved in history as follows.

1. Barter system. This was the earliest form of exchange where commodities were exchanged directly for other commodities.
2. Use of commodities of high use value e.g. salt, tobacco, corn, etc. They were used to determine the value of other commodities. Such commodities were used because of their value and ability to satisfy human wants. However, they are perishable and bulky.
3. Use of durable commodities of iron, copper, gold, cowrie shells, silver, etc. However, not all commodities were scarce hence they could not be a good medium of exchange.
4. Use of rare materials i.e. gold and silver were used because of their scarcity and durability.
5. Paper money In the beginning, people used to deposit their gold with the goldsmiths, the custodians of gold who were living at that time. In turn, the goldsmiths could give them receipts which they were to use to get back their gold. Later, people started to use receipts to settle debts and obligations because such receipts were as good as gold. In the beginning, paper money was as good as gold because it was fully backed by gold.

Deposit money

This is created by commercial banks in the process of accepting deposits and lending using cheques (credit creation).

1. It preserves foreign exchange i.e. it enables exchange to take place without working for exchange.
2. It widens the market for commodities.
3. It encourages trade among less developed countries which lack foreign currencies.
4. The effect of price fluctuation is avoided since bargaining is in terms of physical quantities.

1. There is no generally acceptable means of settling debts and obligations.
2. There is no measure of value reflecting the relative quantities of commodities to be exchanged.
3. There is no standard of deferred payment to facilitate payments for debts and transactions at a future time.
4. There was nothing to facilitate specialization to take place since there is no generally acceptable way of paying wages, rent and interest.
5. There is a problem of transporting bulky commodities to use in exchange.
6. Most commodities appear in plenty and therefore lose value easily.
7. Most of the commodities are not divisible into smaller denominations to make smaller transactions possible.
8. It is difficult to get commodities which are homogeneous to use as a means of settling obligations.
9. Problems of double coincidence of wants.

The value of money means the purchasing power of money i.e. the amount of commodities a unit of money can purchase. The value of money depends on the price level. If the price is higher, the value of money is lower and if the price is lower, the value of money is higher.

Effect when the value of money increases

1. Business activities will be stimulated due to increase in purchasing power.
2. There will be less risk to produce (loss) due to sureness of producers to market their products.
3. Profit margin rises due to increase in revenue as a result of increase in purchasing power in the economy.
4. Output also rises. Producers will be stimulated to increase output due to increase in input.
5. Cost of production becomes low hence production increases.

Effect when the value of money decreases

1. Cost of production increases or rises, hence reducing production.
2. It becomes difficult to adjust wages.
3. Purchasing power of individuals will decrease due to increase in price of goods and services hence affects living standard of people.
4. Profit margin will decrease due to increased cost of production.

Refers to the willingness of people to hold money in cash rather than other assets like bonds, bills and other government securities.

The question why do people hold money? Can be explained by the following.

1. The quantity theory of money.
2. The Keynesian demand for money theory.

According to Prof. Irving Fisher, money is like other commodities in the market. As the quantity supplied increases, the price increases i.e. the value of money will decrease and when the quantity supplied decreases, the prices will decrease, hence the value of money increases.

NOTE: According to Fisher, the value of money depends on quantity of money in circulation or level of transactions. e.g. when the quantity of money is double, the price will also be double but the value of it will fall by half.

The theory can be explained by the following equation:

MV = PT

Where, M = Stock of money. V = The velocity of money in circulation. P = General price level. T = Level of transactions. MV = Amount of money spent on purchasing commodities. PT = Value of goods and services sold in an economy.

ASSUMPTIONS OF THE THEORY:

Velocity of money should remain constant. The proportion of increase/decrease in proportion is inversely proportional to the quantity supplied of money.

1. Number of transactions should remain constant.
2. Absence of hoarding i.e. all the money in circulation should be used for transactions.
3. Quantity and velocity should be credited for transactions.
4. There is no barter trade i.e. operating in monetary economy.

The quantity theory of money has been rejected or criticized on the following basis:

1. The theory is based on weak assumptions because all variables are assumed to be constant i.e. V and T. In actual sense, the velocity of money and number of transactions do not remain constant when the quantity of money changes.
2. Prices of different commodities do not change at the same time as the theory explains. Price changes differently depending on conditions of demand and supply.
3. The theory is based on the supply side ignoring the demand side of money i.e. it is both demand and supply of money which determines price.
4. It is just truism and not a theory. The theory is inadequate because it does not consider the interest rate which is the basis of monetary theories.
5. The theory ignores the influence of the government in the price level through price ceiling and price floor.
6. Fisher considers money as a medium of exchange and ignores the direct exchange of goods for goods which exists in some parts of different money.
7. Increase in price can be brought about by scarcity (e.g. existence of monopoly market) but not necessarily due to increase in money supply.

According to Lord John M. Keynes, these are the main reasons as to why people hold money (demand).

1. Transaction motive.
2. Speculation motive.
3. Precautionary motive.

Transaction motive

Money is demanded for facilitating day-to-day uses i.e. to buy everyday requirements such as food, clothes, etc.

