MONEY

What is Money?
To understand the effects of money in the economy, it is necessary to understand exactly what
money is. To do this, it is necessary to develop precise definitions by exploring the functions of
money, looking at why and how it promotes economic efficiency, tracing how its forms have
evolved over time, and examining how money is currently measured.

Meaning of Money
When people use the word money in a conversation, they could be referring to anyone of the
following: -
 Currency or notes and coins
 Wealth, meaning, currency, money in the bank, financial assets like stocks and
shares, real property, e.tc
 Income (defined by economists as a flow of earnings per unit of time.
Economists however, define money or money supply as anything that is generally accepted in
the payment of goods and services or in the repayment of debts.

Money is the most important financial asset in the economy. All financial assets are valued in
terms of money, and flows of funds between lenders and borrowers occur through the medium of
money. Money itself is a true financial asset because all forms of money in use today are claims
against some institution, public or private. For example, one of the largest components of the
money supply today is the current account, which is the debt of a commercial bank. Another
important component of the money supply is currency- notes and coins, which is the pocket
money held by the public. The bulk of currency in use today in Kenya consists of Central Bank
of Kenya Bank notes representing debt obligations of the Central Bank of Kenya.
Liquidity is the term used to describe how cheaply and easily an asset may be converted into a
medium of exchange. Thus, a savings account maybe regarded as a liquid asset while a house is
not. The classification of money stocks in the economy is done according to how easy and quick
it is for a financial asst to be converted into a medium of exchange.

Functions of Money
Money has four key roles in an economy; it serves as:

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  A medium of exchange
 A unit of account
 A store of value
 A standard of deferred payments

Medium of exchange
This is the primary function of money. It means that people are willing to accept money in
exchange for goods and services. An alternative to using a medium of exchange would be barter
trading, the exchange of one good or service for another. Barter would be very cumbersome, as
its early practitioners found out, mainly because of the need for double coincidence of wants.
Double coincidence of wants calls for each individual in a transaction to have something which
the other(s) want. A pastoralist looking for a book on animal husbandry for example, would have
to look for a book keeper who is looking for a goat in order for a transaction to take place. This
would not only be time consuming but it would be a very expensive way of doing business.

By itself, money typically has little or no use as commodity. People accept money only because
they know they can exchange it at a later date for goods and services. This is why modern
governments have been able to separate the monetary unit from precious meals such silver and
gold bullion and successfully issue Fiat money or legal tender (i.e., of paper or data stored in a
computer file) not tied to any particular commodity.

The function of money as a medium of exchange allows for the separation of the act of selling
goods and services from the act of buying goods and services. This reduces the need for double
coincidence in terms of quality, quantity; time and location. There are savings in transaction
costs in form of search time, which in turn promotes economic efficiency, by allowing people to
specialize in what they do best. This also encourages division of labour.

Unit of Account
Money is used as a measure of value in the economy. Thus, the value of goods and services is
measured in terms of money. This makes it easy for people to compare prices, thereby reducing
the amount of information individuals need to make purchase decisions.

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In the absence of money, there would be more prices than goods in the economy, for example,
the price of a loaf of bread would be X shower caps, Y aspirin tablets, Z tomatoes e.t.c
The formula for calculating the number of prices we need when we have N goods is the same for
calculating the number of pairs when there are N items, as follows:
N(N-1)
2
Thus in the case ten goods for example, we would need
10(10-1) =90 =45
2 2
As the economy becomes more complex, the benefits of the function of money as a unit of
account become more apparent.

Store of Value
Money serves as a repository of purchasing power over time that is it acts as a means of storing
today’s purchasing power to purchase a good or a service tomorrow. Of course money is not
always a good store of value. The value of money, measured by its purchasing power, can
experience fluctuations. For example, the prices of commodities have almost tripled in the period
between January and July 2008, mainly due to rising cost of oil in the world market. This in
essence means that the value of each unit of money has decreased by almost two thirds during
this period.

