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Money is considered to be the most liquid asset. Money is primary medium of exchange for various goods and services in any economy. Hence, it determines as to what quantity of goods and/or services can be purchased with a unit of money. 


History of Money

However, before money as we know came into existence, the exchange of goods and services was carried out through means of barter system. For example, a farmer who needs fish to cook will look for a fisherman who needs grains. Then the farmer will give grains to the fisherman and get fish in exchange. However, this was a tedious process due to various reasons: (a) it was difficult to find a person who has something that you need and in return, he also needs exactly the same thing that you have, (b) it was also difficult to determine the quantity of things to be exchanged as mostly, the goods were not fungible, (c) if the goods exchanged are perishable in nature, the exchange needed to be done before the goods went bad, leading to a time constraint. Due to the necessity, gradually, people shifted to use precious metals, such as, gold or silver, to perform exchanges as they resolved many of the issues mentioned above. They were easily acceptable by the other party, did not perish, were durable and portable, and, to a large extent, the quantity exchanged could be uniformly determined. Further, gold and silver has proven value. Historically, we find multiple examples of various civilizations having used coins made of precious metals for performing trade.

However, the coins used for trade were difficult to carry due to weight. Moreover, some economies put more value to gold and some did so to silver or some other metal. Hence, trade between such economies was difficult as intrinsic value of their respective coins was not same for the other party. In other words, exchange rate was different for different metals.


Money as we know

Slowly, due to limitations of coins, bankers started providing paper notes that were redeemable against as much value of gold or silver. Hence, in effect, the paper notes were gold/silver certificates that were easy to carry and/or exchange. The more credibility a bank had, the more easily acceptable was its paper note.

However, as economies grew, there was need for more money but there simply wasn’t as much gold/silver available at the time.

Hence, gradually, paper notes were delinked with the precious metal. In other words, the paper notes issued are declared as a legal tender by the government but they were no longer backed by any physical commodity. If you were to go to a bank to exchange the paper note, you will no longer get equivalent amount of gold/silver. This money is also termed as ‘Fiat Money’. It derives its value basis relationship between its supply and demand, instead of the value of physical commodity. Such money stays in circulation based on faith and credit of the economy by which it is issued. As soon as people start losing faith is money issued by an economy, that particular money will start losing its value.

A currency tied to gold is generally more stable than fiat money due to the limited supply of gold. There are more opportunities for the creation of bubbles with a fiat money due to its unlimited supply.


Money Supply

Money supply refers to total amount of money in circulation in an economy at any given point of time. Apart from the obvious coins and paper notes, there are other components of money supply, such as, demand deposits, time deposits, post office deposits, etc. This is a very important indicator as it helps the economists and analysts in altering monetary policy to reduce or increase money supply in the economy in order to achieve set objectives.

The different types of money are usually classified as ‘M’s’, which range from M0 (narrowest) to M4 (broadest):

  1. M0 or Monetary Base: It refers to the currency in circulation and deposits of domestic banks with the Central Bank. From the domestic bank’s perspective, any increase in the monetary base is excess reserve (reserve over and above the legal requirement)
  2. M1: It refers to the currency in circulation, deposits of domestic banks with the Central Bank, postal accounts and transaction accounts of non-banks.
  3. M2: It refers to the currency in circulation, deposits of domestic banks with the Central Bank, postal accounts, transaction accounts of non-banks and saving deposits.
  4. M3: It refers to the currency in circulation, deposits of domestic banks with the Central Bank, postal accounts, transaction accounts of non-banks, saving deposits and time deposits.
  5. M4: A lesser used monetary aggregate, it is also called ‘extended broad money’. It refers to the currency in circulation, deposits of domestic banks with the Central Bank, postal accounts, transaction accounts of non-banks, saving deposits, time deposits and other types of deposits which may be held by expatriates and governmental agencies.


All countries do not publish all of above mentioned monetary aggregates. Some countries even use terminology which is different from above mentioned. 

True Money Supply (TMS): A monetary aggregate developed by Murray Rothbard and Joseph T. Salerno, TMS refers to money as the final means of payment in all transactions. Hence, for example, it includes transactions that are done through credit cards which are not counted as money as it does not discharge the debt created in transaction. But, it gives rise to second transaction when a credit card bill payment is done by the user. Similarly, it also includes Mutual money market funds which are highly liquid but not counted as money because they need to be sold and converted to money first.


TMS consists of:

  1. Currency in Circulation,
  2. Total Demand Deposits,
  3. Savings Deposits,
  4. U.S. Government Demand Deposits and Note Balances,
  5. 5.Demand Deposits Due to Foreign Commercial Banks,
  6. Demand Deposits Due to Foreign Official Institutions.


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