Barter and its problems
Barter = exchange of goods for goods, without money. Its problems:
- No double coincidence of wants: both people must want exactly what the other has, at the same time.
- No common measure of value: how many pens for one goat?
- Goods can't be divided: half a cow is useless.
- Hard to store value: grain rots, animals die.
- No standard for future payments: a loan of rice, returned in rice of what quality?
Functions of money
Money is anything that is generally accepted as a means of payment.
Primary functions
- Medium of exchange: money splits one barter swap into two easy parts, sale and purchase. No double coincidence needed.
- Unit of account (measure of value): all prices are stated in rupees, so we can compare values and keep accounts.
Secondary functions
- Store of value: money can be saved and used later; it does not rot. (Rising prices lower what it buys, though.)
- Standard of deferred payments: loans, rents and salaries for the future are written in money.
Supply of money: who supplies it
Money supply = total stock of money held by the public at a point of time. It is a stock.
The public = households and firms. Money held by the government, the RBI and commercial banks is not counted, because it is not used for buying goods.
- Currency notes: issued by the RBI (except ₹1 note, by the government). They are fiat money: money by government order, backed by trust, not by gold. They are legal tender: no one in India can refuse them for payment.
- Coins: minted by the Government of India.
- Demand deposits: created by commercial banks. They are not legal tender (a shop may refuse a cheque), but they work as money.
Measuring money supply: M1
M1 = CU + DD + OD (narrow money)
- CU = currency (notes + coins) held by the public.
- DD = net demand deposits held by commercial banks: savings and current accounts that can be withdrawn on demand by cheque, card or UPI. 'Net' means inter-bank deposits (one bank's deposit in another) are left out.
- OD = other deposits with the RBI: demand deposits of some public bodies and international bodies. Very small.
Fixed deposits are not in M1: you cannot spend them directly. Broader measures (M3) add them.
Moving money between CU and DD (withdrawing ₹500 from ATM) does not change M1. It changes only when new currency is issued or banks create new deposits by lending.
Key formulas and definitions
- M1 = CU + DD + OD
- Money supply (a stock) = money held by the public at a point of time
Worked examples
1. Currency with public ₹35 lakh crore, net demand deposits ₹25 lakh crore, other deposits with RBI ₹1 lakh crore. Find M1.
M1 = 35 + 25 + 1 = ₹61 lakh crore.
2. A farmer has wheat and wants cloth. A weaver has cloth and wants a bicycle. Which problem of barter is shown?
Lack of double coincidence of wants: the weaver does not want wheat.
3. Which function of money is used: (a) the price of a book is ₹250, (b) you keep ₹1000 for a trip next month, (c) EMI of ₹5000 for 12 months?
(a) Unit of account. (b) Store of value. (c) Standard of deferred payment.
4. Riya withdraws ₹2000 from her savings account. What happens to CU, DD and M1?
CU rises by 2000, DD falls by 2000, M1 does not change.
5. Is money held by the SBI in its own cash box part of money supply?
No. Cash with banks is not held by the public; it is a bank reserve.
6. Why is a ₹500 note called fiat money and legal tender?
Fiat: it is money because the government orders it, not because the paper is valuable. Legal tender: by law it must be accepted for payment of debts in India.
Common mistakes
- Counting money held by banks or the government in money supply. Only money with the public is counted.
- Including fixed deposits in M1. M1 has only demand deposits.
- Thinking a cheque is money. The demand deposit behind it is money; the cheque is only an order to pay.
- Saying withdrawing cash raises money supply. It only moves money from DD to CU.