Money functions as the only perfectly liquid asset in the financial system. An asset is liquid if it
can be converted into ash quickly with little or no loss in value. A liquid asset processes three
essential characteristics:
 Price stability
 Ready marketability
 Reversibility
An asset is considered liquid if its price tends to be reasonably stable over time, if it has an active
resale market and if it is reversible so that investors can recover their original investment without
loss.

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Standard for Deferred payments
Payment that is deferred to the future is usually stated as a sum of money. If you take goods on
credit as is the case in hire purchase situations, the amount owed is usually stated in terms of
money. Having a common standard for deferred payments, which is the same as the medium of
exchange and the unit of account makes it relatively easy to determine exactly how much
deferred a payment will be, and also the ‘cost’ of deferring the payment, which is the same as the
cost of ‘holding’ money. One measure of the ‘cost’ of holding money is the income foregone by
the owner who fails to access the ‘liquid’ money immediately or who fails to convert his or her
money balances into more profitable investments in real or financial assets. The rate of interest
determined by the financial system is a measure of the penalty suffered by an investor for not
converting money into income-earning assets.

CHARACTERISTICS OF MONEY
For a commodity to function effectively as money, it must meet several criteria as follows:
 It must be easily standardized, making it simple to ascertain value
 It must be widely accepted
 It must be divisible so that it is easy to give ‘change’.
 It must be easy to carry
 It must not deteriorate quickly
Items that have satisfied these criteria and that have been used as money have taken many
unusual forms throughout human history. The list includes beads, cowrie shells, tobacco,
cigarettes, whiskey, salt, e.t.c.

TYPES OF MONEY/ EVOLUTION OF MONEY

The origins of money are little known. Historians believe money originate as religious objects of
value, which ultimately evolved into a medium of exchange by the ancient Babylonian, Greek,
and Roman civilizations whose monetary system included coins.
After the fall of Tome, the medieval economies of Europe moved towards a barter system. Taxes
were often collected in the form of agricultural products or labour services.
Barter was however not a permanent or world wide phenomenon. In Byzantium, (now
Constantinople), for example, the Eastern Roman Empire survived until the eleventh century and
with it the nomisa gold coin, which was the standard currency of the Mediterranean world. In
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Europe, the feudal system and the use of barter eventually diminished, and a monetary economy
gradually emerged. By the eleventh century, there was a revival of trade and a renewed growth
of towns and gold emerged as a medium of exchange.
Historically, two types of money have been used as a medium of exchange that is, commodity
money and fiat money, also known today as legal tender.

Commodity Money
This is was the first kind of money used by civilization-religious relics. Commodity money is a
physical commodity that is used as money but also which has intrinsic value, or alternative non
monetary uses. More recent examples of commodity money are gold and silver coin. These have
uses as jewellery and other decorative uses and thus have value independent of their use as
money. When they circulate as money however, they are valuable as a medium of exchange.
Other commodities that have been used as commodity money in human history include live
animals, sacks of corn, salt and even cigarettes. A common characteristic of commodity money
is that something valuable to society for its physical properties is used to perform a second
function as the medium of exchange.

Full -bodied money

It is a type of commodity money in which the commodity itself circulates as money. The
monetary value of full bodied money exactly equals its commodity value. The gold and silver
coins which were minted by the US Treasury until 1914, were examples of full bodied money. If
for example the price of gold was $1 per ounce it meant that the coin contained one ounce of
gold and it could be melted to extract one ounce of gold for use in jewellery.

Representative full-bodied money

It is paper money that represents a claim to a specific quantity of some commodity. The actual
commodity is held as inventory in a bank vault or other depository and does not circulate. The
gold certificates issued by US Treasury during the early part of the twentieth century were
representative full-bodied money because the value on each certificate was backed by an equal
amount of gold.
The advantage of this kind of money is that the commodity itself does not have to circulate; only
the paper claim to the commodity circulates. The need to carry around heavy bags of gold was
eliminated because paper certificates were much lighter and practical. When representative full-

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bodied money is used as a medium of exchange, the actual commodity has negligible value to
the users.

