BASIC CONCEPTS

Economic growth and development of any country

depends upon a well-knit financial system. Financial
system comprises a set of sub-systems of financial
institutions financial markets, financial instruments and
services which help in the formation of capital. Thus a
financial system provides a mechanism by which
savings are transformed into investments and it can be
said that financial system play an significant role in
economic growth of the country by mobilizing surplus
funds and utilizing them effectively for productive
purpose.

The financial system is characterized by the presence

of integrated, organized and regulated financial
markets, and institutions that meet the short term and
long term financial needs of both the household and
corporate sector. Both financial markets and financial
institutions play an important role in the financial
system by rendering various financial services to the
community. They operate in close combination with
each other.

Financial System;

The word "system", in the term "financial system",

implies a set of complex and closely connected or
interlined institutions, agents, practices, markets,
transactions, claims, and liabilities in the economy.
The financial system is concerned about money, credit

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and finance-the three terms are intimately related yet
are somewhat different from each other. Indian
financial system consists of financial market, financial
instruments and financial intermediation

Role/ Functions of Financial System:

A financial system performs the following functions:

* It serves as a link between savers and investors. It

helps in utilizing the mobilized savings of scattered
savers in more efficient and effective manner. It
channelizes flow of saving into productive investment.
* It assists in the selection of the projects to be
financed and also reviews the performance of such
projects periodically.
* It provides payment mechanism for exchange of
goods and services.
* It provides a mechanism for the transfer of resources
across geographic boundaries.
* It provides a mechanism for managing and
controlling the risk involved in mobilizing savings and
allocating credit.
* It promotes the process of capital formation by
bringing together the supply of saving and the demand
for investible funds.
* It helps in lowering the cost of transaction and
increase returns. Reduce cost motives people to save
more.
* It provides you detailed information to the operators/
players in the market such as individuals, business
houses, Governments etc.

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Components/ Constituents of Indian Financial
system:

The following are the four main components of Indian

Financial system

1. Financial institutions
2. Financial Markets
3. Financial Instruments/Assets/Securities
4. Financial Services.

Financial institutions:

Financial institutions are the intermediaries who

facilitates smooth functioning of the financial system by
making investors and borrowers meet. They mobilize
savings of the surplus units and allocate them in
productive activities promising a better rate of return.
Financial institutions also provide services to entities
seeking advises on various issues ranging from
restructuring to diversification plans. They provide
whole range of services to the entities who want to
raise funds from the markets elsewhere. Financial
institutions act as financial intermediaries because
they act as middlemen between savers and borrowers.
Were these financial institutions may be of Banking or
Non-Banking institutions.

Financial Markets:

Finance is a prerequisite for modern business and

financial institutions play a vital role in economic
system. It's through financial markets the financial
system of an economy works. The main functions of
financial markets are:

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1. to facilitate creation and allocation of credit and
liquidity;
2. to serve as intermediaries for mobilization of
savings;
3. to assist process of balanced economic growth;
4. to provide financial convenience

Financial Instruments

Another important constituent of financial system is

financial instruments. They represent a claim against
the future income and wealth of others. It will be a
claim against a person or an institutions, for the
payment of the some of the money at a specified future
date.

Financial Services:

Efficiency of emerging financial system largely depends

upon the quality and variety of financial services
provided by financial intermediaries. The term financial
services can be defined as "activities, benefits and
satisfaction connected with sale of money, that offers
to users and customers, financial related value".

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Pre-reforms Phase

Until the early 1990s, the role of the financial system in

India was primarily restricted to the function of
channelling resources from the surplus to deficit
sectors. Whereas the financial system performed this
role reasonably well, its operations came to be marked
by some serious deficiencies over the years. The
banking sector suffered from lack of competition, low
capital base, low Productivity and high intermediation
cost. After the nationalization of large banks in 1969
and 1980, the Government-owned banks dominated
the banking sector. The role of technology was minimal
and the quality of service was not given adequate
importance. Banks also did not follow proper risk
management systems and the prudential standards
were weak. All these resulted in poor asset quality and
low profitability. Among non-banking financial
intermediaries, development finance institutions (DFIs)

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operated in an over-protected environment with most
of the funding coming from assured sources at
concessional terms. In the insurance sector, there was
little competition. The mutual fund industry also
suffered from lack of competition and was dominated
for long by one institution, viz., the Unit Trust of India.
Non-banking financial companies (NBFCs) grew rapidly,
but there was no regulation of their asset side.
Financial markets were characterized by control over
pricing of financial assets, barriers to entry, high
transaction costs and restrictions on movement of
funds/participants between the market segments. This
apart from inhibiting the development of the markets
also affected their efficiency.

