Accounting Point College Wah Cantt Money banking and fine B.

Com Part -1

CHAPTER: - 1 INTRODUCTION TO MONEY

Notes Main topics:1. Origin and growth of money 2. Barter system 3. Disadvantages of barter system/difficulties of barter system 4. How money can remove these difficulties 5. The Concept of money 6. Types Of money 7. Methods and principals of note issues 8. Issuance of money in Pakistan 9. Function of money 10. Characteristics of good money 11. The concept of near to money 12. Paper money 13. Role of money in modern economy 14. Money on the other side of the picture

1:-Origin and growth of money

Introduction of money
Money is, in fact, one of the greatest inventions of man. Since money represents generalized purchasing power, it has been the object of Mans desires throughout the ages. Due to inconveniences of barter system, the need for introducing something as a medium of exchange arises. The development of money has passed through various stages in accordance with time, place and circumstances with the progress of civilization of mankind.

Barter System

o To trade goods or services without the exchange of money o Barter means direct exchange of goods. At the beginning, there was no money. People engaged in barter, the exchange of goods for goods, without value equality. Then, a person catching more fish than the necessary for himself and his group exchanged his excess fish for the surplus of another person who, for instance, had planted and yield more corn that what he would need. This elementary form of trade prevailed at the beginning of civilization, and may be found today among people of ancient economies, in regions where difficult access makes money scarce and, even in special situations, where people barter items without regard for their equivalence in value. This is the case, for instance, of a child who exchanges with his friend an expensive toy for another of lesser value, which it treasures. Goods used in barter are generally in their natural state, in line with the environment conditions and activities developed by the group, corresponding to elementary needs of the groups members. This exchange, however, is not free from difficulties, since there is not a common measure of value among the items bartered.

Commodity Money

Some commodities, for their utility, came to be more sought than others are. Accepted by all, they assumed the role of currency, circulating as an element of exchange for other products and used to assess their value. This was the commodity money. Cattle, mainly bovine, was one of the mostly used, and had the advantages of moving for itself, reproducing and rendering services, although there was the risk of diseases and death.

Salt was commodity money, difficult to obtain, mainly in the interior part of continents, also used as a preservative for food. Both cattle and salt left the marks in the Portuguese language of their function as an exchange instrument, as we keep using words such as pecunia (money) and peclio (accumulated money) derived from the Latin work pecus (cattle). The word capital (asset) comes from the Latin capita (head). Similarly, the work salrio (salary, compensation, normally in money, due by the employer for the services of an employee) originates from the use of sal [salt], in Rome, for payment of services rendered

Brazil used, among other commodity moneys, cowry brought by Africans Brazil wood, sugar, cocoa, tobacco and cloth, exchanged in Maranho in the 17th Century due to the almost complete lack of money, traded in the form of yarn balls, skeins and fabrics. Later, commodities became inconvenient for commercial trades, due to changes in their

values, the fact of being indivisible and easily perishable, therefore checking the accumulation of wealth.

Metal

As soon as man discovered metal, it was used to made utensils and weapons previously made of stone. For its advantages, as the possibility of treasuring, divisibility, easy of transportation and beauty, metal became the main standard of value. It was exchanged under different forms. At the beginning, metal was used in its natural state and later under the form of ingots and, still, transformed into objects, from rings to bracelets. Later, metal money gained definite form and weight, receiving a mark indicating its value, indicating also the person responsible for its issue. This measure made transactions faster, as it saved the trouble of weighing it and enabled prompt identification of the quantity of metal offered for trade.

Money in the Form of Objects

Metal items came to be very valued commodities. As its production required, in addition to knowledge of melting, knowing where the metal could be found in nature, the task was not at the reach of everyone. The increased value of these objects led to its use as money and the circulation as money of small-scale replicas of metal objects.

