• One of the important function of a financial
system is the monetary function.
• This is where the introduction of money into
the economy enables those with excess
money and those with deficit to separate the
act of sale from the act of purchase and allows
them to overcome the main problem of barter
• Then what is money ?
Anything that is generally accepted as a
medium of exchange.
The sets of assets in an economy that
people regularly use to buy goods and
services from other people.
• Barter- In the beginning, people bartered.
Barter is the exchange of a good or
service for another good or service, a bag
of rice for a bag of beans thus it is the
direct exchange of goods and services for
other goods and services.
• Disadvantages of Barter:
– Variable Value of Assets
– Time-consuming Negotiation of Price
– Large number of transactions
– Double Coincidence of Wants
• The disadvantages of barter provided an
impetus for the development of money
• To solve that problem humans developed
what is called commodity money.
• A commodity is a basic item used by
almost everyone.
• In the past, salt, tea, tobacco, cattle and
seeds were commodities and therefore
were once used as money.
• Commodities were chosen as preferred barter
items for a number of reasons –
– some because they were conveniently
and easily stored,
– some because they had high value
densities and were easily portable, and
– some because they were durable.
• These commodities, being widely desired,
would be easy to exchange for others and
therefore they came to be accepted as
• Commodities originally accepted for one
purpose were often found to be useful for
other non-economic purposes
• Because of their growing acceptability,
they began to be used for general trading
supplementing or replacing barter.
• However, using commodities as money
had other problems.
– Carrying bags of salt and other
commodities were difficult to store or
were perishable.
• Metals objects were introduced as money
around 5000 B.C. By 700 BC, the Lydians
became the first in the Western world to
make coins.
• Countries were soon minting their own
series of coins with specific values.
• Metal was used because it was readily
available, easy to work with and could be
• Since coins were given a certain value, it
became easier to compare the cost of
items people wanted
• Later paper money was introduced
• With the introduction of paper currency
and non-precious coinage, commodity
money evolved into representative money.
• This meant that what money itself was
made of no longer had to be very valuable.
• In the early days of money, people were
very skeptical about accepting an object
that only represented value and wasn’t
valuable in and of itself.
• A willingness to accept something that
represents value requires a significant
amount of faith, something that early users
of money didn’t have.
• Representative money was backed by a
government or bank's promise to
exchange it for a certain amount of silver
or gold.
• For example, the old British Pound bill or
Pound Sterling was once guaranteed to be
redeemable for a pound of sterling silver.
• For most of the nineteenth and twentieth
centuries, the majority of currencies were
based on representative money through
the use of the gold standard
• Anything used as money – whether a
deerskin, a cowrie seashell, or a dollar bill
should fulfill the following functions:
• medium of exchange
• unit of account
• store of value
• standard of deferred payment
• 1. Medium of exchange: Money permits
to trade at less cost in time and effort.
• Barter is inefficient because is difficult and
time-consuming to find the trading partner.
• Barter is the direct exchange of goods
and services for other goods and services
• A barter system requires a double
coincidence of wants for trade to take
place. Money eliminates this problem.
• As a medium of exchange, or means of
payment, money is generally accepted by
buyers and sellers as payment for goods
and services.
• Other benefit: allows specialization (and
rises productivity)
• 2. Unit of account: Money is the basic
unit for measuring economic value
• As a unit of account, money is a standard
that provides a consistent way of quoting
• Given that goods and services are mostly
exchanged for money, it is natural to
express economic value in terms of money
• Caveat: In countries with volatile inflation,
money is a poor unit of account because
prices must be changed frequently.
• More stable units of account used (dollars
or gold), even if transactions use local
• 3. Store of Value: money is a way of
storing wealth.
• Other types of assets may pay higher
returns, BUT it is a medium of exchange!
• As a store of value, money serves as an
asset that can be used to transport
purchasing power from one time period to
• Money is easily portable, and easily
exchanged for goods at all times.
• The liquidity property of money makes
money a good medium of exchange as
well as a store of value.
Acceptability -- people must be willing to
accept it as a means of payment and in
settlement of a debt
Durability -- must last a reasonable length
of time before deteriorating. It should be
durable, so that value is not lost by
• Divisibility -- to function as money an
asset must be capable of division into
smaller units to accommodate transactions
of differing value
• The medium of exchange should be
divisible because different goods are
valued differently
• Portability / Convenience -- to function
as money an asset must be portable and
easy to use, it must be light, small to carry
around and easy to transfer ownership
• It should be valuable relative to its weight
so that amounts large enough to be useful
in trade can be easily transported.
• Uniformity -- money of the same value
must be of uniform quality.
• It should be of standardized quality, so
that any two units are identical
• Stability of Value -- in order to fulfil its
various functions (especially as a store of
wealth and as a means of evaluating
future payment), it must retain its value
• Hard for Individuals to Produce
Themselves -- it must be hard to forge
Commodity Money –
• money that takes the form of a
commodity with intrinsic value.
• A good used as money that also has
value independent of its use as money.
• something that performs the function of
money and also has alternative, nonmonetary uses, e.g., gold, silver,
• Fiat Money –
• money without intrinsic value that is used
as money because of government decree.
• something that serves as money but has
no other important uses, e.g., Coins,
currency and checkable deposits (current
• Money, such as paper currency, that is
authorized by a central bank or
governmental body and that does not have
to be exchanged by the central bank for
gold or some other commodity money