Money and its Functions Money is something which is generally accepted in payment for goods and services and in settling debts. Historically, many commodities, ranging from precious metals to cigarettes, have been used as money. In prisoner-of-war camps, cigarettes served as money. In the nineteenth century money was mainly gold and silver coins. These are examples of commodity money, ordinary goods with industrial uses (gold) and consumption uses (cigarettes) which also serve as a medium of exchange. The value of commodity money comes from a commodity out of which it is made. In most modern societies, however, commodities are rarely used as money because they are expensive. Instead, they use fiat money, that is mainly paper currency issued by governments and deposits in checking accounts that are accepted as a means of payments for goods and services. Fiat money is sometimes called token money. By collectively agreeing to use fiat money, society economizes on the scarce resources required to produce money as a medium of exchange. The essential condition for the survival of fiat money is the restriction of the right to supply it. Private production is illegal. Society enforces the use of fiat money by making it legal tender. The law says it must be accepted as a means of payment. Up to 1931, paper money was backed by a reserve of gold and any settlement of international debts were settled by the transfer of gold from one country to another. Today, most national currencies are fiat currencies, including the US dollar, the euro, and all other reserve currencies In modern economies, fiat money is supplemented by IOU (I owe you) money. IOU money is a medium of exchange based on the debt of a private firm or individual. A bank deposit is IOU money because it is a debt of the bank. When you have a bank deposit the bank owes you money. Bank deposits are a medium of exchange because they are generally accepted as payment. Although the crucial feature of money is its acceptance as the means of payment or medium of exchange, money has three other functions. It serves as a unit of account, as a store of value, and as a standard of deferred payment. Money, the medium of exchange, is used in one-half of almost all exchanges. Workers exchange labour services for money. People buy or sell goods in exchange for money. Money is the medium through which people exchange goods and services. To see that society benefits from a medium of exchange, imagine a barter economy. A barter economy has no medium of exchange. Goods are traded directly or swapped for other goods. That is why there has to be a double coincidence of wants. The use of money makes the trading process simpler and more efficient. The unit of account is the unit in which prices are quoted and accounts are kept. In Britain prices are quoted in pounds sterling; in America in dollars. It is usually convenient to use the units in which the medium of exchange is measured as the unit of account as well. Money is a store of value because it can be used to make purchases in the future. Nobody would accept money as payment for goods supplied today if the money was going to be worthless when they tried to buy goods with it tomorrow. But money is neither the only nor necessarily the best store of value. Houses, stamp collections, and interest-bearing bank accounts all serve as stores of value. Since money pays no interest and its real purchasing power is eroded by inflation, there are almost certainly better ways to store value. Finally, money serves as a standard of deferred payment or a unit of account over time. A standard of deferred payment is the accepted way (in a given market) to settle a debt, it’s a unit in which debts are denominated

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Supply and Demand for Money Money supply or money stock, is the total amount of money available in an economy at a particular point in time. Changes in money supply affect the price level, inflation and the business cycle. Money supply comes in many forms, including currency, demand deposits, time deposits, and plastic money. The narrowest commonly used measure of money M1 consists of currency (bills, coins, money orders and traveler’s checks) and current accounts or checking accounts. Money measure M2 is sometimes called broad money because it includes various not-quite-money monies such as savings accounts. М2 can be presented as M1 + savings accounts + money market accounts. M3 equals to M2 plus large time deposits of $100 000 or more. Narrow money refers to forms of money that are available immediately for use in transactions, broad those that are not immediately available. When the money supply increases, people have more money to spend, and demand for goods and services increases. This is an economic growth scenario. But, if output does not keep pace with demand, prices increase. When prices rise continuously, inflation results. The central bank is responsible for regulating money supply in the economy. The demand for money is the desired holding of money balances in the form of cash or bank deposits.Why do people hold (demand) currency and checkable deposits (M1), rather than putting their money to work in stocks, bonds, real estate, or other non-money forms of wealth? John Maynard Keynes, in his 1936 work entitled The General Theory of Employment, Interest, and Money, gave three important motives for doing so: transactions demand, precautionary demand, and speculative demand. The transactions demand for money is the stock of money people hold to pay everyday predictable expenses. The desire to have ‘walking around money’ to make quick and easy purchases is the principal reason for holding money. Without enough cash, the public must suffer forgone interest. People have a second motive to hold money, called the precautionary demand for money. The precautionary demand for money is the stock of money held to pay unpredictable expenses. This is the ‘mattress money’ people hold to guard against those proverbial rainy days. The third motive for holding money is the speculative demand. The speculative demand for money is the stock of money held to take advantage of expected future changes in the price of bonds, stocks, or other non-money financial assets. It is the so called ‘betting money’. As the interest rate falls, the opportunity cost of holding money falls, and people increase their speculative balances. Demand for money is a crucial implication for the optimal way in which a central bank should carry out monetary policy.