Ancient Coins

In the 7th century B.C. the first coins resembling current ones appeared: they were small metal pieces, with fixed weight and value, and bearing an official seal that is the mark of who has minted them and also a guaranty of their value. Gold and silver coins are minted in Greece, and small oval ingots are used in Lydia, made of a gold and silver alloy called electrum. Coins reflect the mentality of a people and their time. One may find political, economic, technological and cultural aspects in coins. Through the impressions found in coins, we are able to know the effigy of personalities who lived centuries ago. Probably, the first historic character to have his effigy registered in a coin was Alexander the Great, of Macedonia, around the year 330 B.C. At the beginning, coin pieces were made by hand in a very coarse way, had irregular edges, and were not absolutely equal to one another as todays ones.

Gold, Silver and Copper

For many centuries, countries minted their most highly valued coins in gold, using silver and copper for lesser value coins. This system was kept up to the end of the last century, when cupronickel, and later other metallic alloys, became used, and coins came to circulate for their extrinsic value, that is to say, for their face value, which is independent from their metal content. With the appearance of paper money, minting of metal coins was restricted to lower values, necessary as change. In this new role, durability became the most requested quality for coins.

Paper Money

In the middle Ages, the keeping of values with goldsmiths, persons trading with gold and silver items, was common. The goldsmith, as a guaranty, delivered a receipt. With time, these receipts came to be used to make payments, circulating from hand to hand, giving origin to paper money. In Brazil, the first bank notes, precursors of the current notes, were issued by Banco do Brasil in 1810. They had its value written by hand, as we today do with our checks.

2:- Barter System and its defects

Barter is a system in which goods and services are exchanged for other goods and services without the use of money. In a barter system goods buy goods. Barter system involves the direct exchange of one good for another good.

Important definitions of barter system are as follows:

R.H. PARKER: "Barter is the direct exchange of goods and services without the use of money as either the means of payment or a unit of account." S. H. S. SLOAN: "Barter is the direct exchange of commodity or service for another without the use of money."

Defects of Barter:
Battering is the most inconvenient method of exchange. Much more time of the people is wasted in trying to exchange goods and services. As a method of exchange the barter system suffered for many shortcomings, inconveniences and difficulties.

The main inconveniences are as under:

1. LACK OF DOUBLE COINCIDENCE OF WANTS (NON-MATCHING) OF WANTS: The main difficulty of barter system is the lack of double coincidence of wants i.e. non-matching of wants. In a barter system a person who wants to exchange his goods must find not only some person who is willing to exchange his commodity but also find some one that is willing to give in exchange the same commodity which is wanted by first person. Example,

A person possessed wheat, which he wanted to barter (exchange) for cloth. He could not succeed in acquiring cloth until he met some one who not only had cloth but was also willing to barter with wheat. 2. LACK OF COMMON MEASURE: The second shortcoming of barter system is the lack of any common unit in terms of which to measure the values of goods and services. In the absence of any common measure of value, the value of each commodity in the market can not be expressed as one quantity. Example, If there are 500 different kinds and qualities of goods and services meant for exchange in the market, the value of each kind and quality of each good and service would have to be expressed in terms of 499 others. Such a number of prices would be confusing and difficult to remember. 3. LACK OF SUB-DIVISION: The third serious difficulty of barter system is the lack of sub-division of commodities. There are certain commodities which can not be divided without loss of value. Example The owner of cow wants to have 5 kilos of sugar. The barter between the person having cow and sugar will not take place because the value of cow is much more than 5 kilos of sugar. As it is not possible to divide his cow, no exchange will be possible between the two persons. 4. LACK OF STORE OF VALUE: The barter system suffered the lack of any satisfactory and reliable method of storing the value. There is way of storing of wealth for a long period. Some commodities lose their value with the passage of time. Some commodities are perishable in nature, such as milk, fish and vegetable. Other commodities such as wheat, cotton, etc., deteriorate in quality and value with the passage of time. Example Cattle, grains and other such perishable commodities could not store for a long period.

5.