$M_T = kY; k > 0$

Where, $M_T$ = Demand of money for transaction. $Y$ = Consumer's income. $k$ = Constant of fixed proportion.

Alternatives.

$M^T_D = f(Y)$

The quantity of money demanded for transactional motive is directly proportional to the person's income. Also, the longer the payment period, the more money for transaction and vice versa.

Precautionary motive

Individuals hold extra money as a precaution against unseen events or circumstances e.g. sickness, etc. This additional money held to meet unexpected events in the future is said to be held for precautionary motives. It depends on the person's nominal income.

$M_T$ = Demand of money for transaction. $Y$ = Consumer's income. $k$ = Constant of fixed proportion.

Alternatives.

$M^T_D = f(Y)$

Speculative motive

If money is held in excess amount required for transaction and precautionary motive, then it is held for speculative purpose. Speculative demands depend on the future trend on the interest rate. Investors will prepare to convert their assets into investment e.g. purchasing bonds rather than holding money in cash when interest rate is low.

Therefore, demand for money for speculative motive is inversely related to interest rate i.e.

$M^S_D = k(i); k > 0$

$M^S_D$ = Demand of money for speculative motive. $i$ = Interest rate.

People hold money for earning income through speculation. This depends on the rate of interest.

Graph for illustration

From the graph, when the rate of interest is expected to fall from $Or_2$ to $Or_1$, speculators convert bonds to cash and therefore demand for money $OM_1$ to $OM_2$ to avoid capital loss. When the rate of interest is expected to increase from $Or_1$ to $Or_2$, speculators buy bonds and hence demand less money ($OM_2$). This liquidity trap shows the point below which the interest rate would be too low to encourage speculation to invest in bonds and as a result, only money is held.

Finance motive

People hold money to finance gaining investment in which capital has been sunk. Such money held would constitute the variable costs of such investment.

NB: Determinants of demand for money: In addition to the Keynesian demand for money theory, others are:

In high demand for money is high because of the low value of money. Low demand for money is low because of the high value of money.

Generally $M^T_D, P, S = f(Y, i)$

Where $M^T_D$ = Demand for money $P$ = Precautionary motive. $S$ = Speculative motive. $T$ = Transactional motive. $Y$ = Consumer's income. $i$ = Interest rate.

Refers to the money in circulation plus money in current savings and time deposit accounts.

$MV_2 = M_1$ + savings and time deposits. = $M_1$ + $SD$ + $TD$

Where $M_1$ = $CC$ + $DD$ $CC$ = Currency in circulation. $DD$ = Demand deposits.

This definition treats money as medium of exchange and therefore considers only money which in reality is available to be used to facilitate exchange.

Refers to the volume of money in an economy. There are several definitions of money supply as follows:

Narrow definition of money supply

Money supply as money in hands of the public plus money on demand deposits (current account).

$M_1$ = $CC$ + $DD$

Where $CC$ = Currency in circulation $DD$ = Demand deposits.

This definition treats money as a medium of exchange and therefore considers only money which in reality is available to be used to facilitate exchange.

Broader definition of money supply

Refers to the money in circulation plus money in current, savings and time deposit accounts.

$MV_2 = M_1$ + savings and time deposits. = $M_1$ + $SD$ + $TD$

Where $M_1$ = $CC$ + $DD$ $SD$ = Savings $TD$ = Time deposits.

This takes money to be a store of value.

Other definitions

Includes the definitions of other assets like bonds and foreign currencies. i.e. $M_3 = M_2$ + near money (Quasi)

NB: Near money (Quasi) refers to the assets that can easily be converted to cash.

1. Exogenous (discretionary) supply of money. This is determined by the monetary authority which may be central bank or ministry of finance. Exogenous supply of money is usually assumed fixed.

   

2. Endogenous (automatic) supply of money: This depends on the level of economic activities e.g. output of interest, etc.

1. Printing more money by monetary authority. When the government undertakes runs short of money, more money can be printed to finance them. This is called financed accommodation. Demonetization is withdrawing all money in circulation reduces money supply.

2. Government borrowing from the central bank. This also implies printing of money since the central bank has no money to lend. When the central bank buys securities (e.g. bonds) from the public, money supply increases but when the central bank sells securities to the public, money supply is reduced.

3. Balance of payments (BOP) surplus. When export exceeds imports, the surplus foreign exchange is exchanged for local currency. Such money circulates in the economy and vice versa during balance of payment deficit.

4. Foreign capital inflow e.g. tourists who exchange foreign exchange in local currency spend during their stay in the country and vice versa during capital outflow.

5. Special deposits. If increased or imposed by the central bank reduces money supply.

6. Credit by commercial banks. This act by commercial banks using the cheque facility expands to result into greater volume of credit than the amount originally lent out. The increase in money supply in the currency.

7. Interest rate. This is the rate at which the central bank charges commercial banks for the loan given to them. Increase in interest rate to the public will discourage borrowing and encourage saving hence decrease in supply and vice versa when the bank decreases.

8. Selective credit control. If few factors get credit, money supply reduces while if credit is not restricted, money supply increases.