Financial Sector Reforms in India

It was in this backdrop that wide-ranging financial

sector reforms in India were introduced as an integral
part of the economic reforms initiated in the early
1990s with a view to improving the macroeconomic
performance of the economy. The reforms in the
financial sector focused on creating efficient and stable
financial institutions and markets. The approach to
financial sector reforms in India was one of gradual and
non-disruptive progress through a consultative process.
The Reserve Bank has been consistently working
towards setting an enabling regulatory framework with
prompt and effective supervision, development of
technological and institutional infrastructure, as well as
changing the interface with the market participants
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through a consultative process. Persistent efforts have
been made towards adoption of international
benchmarks as appropriate to Indian conditions. While
certain changes in the legal infrastructure are yet to be
effected, the developments so far have brought the
Indian financial system closer to global standards.

The reform of the interest regime constitutes an

integral part of the financial sector reform. With the
onset of financial sector reforms, the interest rate
regime has been largely deregulated with a view
towards better price discovery and efficient resource
allocation. Initially, steps were taken to develop the
domestic money market and freeing of the money
market rates. The interest rates offered on Government
securities were progressively raised so that the
Government borrowing could be carried out at market-
related rates. In respect of banks, a major effort was
undertaken to simplify the administered structure of
interest rates. Banks now have sufficient flexibility to
decide their deposit and lending rate structures and
manage their assets and liabilities accordingly. At
present, apart from savings account and NRE deposit
on the deposit side and export credit and small loans
on the lending side, all other interest rates are
deregulated. Indian banking system operated for a long
time with high reserve requirements both in the form
of Cash Reserve Ratio (CRR) and Statutory Liquidity
Ratio (SLR). This was a consequence of the high fiscal
deficit and a high degree of monetisation of fiscal
deficit. The efforts in the recent period have been to
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lower both the CRR and SLR. The statutory minimum of
25 per cent for SLR has already been reached, and
while the Reserve Bank continues to pursue its
medium-term objective of reducing the CRR to the
statutory minimum level of 3.0 per cent, the CRR of
SCBs is currently placed at 5.0 per cent of NDTL.

As part of the reforms programme, due attention has

been given to diversification of ownership leading to
greater market accountability and improved efficiency.
Initially, there was infusion of capital by the
Government in public sector banks, which was followed
by expanding the capital base with equity participation
by the private investors. This was followed by a
reduction in the Government shareholding in public
sector banks to 51 per cent. Consequently, the share of
the public sector banks in the aggregate assets of the
banking sector has come down from 90 per cent in
1991 to around 75 per cent in 2004. With a view to
enhancing efficiency and productivity through
competition, guidelines were laid down for
establishment of new banks in the private sector and
the foreign banks have been allowed more liberal
entry. Since 1993, twelve new private sector banks
have been set up. As a major step towards enhancing
competition in the banking sector, foreign direct
investment in the private sector banks is now allowed
up to 74 per cent, subject to conformity with the
guidelines issued from time to time.

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Conclusion: The Indian financial system has undergone
structural transformation over the past decade. The
financial sector has acquired strength, efficiency and
stability by the combined effect of competition,
regulatory measures, and policy environment. While
competition, consolidation and convergence have been
recognized as the key drivers of the banking sector in
the coming years

Reference:

1. Indian Financial System by M.Y.Khan.1980.

2. The Financial System of India by Gyan Chand.2000

Introduction

The Finance is the science of money management. We

can say that finance is something related to
management of money and other assets. Finance
represents the resources by way funds needed for a
particular activity. Finance is also referred to as
"Funds" or "Capital", when referring to the financial
needs of a corporate body. Now you can finance
anything that you want for example you can have
home loans, business loans, education economic
development of a nation is reflected by the progress of
the various economic units, broadly classified into
corporate sector, government and household sector.

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There are areas or people with surplus funds and there
are those with a deficit. A financial system or financial
sector functions as an intermediary and facilitates the
flow of funds from the areas of surplus to the areas of
deficit. A Financial System is a composition of various
institutions, markets, regulations and laws, practices,
money manager, analysts, transactions and claims and
liabilities.