DIFFICULTY OF FUTURE PAYMENTS:

The barter system suffered the difficulty of the future payments. When goods are lent to another person, the payment had to be stated in terms of certain goods. This gave rise to many problems. In the absence of any reasonable method to state debts in future payment, credit transactions are not possible and volume of trade remains low. 6. DIFFICULTY OF TRANSFER OF WEALTH: Under barter system there is difficulty of transfer of wealth from one place to another place. Immovable property cannot be transferred to another place. The transfer of movable property is very difficult and costly. Suppose a person wants to shift one hundred heads of cattle from Faisalabad to Karachi. You can well imagine the difficulties he would face. 7. DIFFICULTIES IN TAX COLLECTION: The difficulty of barter system is the imposing and collection of tax in the form of goods. If the government is able to collect the tax in the form of goods, there would be problem of the storage of goods. If so possible, the government will face difficulties to utilize the revenue for development and non-development purposes. 8. NO CAPITAL FORMATION: Under barter system people are concerned with their current needs. They do not save and there is no capital formation. The difficulty of store of wealth hinders from saving and capital formation. Thus, there is no capital formation under the barter system. 9. NO INVESTMENT: The barter system suffered the lack of store of value so, there was no saving. Hence investment could not be made. 10. NO DIVISION OF LABOR: Under barter system investment could not be made. Goods are produced in small scale. So, there was no division of labor. 11. NO BANKING SYSTEM: Banks deal in money; there is no money in barter system, so, there is no concept of banking in barter system. 12. NO INDUSTRIAL DEVELOPMENT:

The establishment of banks and stock exchanges is necessary for industrial development. Banks and stock exchanges cannot be established under barter system, so there is no possibility of industrial development. Conclusion: The difficulties faced by people in a barter system were indeed too many, as this was an inefficient method of trade and it severely restricted the scope of man's social and economic progress. With the passage of time, the barter system gradually dissolved and new mediums of exchange were introduced.

3:-How money can remove these difficulties

1. Medium of exchange 2. store of value 3. price mechanism 4. credit and Advances 5. banking Institutions 6. Investment and savings 7. Public fianc/ government Revenue 8. International trader 9. specialization 10.Foreign investment
Note For detail please go through class notes and book Money Banking and Finance by Riaz Ahmed Mina

4:-Types of money Introduction

Historical evidences show that money has evolved indigenous in response to the economic needs of the people. The money is generally classified under following six heads on the basis of its course of evolution, nature and characteristics.

1. Commodity Money:
In the earliest stage of human civilization, different commodities or species were used as money or medium of exchange. The most popular commodities or species were leather, animal skins, salt, wheat etc.

2. Metal Money:

Metal money consists of coins made of gold, silver or nickel. Metallic money varies in weight, fineness and value. All metallic coins are unstamped with a die in order to avoid chopping and abrasion against clipping or filing. In Pakistan coins of rupee five two and one are metallic money. Metallic money cannot be eliminated from the economy; it is saying its role in one shape or the other. Metallic money is of following kinds. FULL BODIED MONEY: If consists of those coins the metallic value of which is equal to their face value. They are also called "standard money or natural money". These are made from standard metals like gold and silver according to mint rules and regulations. The gold and silver coins are considered as full-bodied money. Now such money is not used anywhere in the world. TOKEN MONEY:

The coins whose face value is higher than their intrinsic value are called token money. They are usually made of sliver, copper or nickel. They are of small denominations and used for small payments. All metallic money, which circulates in present days, is token money.

3. Paper Money:

Money made of paper is called paper money. It consists of notes issued by the government or its Central Bank. Paper money is also called folding money or currency money. It is accepted in payment of goods or services, taxes and all public and private debts. The use of paper money has become very wide due to its many conveniences as a medium of exchange. Paper money is generally classified under following three heads:

(I) REPRESENTATIVE PAPER MONEY:

Representative paper money is that money which is fully backed by equivalent metallic or other reserves. It means the holder of such paper money or currency note can easily get it converted into gold or other metallic money on demand.

(II) CONVERTIBLE PAPER MONEY:

Paper money which can be converted into gold or metallic money on demand but all the notes issued are not fully backed by gold is called convertible paper money. The state or the public authority which issues convertible paper currency does not keep an equal value of metallic reserves behind it because she knows that all the notes are not generally presented for conversion at the same time.

