Monetary Economics: Barter System, Definition, Function and Evolution of Money

The Barter System

Money as a medium of exchange was not used in the early history of mankind. Exchange of the goods was not very frequent as households were self-sufficient. Whatever exchange took place between the households was in the form of barter, that is, exchange of goods for other goods.

The barter system does not provide for the direct purchase of goods since there was no common unit of account and medium of exchange (Money).

Note for Students: Example, if a person grows only wheat and after his self-consumption, he wants to exchange it for apple. He can do so only if the other person having apples wants wheat. If that is not the case, no exchange will take place. This problem is called double coincidence of wants.

Moreover, if they both agree to trade an apple for wheat, then the next problem is how to determine how much apple is worth one kg of wheat and vice versa. Both the individuals will argue for more of another person commodity in return of his. Therefore, exchange of goods will be limited and most of the time will not take place at all.

Difficulties under Barter System of Trade

To overcome the problems of Barter trade, early humans started devising a system of payments and exchange that allows direct purchase of goods using any instrument that has following features:

  • A unit of Account (it must be measured)
  • High Liquidity
  • It can be stored
  • It must be wanted by everyone (It should have high demand)
  • It can be exchanged easily (Medium of Exchange)

Evolution of Money

Commodity Money Metallic Money Paper Money
In the very beginning, there exist few commodities which were needed by everyone. Commodities like arrows, bows, sea shells which are used mostly in hunting become the first form of medium of exchange and hence acted as money. With further progress of civilisation commodity money is replaced by precious items like Gold and Silver for monetary use. Gold and Silver largely formed the Metallic Money. The advent of State and political structure had given rise to a new form of money which although has no underlying value but has a guarantee by the governments. The government guaranteed money is known as Paper Money.
In the second stage of the evolution, when the early human shifted from hunting to agriculture, animals like cattle’s, goats, sheep become the medium of exchange and acted as money. The Metallic money offered several advantages.

They were easy to handle. They can be easily stored.

They do not deteriorate.

They have the right degree of scarcity which made them valuable for all, hence acted as a perfect medium of exchange.

 

Paper money acted as money not because it has some value (unlike gold which has high value) but simply because they are guaranteed by the governments and are scared.

With time, paper money took the form of Bank Notes to be printed by the Central Banks.

Since commodities have certain limitations like lack of a standard unit of account, limited supply and natural factors etc. Their use limited and replaced by other forms of money. With time and technology, the hard form of gold and silver was replaced by coinage system (gold and silver coins) which were to widely used as money. The last stage of evolution of money was in the form of Bank Deposits Especially Demand deposits, which people hold with the commercial banks and that can be withdrawn at any time. Thus, providing high liquidity.

Money and its Functions

Definition of Money:

“Anything which is widely accepted in payment of goods or in the discharge of other kind of payment obligations”.

“Money can be defined as anything that is generally acceptable as a medium of exchange and at the same time act as a measure and a store of value”.

Economist has simply defined money as “Money is what Money does”. That is money is anything which performs the function of money.

Functions of Money:

The four main functions of money are;

Medium of Exchange Store of Value Measure of Value Standard of Payments
A can sell goods to B and in return can demand money for his sale.

B can use the money to buy other goods from C.

As long as the money is accepted, the process of exchange keeps on happening.

This feature of money is known as Medium of Exchange.

Money act as a store of value.

Money being the most liquid asset is the most convenient way to store wealth.

Thus, money can be stored as an asset.

It thus, becomes very important that the good chosen as money should be such that can be easily stored.

The case for other liquid assets like gold or real estate is different; they first have to be sold and converted into money. The money realised from them can be used to buy goods and services.

Money serves as a common measure of value or a unit of account.

As the value of all goods and services are now measured in terms of money, the relative comparison of goods is possible.

Each commodity has its own price and monetary value now. A car is worth Rupee 10 Lakh, and A kg of apple is worth Rupee 100. One can simply pay the price and buy car or apple.

Money also serves as a standard mode of Deferred payments.

If a loan is taken today, it will be paid back in future time using the money.

The loan amount is measured in terms of money and is paid back in money.

 

Modern Monetary Systems

Convertible Paper Money/Full Reserve System In-convertible/ Fiat Money Minimum Reserve System
Paper money has come to occupy a very important place in the modern monetary system of almost all the countries.

The term paper money applies only to the notes issued by the government and the central banks.

With the passage of time, the relative scarcity of gold and silver has increased. Therefore, the governments find it very difficult to back all their legal currency with an equal value of gold and silver. Thus, nowadays paper currency is of inconvertible type. The ‘Minimum Reserve System’ is the current form of currency system practised World over and in India too since 1957.
For quite a long time, Paper money remained a convertible paper money. Under this system, money is convertible into standard coins made of gold and silver.

The Paper money issued by the governments and central banks was fully backed by the gold and reserve of equal value. Therefore, this paper currency system is called ‘Full Reserve System’.

Under the Inconvertible monetary system, money is not convertible into gold or silver or other precious metals.

The paper money issued by the central banks is not backed by underlying precious metal. The issuing authorities is not responsible to convert the paper notes into gold and silver.

Thus, the currency notes issued by the Central Banks are ‘Fiat Money’, that is, they are issued by a ‘Fiat’ (which means ‘Order’) of the government.

Fiat Paper money is in the form legal tender promised by the governments. Since they are legal tender, they can be widely used to purchase goods and services.

Under this system, the central banks are required to keep only a minimum amount of gold and other approved securities (In India the RBI is required to keep Rupee 200 Crores).

On the basis of minimum reserve, the central banks can issue the currency in any number subject to the economic condition of the country.

 

Importance and Significance of Money

By
Himanshu Arora
Doctoral Scholar in Economics & Senior Research Fellow, CDS, Jawaharlal Nehru University

 

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