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Instruments of Monetary Policy Monetary policy is a central government policy with respect to the quantity of money in the economy, the rate of interest and the exchange rate. Two basic types of monetary policy are contractionary (or tight) and expansionary (or easy/free/loose) policies. Expansionary monetary policy is a policy which expands (increases) the supply of money, whereas contractionary monetary policy is the one that contracts (decreases) the supply of a country's currency. The main instrument used by a central bank to achieve its goals is the interest rate – also known as the discount rate or base rate. This is the rate at which the central bank is ready to lend to commercial banks. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation. Let us look at how a rise in the discount rate affects the banking system and the financial markets. Banks may wish to borrow if they feel that their level of reserves is too low. A rise in the discount rate makes it more costly for commercial banks to borrow from the central bank. If the cost of borrowing from the central bank goes up, commercial banks are less inclined to borrow from it. Since borrowing from the central bank is also a source of bank reserves, an increase in the interest rate and subsequent reduction in borrowing from the central bank puts the commercial banks in a situation where they have lower reserves than they planned to hold. In response, they will reduce their lending by increasing the rates they charge to households and firms. In practice, commercial banks react very quickly to increases in the discount rate. Another instrument of monetary policy is open market operations, which involve the purchase or sale of government securities by the central bank. When the central bank buys treasury bills or government bonds from a commercial bank, it makes payment simply by increasing the amount of reserves in the account of the commercial bank. Thus, the central bank uses its monopoly power over money creation. As the level of reserves increases, the commercial banks realize that they have more reserves than they need for prudent operation. Therefore, they extend their lending to households and firms by lowering their interest rates. In contrast, when the central bank sells treasury bills or government bonds, the commercial bank will make the payment for the securities from the reserves it deposited at the commercial bank. After the transaction has been completed, the level of reserves will be lower than before, and hence the commercial banks will raise their interest rate to cut their credit to households and firms. In both cases, the change in the reserves translates into a change in the credit provided to firms and households. Finally, the central bank also requires the commercial banks to hold a percentage of their deposits as reserves. These are called required reserves, and the percentage is known as the required reserve ratio. These reserves are meant to ensure some minimum level of prudence, even if not all commercial banks want to operate as prudently as they should. If the central bank increases the reserve ratio, then the actual reserves of the banks will fall short of the required ratio. Thus the banks will have to raise their interest rate to cut back on loans, and deposit the money freed up as reserves at the central bank. The opposite happens if the central bank decreases the required reserve ratio. Suddenly banks have more reserves than they want to hold, so they will lend the money instead of holding it at the central bank. So if the required reserve ratio increases, the commercial banks lending to households and firms falls. The opposite happens when the required reserve ratio decreases. It is important to point out that required reserve ratios are very stable – central banks do not like to change them too often. The level of cash deposits and commercial banks' reserves held at the central bank plays an important role in transmitting the central bank's monetary policy to the banking sector and the financial markets. The cash in circulation and the reserves of private banks together are called the monetary base. As we have already said, the central bank has a monopoly over money creation, more precisely, over monetary base creation. The power of a central bank rests on its ability to control the monetary base. Monetary policy is an effective tool for influencing the economy in the short run. But the trouble is that it is difficult to predict the length of time policies need to take effect. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.