(III) IN-CONVERTIBLE PAPER MONEY /Fiat Money:

In-convertible paper money is that form of paper money which is not convertible into gold or silver on demand. It is acceptable because it has been declared legal tender by the issuing authority and has general acceptance as medium of exchange. Generally, in convertible paper money it termed as "Fiat Money".

4. Near Money:

Numbers of assets, which are liquid in nature but cannot be used as a medium of exchange, are considered as near money. For example time deposits, shares, government bonds and securities. Near money can be easily converted into cash without any delay and loss in value.

5. Credit/Bank Money:
Bank money occupies a very predominant position as a medium of exchange in the advanced countries of the world today. Nearly 90% of all transactions take place by cheques. The term bank money applies to that near money, which consists of cheques, bills of exchanges and drafts.

(I) CHEQUE:
A cheque is merely an order on a bank by its client to pay specified sum of money to him or to a third party on demand. '

(II) BILLS OF EXCHANGE:

An instrument in writing, containing an unconditional order signed by the maker, directing a certain person to pay a certain sum of money, only to or to the order of a certain person, or to the bearer of the instrument.

(III) DRAFT:
A draft is a cheque drawn by a bank on its own branch at a different place requesting it to pay on demand a specified amount to the person named in it. It is one of the cheapest methods of sending money both inside or outside the country.

(IV) PLASTIC MONEY:

Plastic money means the credit cards, debit cards or smart cards, which have silicon chips arid a specially printed set of characters. These cards are used for making payments for the purchase of goods or services locally and internationally. .

6. Legal Tender Money:

The money which creditors must accept in settlement of their claims by law is called legal tender money. If we offer such money in discharge of a debt, no one can refuse to take it as government guarantees it. It has following two types.

(I) LIMITED TENDER MONEY:

It can be accepted only up to a specific limit. It Pakistan, coins of small denomination value up to Rs. 1,2 and 5 are limited legal tender money because coins are token money which are used in small payments.

(II) UNLIMITED TENDER MONEY:

These can be paid up to any amount to the creditors for the, settlement of claims or dues. Notes, of Rs. 10, Rs. 20, Rs. 50, Rs. 100, Rs. 500, Rs. 1000 and Rs. 5000 are unlimited legal tender in Pakistan.

7. Money Of Account:

It means the unit of money by which the value of goods or services is expressed. Money of account in Pakistan is rupee because all people count their money in rupees. In the same way, price of all goods or services is also expressed in rupees. Every country has its own money of account. For example, England has Pound, Europe has Euro, America has Dollar and Saudi Arabia has Rial etc.

Note For detail please go through class notes and book Money Banking and Finance by Riaz Ahmed Mina

5:-Principle of Issuing Notes | Merits and De-Merits of Issuing Methods

There are two principles of note issue. The first is the currency principle and the second is banking principle. There are different views about these principles. One school of thought says that there should be full convertibility of notes into gold bullion. The second gives importance to the elasticity of supply.

Currency Principle:
According to the advocates of the currency principles, the paper money is an economical and convenient substitute of metal money. They insist that paper money in circulation should be backed by 100% gold reserves. There will always be availability of gold for the redemption of notes when presented which creates stability in price level and exchange rates, because every note issued is covered by gold behind it.

MERITS
SAFETY AND SECURITY: NO DANGER OF INFLATION: It gives full safety and security to the paper currency. There is no danger of over-issue of the currency, which is an effective check to the possibilities of inflation. PUBLIC CONFIDENCE: The currency principle provides greater confidence to the public, because it provides assurance in ease of convertibility of notes.

DEMERITS

INELASTIC:

It makes the supply of money highly inelastic, because the issuance of notes is only possible on the availability of gold. So, the government cannot issue notes in case of emergency. DEPENDENT: According to this principle, paper currency can only be primed and issued if there is 1009b gold cover available against it. The issuance of currency thus completely depends upon the availability of gold rather than the trade and industry need. LOCK UP OF GOLD: There is unnecessary lock up of gold for the currency, which may be used for some other purposes. REAL WORLD: It is not acceptable in the real world and has no support from all over the world.