Fiat Money
Fiat money is paper money that is not backed by any commodity. The use of representative full-
bodied money got people accustomed to the use of paper money. This lend to the innovation of
unbacked money in the form of token coins and unbacked (fiat) paper money.
Token coins resemble commodity money, but contain less valuable metals, such as copper,
nickel, or zinc instead of silver or gold.

Legal tender
It is fiat money used by modern economies today simply because the money is guaranteed by the
issuing authorities and people have confidence in it. In Kenya, for example, people are obligated
by law to accept legal tender in settlement of debts

Checkable (demand) deposits

This is a category unbacked money issued by banks and other financial institutions. Cheques
issued against demand deposit accounts for example are generally accepted as payments,
although they are not backed by any commodity. They are instead backed by either paper money
held in the bank vault or, more likely by nothing tangible.
Most economies today use fiat money, money that is backed by no physical commodity but by
the fact that it is generally accepted by society as a medium of exchange. Without this
acceptance, no one would for example, value the dollar bill, the sterling pound note or the
Kenyan shilling denominate notes in exchange for goods and services.

THE EVOLUTION OF THE PAYMENT SYSTEM

Payment systems have moved in tandem with the evolution of money. To get a perspective of
where the payment system is heading it is important to understand how it has evolved. It has
come a long way, from the time of barter, through times of full-bodied commodity money to
today’s era of fiat money.

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Other than being lighter than commodity money, Paper currency has evolved into a legal
arrangement whereby countries can change the currency that the use at will. An example is the
Euro, which has been adopted by the majority of European countries and the ongoing debate
about the possibility of countries of the East African Community adopting a common currency.
Major drawbacks of paper currency and coins are that they can be easily stolen and they can be
expensive to transport due to their bulk if they are in large amounts. To deal with these problems,
the development banking brought with it another step in the evolution of payment system, the
cheque as a means of payment.
The development of the cheque can be traced back to the time when gold became generally
accepted as a means of payment in Europe. People who had deposited money with goldsmiths
for safekeeping started issuing notes signed to shopkeepers and other goods or service providers
to claim part of the depositor’s deposited gold as payment for goods taken or services rendered.
The cheques in use today are simply claims against the drawer’s funds in an account held in a
bank or credit line accorded by the bank.
Payment systems based on cheques however have drawbacks in that it take time to carry cheques
from place to place and also it takes several days before a cheque can be cleared.
Banks have tried o overcome the shortcomings of the cheque system by introducing various
forms of electronic payment systems. The most common of these are:
 Debit cards: These look like credit cards. They enable consumers to purchase
goods by electronically transferring funds directly from their bank accounts to a
merchant’s account. Debit card holders can also obtain currency from Automatic Teller
Machines (ATMs)
 Stored-value Cards: these look like debit and credit cards they differ in that they
contain a fixed amount of digital cash. The most sophisticated of these is the smart card,
which contains its own computer chip such that it can be loaded with digital cash from its
owner’s bank account whenever needed. They can, for example, be loaded from ATM
machines, personal computers or specially equipped telephones.
 Electronic Cash: Electronic cash or e-cash is a form of electronic money that
can be used on the internet for the purchase of goods and services. A consumer gets e-
cash by setting up an account with a bank that links to the internet and then has the e-cash
transferred to his or her PC. The consumer then surfs on an internet store and selects the

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 buy option for a particular item, whereby the e-cash is automatically transferred from the
computer to the merchant’s computer. The merchant can then have the funds transferred
from the consumer’s bank account to their account before the goods are shipped.
 Electronic cheques: These allow users of the internet to pay their bills directly
over the internet without having to send a paper cheque. The user has his/her PC write the
equivalent of a cheque and then sends the electronic cheque to the other party, who in
turn sends it to his/her bank. The bank would then transfer the funds from the originator’s
account to the recipient’s account upon verification of the validity of the cheque. This
process is far much cheaper and convenient than using paper cheques because it is
executed electronically.

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