The word "system", in the term "financial system",

implies a set of complex and closely connected or
interlined institutions, agents, practices, markets,
transactions, claims, and liabilities in the economy. The
financial system is concerned about money, credit and
finance-the three terms are intimately related yet are
somewhat different from each other. Indian financial
system consists of financial market, financial
instruments and financial intermediation. These are
briefly discussed below;

Financial system overview

A Financial Market can be defined as the market in

which financial assets are created or transferred. As
against a real transaction that involves exchange of
money for real goods or services, a financial
transaction involves creation or transfer of a financial
asset. Financial Assets or Financial Instruments
represents a claim to the payment of a sum of money
sometime in the future and /or periodic payment in the
form of interest or dividend.

Money Market- The money market ifs a wholesale debt

market for low-risk, highly-liquid, short-term
instrument. Funds are available in this market for

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periods ranging from a single day up to a year. This
market is dominated mostly by government, banks and
financial institutions.

Capital Market - The capital market is designed to

finance the long-term investments. The transactions
taking place in this market will be for periods over a
year.

Forex Market - The Forex market deals with the

multicurrency requirements, which are met by the
exchange of currencies. Depending on the exchange
rate that is applicable, the transfer of funds takes place
in this market. This is one of the most developed and
integrated market across the globe.

Credit Market- Credit market is a place where banks,

FIs and NBFCs purvey short, medium and long-term
loans to corporate and individuals.

Financial Intermediaries-

Having designed the instrument, the issuer should then

ensure that these financial assets reach the ultimate
investor in order to garner the requisite amount. When
the borrower of funds approaches the financial market
to raise funds, mere issue of securities will not suffice.
Adequate information of the issue, issuer and the
security should be passed on to take place. There
should be a proper channel within the financial system
to ensure such transfer. To serve this purpose, financial
intermediaries came into existence. Financial
intermediation in the organized sector is conducted by
a wide range of institutions functioning under the
overall surveillance of the Reserve Bank of India. In the

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initial stages, the role of the intermediary was mostly
related to ensure transfer of funds from the lender to
the borrower. This service was offered by banks, FIs,
brokers, and dealers. However, as the financial system
widened along with the developments taking place in
the financial markets, the scope of its operations also
widened. Some of the important intermediaries
operating ink the financial markets include; investment
bankers, underwriters, stock exchanges, registrars,
depositories, custodians, portfolio managers, mutual
funds, financial advertisers financial consultants,
primary dealers, satellite dealers, self regulatory
organizations, etc. Though the markets are different,
there may be a few intermediaries offering their
services in move than one market e.g. underwriter.
However, the services offered by them vary from one
market to another.

Intermediary - Market-Role

Stock Exchange -Capital Market -Secondary Market to

securities

Investment Bankers - capital Market, credit Market -

corporate advisory services, Issue of securities

Registrars, Depositories ,custodian - Capital Market -

Issue securities management

Primary dealers satellite Dealers - Money Market -

share transfer activity market making for govt.

Forex Dealers - Forex Market

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Financial tools-

Money Market Tools-

The money market can be defined as a market for

short-term money and financial assets that are near
substitutes for money. The term short-term means
generally a period up to one year and near substitutes
to money is used to denote any financial asset which
can be quickly converted into money with minimum
transaction cost.

Some of the important money market instruments are

briefly discussed below:

1. Call/Notice Money
2. Treasury Bills
3. Term Money
4. Certificates of Deposit
5. Commercial Papers

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent on

demand for a very short period. When money is
borrowed or lent for a day, it is known as Call
(Overnight) Money. Intervening holidays and/or
Sunday are excluded for this purpose. Thus money,
borrowed on a day and repaid on the next working day,
(irrespective of the number of intervening holidays) is
"Call Money". When money is borrowed or lent for
more than a day and up to 14 days, it is "Notice
Money". No collateral security is required to cover
these transactions.

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2. Inter-Bank Term Money

Inter-bank market for deposits of maturity beyond 14

days is referred to as the term money market. The
entry restrictions are the same as those for Call/Notice
Money except that, as per existing regulations, the
specified entities are not allowed to lend beyond 14
days.

3. Treasury Bills.

Treasury Bills are short term (up to one year)

borrowing instruments of the union government. It is
an IOU of the Government. It is a promise by the
Government to pay a stated sum after expiry of the
stated period from the date of issue (14/91/182/364
days i.e. less than one year). They are issued at a
discount to the face value, and on maturity the face
value is paid to the holder. The rate of discount and the
corresponding issue price are determined at each
auction.