Banking Principle:
According to this principle, there is no need to have the reserve of gold and silver for the issuance of notes. The banks are authorized to regulate the note issue keeping in view the needs of trade and industry the banks themselves maintain adequate reserves of gold for meeting the obligations of notes. If there is an over issue of notes, the excess money will be automatically presented for cash payment and thus the proper ratio will be maintained between the supply of money and the gold reserves.

MERITS
ELASTIC SYSTEM: The banking principle is elastic because gold is not kept for current percent value of notes issued. GOVERNMENT NEEDS: POPULARITY: This system is fit for meeting the government needs in case of emergencies. This system is popular all over the world. Every country is issuing money under this system.

SURETY:

It also provides surety for the convertibility of notes. DEMERITS OVER-ISSUE: In order to meet the demand for money, there may be a further issue of notes beyond to a certain limit which leads to inflation. ECONOMIC CRISIS: BALANCE OF PAYMENT: During economic crisis the convertibility of notes may be refused. This is not good for keeping the stable exchange rates. Whenever there is a change in foreign, exchange rates, the balance of payment position becomes more unfavorable

Methods of Issuing Currency Notes

There are different methods of money notes issuing adopted by different countries of the world at different times. The most important of them are as under Minimum Reserve System Fixed Fiduciary Proportional Reserve System

Fixed Fiduciary System:

Under fixed fiduciary system, the government fixes a fixed amount of notes without keeping any metallic reserve. But this portion of currency must be backed by government securities, which is called fiduciary Limit. The notes issued other than fiduciary limit must be fully backed by gold or silver reserves. This system was introduced in England in 1844 in the Bank charter Act of 1844. Norway and Japan also adopted this method. This system acted as a brake on the undue expansion of currency

and credit in the time of prosperity. This system also provides security for the convertibility of notes.

MERITS
(I) SAFETY: This method of note issue provides safety to notes issued and acts as brake, which also provides safety to currency value. (II) STABILITY: This system not only provides value stability but also provides economic stability, which is helpful for regulating internal prices and exchange rate. DEMERITS (I) UNSUITABLE FOR MODERN ECONOMY: In the modem age of ever changing world, the government needs a capital to finance its projects. But this system is unsuitable for a Modern economy in which money needs are often changed. (II) METAL DRAIN: Under this system an internal and external drain of gold or silver cause to decrease in supply of notes even though economic conditions require increase in it. (III) IN-ELASTICITY: This system is relatively inelastic because under this, notes other than "fiduciary limit can be issued only by increasing gold or silver reserves of the same value. Government can change the fiduciary limit but change in the limit shows weakness of the government. (IV) LOCK UP OF GOLD: This system locks up a fixed quantity of gold, which could otherwise be used for productive purposes. (V) HIGH FIDUCIARY LIMIT: If fiduciary limit is high or it has been increased with the passage of time then people will loose confidence in the currency. (VI) UNRESPONSIVE TO THE REQUIREMENTS OF TRADE: It is uneconomical and unresponsive to the requirements of trade.

Proportional Reserve System:

Under this system the central bank is required to keep only a certain percentage of notes issued in the form of gold or silver. The reserve proportion is usually from 30% to 40%. It means a central bank can issue Rs. 100 note after keeping gold silver valuing Rs. 30 or 40. This method of currency regulation is the most affordable system of the present time and is widely used in many countries. It was first of all adopted by Germany in 1876 and followed with modifications by U.S.A in 1914.

