Chapter 5: Money

The Barter System and Its Difficulties

Before money, people exchanged goods directly — this is called the barter system. While simple in concept, it had serious practical limitations that eventually necessitated the development of money.

• Double coincidence of wants: Both parties must want exactly what the other offers — simultaneously. This is the fundamental problem of barter.
• No common measure of value: There is no standard unit to compare the value of unlike goods.
• Lack of store of value: Perishable goods cannot be stored as wealth for future use.
• Indivisibility: Some goods (e.g., a cow) cannot be divided for smaller transactions.
• Difficulty in deferred payments: No standard for future payment obligations (loans, credit).

Functions of Money

Money solves every difficulty of barter. Its functions are classified as primary (most essential) and secondary.

Primary Functions:

• Medium of Exchange: Money is universally accepted in exchange for goods and services, eliminating double coincidence of wants.
• Measure of Value (Unit of Account): Money provides a common unit to express the price/value of all goods and services.

Secondary Functions:

• Store of Value: Money can be saved and retrieved in the future without losing its value — wealth can be held in money form.
• Standard of Deferred Payments: Future obligations (loans, EMIs) are expressed in terms of money, enabling credit transactions.

Some textbooks also list contingent functions such as transfer of value and distribution of national income, but these are not part of the standard CBSE syllabus.

Types of Money

• Commodity Money: Objects with intrinsic value used as money (e.g., cattle, grain, salt in ancient times).
• Metallic Money: Coins made of gold, silver, copper. Value could be intrinsic (full-bodied) or token.
• Paper Money: Currency notes issued by the central bank (RBI in India). Not backed by gold today — called fiat money.
• Plastic/Credit Money: Debit cards, credit cards. Represent claims on bank balances; a modern form of money.
• Bank Deposits (Credit Money): Demand deposits with commercial banks that can be withdrawn on demand. Counted in money supply.

Important: Money is a stock concept — it is measured at a point in time, not over a period.

Money Supply (Monetary Aggregates) in India

The Reserve Bank of India (RBI) measures money supply in four ways, from narrowest to broadest:

• M1 (Narrow Money): Currency with the public + Demand Deposits with commercial banks + Other deposits with RBI. Most liquid.
• M2: M1 + Savings deposits with Post Office savings banks.
• M3 (Broad Money): M1 + Time Deposits with commercial banks. Most commonly used measure of money supply.
• M4: M3 + All deposits with Post Office savings banks (excluding National Savings Certificates). Least liquid.

Liquidity order: M1 > M2 > M3 > M4 in terms of liquidity. M4 > M3 > M2 > M1 in terms of size.

The supply of money consists of: (i) Currency (notes + coins) held by the public, and (ii) Demand deposits with commercial banks.

Fisher's Quantity Theory of Money

Irving Fisher's equation of exchange explains the relationship between money supply and the price level:

MV = PT

• M = Money supply (stock of money in the economy)
• V = Velocity of circulation (number of times each unit of money changes hands in a given period)
• P = General price level
• T = Volume of transactions (total goods and services bought/sold)

Fisher assumed V and T are constant in the short run. Therefore, if M doubles, P doubles — establishing a direct proportional relationship between money supply and prices. This forms the basis of the Quantity Theory of Money.

Rearranged: P = MV/T. To find P: multiply M by V, then divide by T.

Key Concepts at a Glance

Sample MCQs — Chapter 4: Money