4. Certificate of Deposits

Certificates of Deposit (CDs) is a negotiable money

market instrument and issued in dematerialized form
or as a Usance Promissory Note, for funds deposited at
a bank or other eligible financial institution for a
specified time period. Guidelines for issue of CDs are
presently governed by various directives issued by the
Reserve Bank of India, as amended from time to time.
CDs can be issued by (i) scheduled commercial banks
excluding Regional Rural Banks (RRBs) and Local Area
Banks (LABs); and (ii) select all-India Financial

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Institutions that have been permitted by RBI to raise
short-term resources within the umbrella limit fixed by
RBI. Banks have the freedom to issue CDs depending
on their requirements. An FI may issue CDs within the
overall umbrella limit fixed by RBI, i.e., issue of CD
together with other instruments viz., term money, term
deposits, commercial papers and interoperate deposits
should not exceed 100 per cent of its net owned funds,
as per the latest audited balance sheet.

5. Commercial Paper

CP is a note in evidence of the debt obligation of the

issuer. On issuing commercial paper the debt obligation
is transformed into an instrument. CP is thus an
unsecured promissory note privately placed with
investors at a discount rate to face value determined
by market forces. CP is freely negotiable by
endorsement and delivery. A company shall be eligible
to issue CP provided - (a) the tangible net worth of the
company, as per the latest audited balance sheet, is
not less than Rs. 4 crore; (b) the working capital (fund-
based) limit of the company from the banking system
is not less than Rs.4 crore and (c) the borrowal account
of the company is classified as a Standard Asset by the
financing bank/s. The minimum maturity period of CP
is 7 days. The minimum credit rating shall be P-2 of
CRISIL or such equivalent rating by other agencies.

The capital market generally consists of the following

long term period i.e., more than one year period,
financial instruments; in the equity segment Equity
shares, preference shares, convertible preference
shares, non-convertible preference shares etc and in
the debt segment debentures, zero coupon bonds,

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deep discount bonds etc.

Hybrid Instruments

Hybrid instruments have both the features of equity

and debenture. This kind of instruments is called as
hybrid instruments. Examples are convertible
debentures, warrants etc.

In India money market is regulated by Reserve bank of

India and Securities Exchange Board of India (SEBI)
regulates capital market. Capital market consists of
primary market and secondary market. All Initial Public
Offerings comes under the primary market and all
secondary market transactions deals in secondary
market. Secondary market refers to a market where
securities are traded after being initially offered to the
public in the primary market and/or listed on the Stock
Exchange. Secondary market comprises of equity
markets and the debt markets. In the secondary
market transactions BSE and NSE plays a great role in
exchange of capital market instruments.

Conclusion-

Financial System of any country consists of financial

markets, financial intermediation and financial
instruments or financial products. Financial system is
An information system, comprised of one or more
applications, that is used for any of the following:
collecting, processing, maintaining, transmitting, and
reporting data about financial events supporting
financial planning or budgeting activities; accumulating
and reporting cost information.

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Economists' Meaning of Money

1. Basic Definition

Money is anything that is generally accepted in payment for goods

and services and for the repayment of debts, as a matter of social
custom.

It follows that money is defined more by its function (what purposes it

serves) than by its form (coin, paper, gold bars, etc.).

Moreover, the stress on "generally accepted" in this definition

indicates that money is largely a social convention in the sense that
what actually constitutes money in a society depends on what people
in the society are generally willing to accept as money.

An interesting question is how this "general acceptance" comes to be

established!

Note on Terminology:

Money must be distinguished from both "wealth" and "income."

The wealth of an agent at any given point in time is the current
market value of the total collection of assets currently owned by
that agent. Money holdings might constitute part of an agent's
wealth, but the agent would presumably own other types of
assets as well (e.g., land, equipment,...). On the other hand,
income is a flow of value accrued over some specified period of
time.
Example: A student works part time as a teaching assistant,
earning Rs. 900 per month, and has a checking account balance
of Rs. 400. He also owns a bicycle worth Rs. 1100 and books
worth Rs. 500. Consequently, ignoring for simplicity the
student's "human capital" (e.g., his embodied labor skills, valued
by estimating the capitalized stream of all of his potential future
wage earnings), one has:

• Money holdings = Rs. 400

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 • Wealth = Market value of his asset holdings
consisting of (money holdings, car, books) = (Rs. 400 +
Rs. 1,100 + Rs. 500) = Rs. 2,000
• Income = Rs. 900 per month

As illustrated by this example, income is a flow variable in the

sense that it measures an amount of value accrued over a
specified period of time (e.g., a month). In contrast, money and
wealth are both stock variables in the sense that they measure an
amount of value at a given point in time.