MERITS
(I) ELASTICITY: This system is more elastic than fixed Fiduciary system. For example, if bank obtains, Rs. 40 worth of gold, it can issue Rs. 100 note under the proportional Reserve system. Whereas under fixed Fiduciary system the bank can issue note of Rs. 40 only, once the fiduciary limit reached. (II) SAFETY: The reserve maintains in this method serves as a safeguard against excessive note issue and inflation can be checked. DEMERITS (I) EFFECT ON ECONOMY: This system adversely affects the economy an excessive supply of money in the economy cause to create certain economic problems. (II) UNABLE TO CONTROL PRICES: Unnecessary money cause to decrease the purchasing power of the currency, which badly effects the common man. (III) LOCK UP OF GOLD: The defect with this system is that it locks up the gold reserves unnecessarily. So we cannot use it for other purposes. (IV) DRASTIC REDUCTION OF NOTE ISSUE: It brings about a drastic reduction of note issue in the event of gold being exported to another country.

Minimum Reserve System:

Fixed minimum reserve system allows the central bank to keep only a fixed amount of reserve against whatever the amount of note issue. The reserve is in the form of gold, silver and-foreign exchange or in the form of any of these types of things. This methodis being used in Pakistan after December 1965. India is also applying it since 1957. South Africa has adopted it in 1930. Holland has been issuing notes under this method for many years.

MERITS
(I) ELASTIC: This system is much elastic than above stated methods of note issue which can meet the ever-changing needs of the money by the govt. (II) ECONOMICAL: Because a fixed amount of gold, silver or foreign exchange is to be maintained as fixed minimum reserve, therefore it becomes much economical and government can also change the fixed minimum reserve at anytime.

DEMERITS
(I) OVER ISSUANCE OF CURRENCY: Under this method, there is a danger of excessive note issue, which consequently brings inflation. This inflation adversely affects the economy. (II) CURRENCY VALUE: An excessive note issue cause to decrease. in the currency value this decrease in the value of currency cause to contract the purchasing power of the consumers.

Method of Note Issue Adopted In Pakistan:

Pakistan has used proportional reserve system up to December 1965. Under this method 30% was to be kept as reserve in the form of gold coin, gold, silver bullion and approved foreign exchange. The balance was covered by rupee coin and government security after 1965. State Bank of Pakistan adopted fixed minimum reserve system under this system the bank has to keep only legally fixed amount of minimum reserve in gold, or silver. Moreover the government in consultation with the State Bank can alter it. Note

For detail please go through class notes and book Money Banking and Finance by Riaz Ahmed Mina

6:-Function of money
In todays world money perform varies functions but there are three important function of money Primary functions Secondary functions Contingent functions Other functions

Primary functions:
Medium of exchange Stander of value Store of value Standard deferred payments

Secondary functions
Market mechanism Income and consumption Instruments of modern economy Aids to economic activities Monetary and fiscal management Specialization and trade

Contingent functions
Basis for economic theories Determination/ distribution of national income Efficiency and optimum Allocation Basis of credit

Other functions
Measurement of liquidity Determination of Solvency Different Uses

Note For detail please go through class notes and book Money Banking and Finance by Riaz Ahmed Mina

7:-Characteristics of a Good Money

Acceptability - The businesses and public accept it as payment for goods and services. Standardized quality - The same units of money must be the same size, quality, color, so people are certain what they are getting. Durability - Has to be physically durable or it may lose its value quickly. Valuable relative to its weight - Large amounts of money can be used in transactions and easily carried around. Divisibility - Money must be broken down into smaller units to purchase low value goods and services. Portable Hard to copy Recognizable Elasticity Scarcity

Note For detail please go through class notes and book Money Banking and Finance by Riaz Ahmed Mina

8:- The concept of near to money Definition

Highly liquid assets which are not cash but can easily be converted into cash such as bank deposit and bill of exchange similarly to cash equivalents

Difference between money and near to money

Interest earning Content Liquidity Legal Tender Stander unit

Note For detail please go through class notes and book Money Banking and Finance by Riaz Ahmed Mina

Notes Prepared By Professor AdeelAkhtar Reviewed By Professor Talat Director of APC Special Note: Some topics need further explanation, so please discuss notes in class with your class fellows and also check reference books and internet for further detail.

References:
Money banking and fianc (Riaz Ahmed Mian) Research articles of (R.h Parker, S.Sloan) Internet http://wiki.answers.com, http://www.business-science-articles.com