2. Types of Money

• Commodity Money: Commodity money is any commodity

(economic good) that is used as money, i.e., that is generally
accepted as a means of payment for goods and services and for
the repayment of debts.

Commodity Money Examples from the Past:

Cattle, food grains, gold, silver etc.

• Fiat Money: Fiat money is any paper money that is "unbacked"

and "legal tender." A money is unbacked if it is not
collateralized by any valuable commodity. That is, no one is
obliged by law to convert the money into coins, precious metals,
or any other type of physical good or service. A money is legal
tender for a country if, by law, the citizens of the country must
accept the money for repayment of debts.

Fiat Money Example:

The Rupee notes issued by the RBI are paper money that are
unbacked legal tender, hence fiat money. The general
acceptance of rupee notes in India as payment for goods and
services depends upon the persistence of a widely shared trust
among citizens that any person who accepts rupee now in
exchange for goods or services will be able to exchange these
rupees later for other goods and services.

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• Electronic Means of Payment (EMOP): A means of payment
that permits payments to be transmitted using electronic
telecommunications.

EMOP Examples:

• RTGS and NEFT are related to funds transfer over the internet
using your internet banking.
RTGS Real Time Gross Settlement (Minimum Amt Rs 1 lakh)
•
NEFT National Electronic Funds Transfer (Any amt)

IFSC is Indian Financial System Code. This is eleven digit

alphanumeric code and unique to each branch of bank. First four
tells about name of bank and remaining seven tells about branch
number. This code is given on the cheque book. It also required
transferring the money by NEFT or RTGS if one does not know
the address of branch.

Other examples include private EMOP systems such as CHIPS

and SWIFT (used by banks, money market mutual funds,
securities dealers, and corporations to wire funds) and ACHs
(automatic clearing houses) used for smaller wire transfers, e.g.,
from employers to their employees.
Clearing House Interbank Payments System (CHIPS) is a
privately owned funds transfer system that handles time-
sensitive, high-value payments between the world's major
banks. This clearing house processes about 95% of the dollar-
denominated payments moving between countries around the
world, including trade-related payments and foreign exchange
trades. CHIPS, which is operated by the Clearing House
Payments Co. LLC in New York City, has operated since 2001
as a real-time clearing and settlement system.

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FEDERAL WIRE (fed wire)
Is a high-speed electronic communications network linking the
Federal Reserve Board of Governors, the 12 Federal Reserve
Banks and 24 branches, the U.S. Treasury Department, and
other federal agencies. The Federal Reserve Wire Network,
more commonly known as Fed Wire, is used by the Reserve
Banks and the Treasury for high-value time-sensitive payments,
such as funds transfers between reserve banks, purchases or
sales of fed funds transfers between correspondent banks, and
sales of book entry U.S. government securities.
Federal Reserve member bank and other depository financial
institutions also have access to the Fed Wire network to their
own account and in transferring funds on behalf of a customer,
when timeliness and certainty of payment are important. The
Treasury Department and federal agencies make extensive use
of the Fed Wire in collection of funds from Treasury tax and
loan account in commercial banks, and in disbursement of
funds.
Fed Wire transfers are immediate transfers of funds, and are
effective usually within minutes of the time a payment is
initiated. They are guaranteed as final payments when the
receiving financial institution is notified of the credit to its
reserve account.
SOCIETY FOR WORLD-WIDE INTER-BANK FINANCIAL
TELECOMMUNICATION (SWIFT)
It is a nonprofit, cooperative organization that facilitates the
exchange of payment messages between financial institutions
around the world. SWIFT was organized in 1973 by a group of
European bankers who wanted a more efficient method than
telegraph wire (telex) or mail to send payment instructions to
correspondent banks. Among its voting members are U.S.
money center and regional banks, and major banks in Europe,
Latin America, Africa, Asia, and Australia. SWIFT began
operations in 1977, providing the framework for an international
communication system between financial institutions.
Recent changes in SWIFT rules gave multinational corporations
and BROKER-DEALER securities firm direct access (but

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 nonvoting membership) to confirmations of foreign exchange
and money market securities trades, and derivative securities
transactions. In 2005, the SWIFT network boasted 7,600
member institutions operating in 200 countries.
Payments between SWIFT members take place on domestic
funds clearing systems.

Interesting EMOP observation:

In the United States, even though an EMOP is used by less than
1 percent of the number of payments made, over 80 percent of
the dollar value of payments made is through EMOP transfers.
(What is the status in India?)

• Electronic Money (e-Money): E-money is money that is stored

electronically rather than in paper or commodity form. Once
established, e-money cuts way down on transactions costs; but it
can be expensive to set up an e-money system, and concerns
have been raised about record-keeping, security, and privacy (as
well as the elimination of "float" for consumers!).

e-Money Examples:

• Debit Cards: Charged expenses are immediately

deducted from some corresponding bank account -- there
is no float (time between purchase and deduction) as with
credit cards and paper checks;
• Stored-Value Cards: Charged expenses are
immediately deducted from a fixed amount of digital cash
stored on the card;
• Electronic Cash: A form of e-money that can be
used to purchase goods and services on the Internet;
• Electronic Checks: A process by which users of the
Internet can pay their bills directly over the Internet
without having to send a paper check.

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 Functions of Money

Money performs three basic functions in an economy: (1) It serves

as a unit of account; (2) it serves as a medium of exchange; and
(3) it serves as a store of value.

• Unit of Account: A unit in terms of which a single price for

each good and service can be quoted.

Example:
The price of an apple is given as Rupees per apple, the price of a
liter of milk is given as Rupees/litre of milk, etc. That is, each
good or service on sale at an outlet is generally offered at a
single quoted "rupee price" -- that is, a price quoted in terms of
rupees.
In reality, however, any particular good or service (e.g., apples)
has a huge array of different prices that could be quoted for it,
one for each other good or service in the economy (e.g., Kg. of
bread per apple, cans of beer per apple, hours of doctor visits per
apple, etc.)
Without a money unit to provide a single accepted unit of
account, sellers would have to quote prices of items in terms of
whichever goods or services they were willing to accept in
return at the time the items were purchased. That is, as clarified
further below, the payment system would be a "barter" payment
system.

• Medium of Exchange: An accepted means of payment for

trade of goods and services.

As noted above, the existence of a money unit permits each item

for sale to have a single price quoted for it in terms of the money
unit. But this is not enough to ensure the item will actually be
sold to buyers for money units.
Sellers have to be willing to accept the money units from buyers
in return for giving up the item, which requires a trust on the
part of sellers that others will in turn be willing to accept these
money units from them at a later time in return for goods and
services. That is, the money units have to act as a medium of
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 exchange in the economy before one can conclude that they
indeed constitute money in the economy.

• Store of Value: A repository of purchasing power for future

use.

Money can be held for future use, allowing for the ability to
save (store value) over time. All assets act as stores of value to
some extent, but money by definition is the most liquid, i.e., the
most easily converted into a medium of exchange, since by
definition it already is a medium of exchange!
On the other hand, money is by no means a risk-free store of
value. The real purchasing power of money depends on the
inflation rate, that is, on the rate at which the general price level
is changing. If the inflation rate is positive (prices are
increasing), any money held loses purchasing power over time.
If the inflation rate is negative (prices are decreasing), any
money held gains purchasing power over time.
To the extent that the inflation rate is unpredictable, inflation
reduces the ability of money to act as a reliable store of value
and as a method of deferred payment in borrowing-lending
transactions. A positive inflation rate is bad for lenders and good
for borrowers since the dollars lent out are worth more than the
dollars later paid back. Conversely, a negative inflation rate is
good for lenders and bad for borrowers.
In extreme cases in which the inflation rate exceeds 50 percent
per month -- a situation referred to as hyperinflation -- the
entire monetary system generally breaks down and is replaced
by barter. This has devastating effects on an economy.
Post-WWI Germany suffered a hyperinflation in which the
inflation rate at times exceeded 1000 percent per month. More
recently, various Latin American economies experienced
hyperinflations during the 1980s. For example, in the first half
of 1985 Bolivia's inflation rate was running at 20,000 percent.

Evolution of Payment Systems

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Tracing the historical evolution of payment systems in various
economies is a fascinating and complex task. Although highly
simplified, the following three-stage process captures the general
way in which this evolution has occurred in many parts of the
world.

• Autarky: Each family or tribal group produces all of what they

consume, with the outputs of production being shared in
accordance with some kind of group distribution rule
determining who gets what and in what amount. No trade takes
place and there is no use of money.
• Barter Payment System: Within family or tribal groups, and
possibly between such groups, people trade goods and services
for other goods and services. There is no use of money.
• Monetary Payment System: People trade goods and services in
return for money.

A barter payment system has several problems that make it

extremely inefficient relative to a monetary payment system if a
large number of goods and services are produced in an economy:

• Double Coincidence of Wants: Under a barter payment system,

a double coincidence of wants is needed before any trade can
take place. That is, two individuals seeking to trade must have
exactly the goods or services that each other wants. The
requirement of having a double coincidence of wants before
exchange can take place discourages both specialization in labor
(generally referred to as "division of labor") and specialization
in production; for the fewer the types of goods and services one
produces for sale, the fewer the types of goods and services one
can expect to be able to trade for. The need for double
coincidence of wants in barter payments systems thus tends to
reduce productive efficiency.
• Multiple Prices for Each Good or Service: Under a barter
payment system, many different prices must be maintained for
each good and service, making informed decisions about what to
buy (and from whom to buy it) extremely difficult. Specifically,

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 an exchange ratio ("goods price") is needed for every distinct
pair of items to be traded.

For example, given two items (say apples and beer), one needs
one goods price (apples per beer or beer per apples, either one
will do). For three items (say apples, beer, and cars), one needs
three goods prices (e.g., apples per beer, apples per car, and beer
per cars). But for four items one needs six prices, for five items
one needs ten prices, and so it goes. As the number of items
keeps increasing, the number of needed goods prices increases
dramatically.
More precisely, given a barter economy with n goods, the
number of needed goods prices is n[n-1]/2, which is the number
of distinct ways that n items can be selected 2 at a time without
consideration of order. An equivalent formula for calculating the
needed number of goods prices in a barter economy with n
goods is the sum of numbers between 1 and n-1, inclusive; i.e.,
(n-1) + (n-2) + ... + 1. Can you explain why?

• High Transactions Costs: Under a barter payment system, the

above two problems result in high transaction costs, that is,
large amounts of resources (time, effort, shoe leather,...) being
spent on trying to exchange goods and services.

As previously discussed, the use of money dramatically cuts down on

the transactions costs arising from barter, so it is not surprising that
barter payment systems have tended to evolve into monetary payment
systems.

The nature of the monies used in monetary payment systems

continues to evolve over time.

The first monies were commodities, that is, they were economic
goods such as cattle, tobacco, and gold which had a direct use value
(e.g., for eating, smoking, jewelry). Their direct use value made them
useful as mediums of exchange because people were willing to accept
them as means of payment even if they, themselves, had no direct use
for them.

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Different types of commodities have different kinds of drawbacks for
use as commodity money. For example, gold and silver are durable
and can be molded into portable coins of standard size for ease of use
in trade, but they tend to lose commodity value when subdivided into
very small quantities for everyday transactions. On the other hand,
tobacco is not very durable and its quality is highly variable, but it can
be subdivided into small amounts without loss of commodity value.

To avoid various difficulties associated with the direct use of

commodity monies in trade, private banks along with governments
began to issue paper notes (claims against themselves) that were
backed (collateralized) by the commodity money they replaced,
usually gold or silver coin. That is, the issuers of these paper notes
normally promised to redeem their notes in gold or silver coins on
demand. This paper form of money was therefore simply a way to cut
down on the transactions costs associated with the use of commodity
monies without actually eliminating these commodity monies.

As trade continued to expand, however, the power to issue notes was

increasingly transferred to governments and the link with commodity
monies became increasingly tenuous. Eventually paper notes evolved
into fiat monies, i.e., unbacked paper monies officially designated as
legal tender. Moreover, the link between the precious metal content of
coins and the face value of coins also became tenuous. Indeed, coins
in use today are often referred to as token coins because the amounts
of silver and other precious metals they contain are far below their
face values.

The use of fiat money in trade is itself subject to several difficulties:

in particular, expense of transport, and risk of theft. Attempts to
combat these difficulties led to the invention of checkable demand
deposits. More recent innovations include electronic means of
payments (EMOPs), which permit value to be transmitted
electronically, and electronic monies (e-monies), which permit value
to be stored electronically.

In summary, the nature of monies used in monetary payment systems

has tended to evolve over time from commodity money, to fiat

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money, to checkable demand deposits, to EMOPs, and most recently
to e-monies. At this point in time, all of these forms of money are
used to varying extents in different parts of the world. Will the earlier
forms of money will ever be entirely eliminated by the later forms
remains to be seen.

Measuring Money

Rupee and coins issued by the RBI are together referred to as

currency.

In value terms, however, currency represents only a small part of what

is used today as money. For this reason, the RBI makes use of various
broader measures of the money supply.

Accurate measurement of the money supply is important for the

following reasons:

• Changes in the money supply are thought to have rather

immediate effects on short-term interest rates, intermediate-run
effects on key macro variables such as real GDP, and longer-run
effects on other key macro variables such as the aggregate price
level and the inflation rate.
• The RBI has some ability to manipulate and control the money
supply (hence short-term interest rates) through open-market
operations, i.e., sales and purchases of government bonds to and
from the private sector. Thus, by appropriately managing the
money supply (and short-term interest rates), the RBI can exert
some longer-run control over key macro variables.

NOTE: Monetary policy refers to the efforts of central banks

such as the RBI to control key macro variables through the
management of the money supply and (short-term) interest rates.

• Without an accurate measurement of the money supply,

however, it is difficult for the RBI to judge the effectiveness of
its monetary policy. To judge this effectiveness, the RBI must
first be able to measure the extent to which it has succeeded in

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 changing the money supply in accordance with its plans.
Second, the RBI must be able to measure the extent to which
these changes in the money supply have had intended effects on
key macro variables.

There are two basic ways of measuring money: the "theoretical

approach" and the "empirical approach."

The Theoretical Approach to Money Measurement:

The theoretical approach to money measurement tries to use
economic theory to decide which assets should be included in
the measure of money. In particular, the theoretical approach
focuses on the relative "moneyness" of assets -- in particular, the
degree to which assets function as mediums of exchange.
Traditionally, advocates of this theoretical approach have argued
that only those assets that clearly function as a medium of
exchange should be counted in the measure of money.
Unfortunately, however, many assets function as a medium of
exchange to some degree and the appropriate cut-off point is not
clear.
More recently, however, economists have argued for a
"weighted aggregate" approach to the measure of money.
In the latter approach, all assets functioning to some degree as a
medium of exchange are included in the measure of money.
However, each of these assets is weighted, with assets that
function more as a medium of exchange receiving a relatively
larger weight. This eliminates the need to specify a sharp
threshold determining which assets are included or excluded
from consideration. However, one is still left with the problem
of how to select specific weight magnitudes for the included
assets.
The verdict on the reliability and usefulness of these newer
weighted-aggregate measures is still out.

The Empirical Approach to Money Measurement:

The empirical approach to the measurement of money takes a
more pragmatic view and argues that the decision about what to

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 call money should be based on which measure of money works
best in helping to predict the movements of key macro variables.
Unfortunately for the empirical approach, experience has shown
that different measures may work better for predicting different
variables at any given point in time. For example, the measure
that works best for predicting recessions may not be the measure
that works best for predicting exchange rates. Morever, the
usefulness of any one measure for predicting any one variable
tends to vary over time. What works in one period may not work
well in the next.
The three measures of money most commonly used by the Fed
-- M1, M2, and M3.
These measures, generally referred to as monetary aggregates,
are "nested" in the sense that each aggregate is broader than its
predecessor. For example, M2 includes all assets in M1 together
with several additional assets not included in M1.
The narrowest monetary aggregate, M1, conforms to the
theoretical point of view in that it only contains highly liquid
assets that are directly usable as mediums of exchange
(currency, traveler's checks, demand deposits, and other
checkable deposits). However, the continual introduction of new
forms of money-like instruments has driven the RBI to make
additional use of broader monetary aggregates such as M2 and
M3 in order to improve its prediction of and control over key
macro variables.
Question: Why might you guess that, the narrower the measure
of money, the more "unstable" will be its relationship to key
macro variables such as GDP and inflation?
The monetary aggregates M1 and M2 have tended to move
together over time, but there have been occasions in which they
have moved in substantially different directions. These
differences in movement underscore the difficulty of obtaining
useful empirical measures of money.

Reliability of Monetary Data

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Estimates of the various monetary aggregates are frequently revised
by large amounts for two reasons.

• First, small depository institutions are only required to report the

amount of their deposits infrequently, forcing the Fed to
estimate these amounts between the reporting dates.
• Second, the monetary aggregates are based on "seasonally
adjusted" data, meaning that corrections are made for systematic
peaks and dips in money use due to such time-dependent events
as regular holidays and seasonal changes in weather. The
appropriate extent of these seasonal adjustments often only
becomes clear after the fact, requiring revisions to the
adjustments made at the time of the event.

The revisions made in monetary aggregate estimates can be

considerable from one month to the next. However, when averaged
over time, these revisions tend to average out to zero.

A useful conclusion to draw from these observations is that one

should probably not pay too much attention to reported monthly
movements in monetary aggregates. It is far more meaningful and
useful to consider the trends in these monetary aggregates, i.e., to
consider the average movements in these monetary aggregate over
longer periods of time.

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