In the economic system all values are measured in terms of money. We sell our services and our goods for money, and exchange that money for other goods and services that we require.
Money
If you ask a boy what he regards as money, he will probably pull out of his pocket a penny or halfpenny or perhaps sixpence, and tell you that is money. Of course, he will add, there are £i and ios. notes, half-crowns and shillings, but he is not likely to mention sovereigns or half-sovereigns. He belongs to a generation that ha
s never seen gold in circulation.
What is Money?
For small transactions in this country we use coins of nickel, copper and bronze. These coins are known as token money, because the value of the metal contained in each is less than the face value of the coin. If a shilling were melted down, there would not be a shillings worth of metal in the resulting metallic mixture. For our larger transactions we use paper money
Each of these forms of money is a medium of exchange, i.e., something that we can give in exchange for some article or service that we require. We sell our services for money in the form of wages or salaries, and use that money to buy things we want—food, clothing, shelter, cigarettes and seats at the cinema.
Money, therefore, is a means whereby we exchange our goods and services for the goods and services that we need to satisfy our wants. And the money we pay to the shopkeeper or cinema proprietor enables him, in turn, to exchange the goods or services he sells for other things that he needs. Money is, in fact, anything that is widely used and accepted within a community as a means of exchange.
Various Kinds of Money
Before money took the form of coins and paper notes, many other things were used as media of exchange. As a rule, such things were commodities in fairly general use or ownership. Cattle served that purpose in early pastoral communities, while slaves, furs, skins, shells, tea, tobacco and rice have been used at various times and in various places. But to us the use of any such things would appear to be highly inconvenient, and we should certainly not regard them as fulfilling the functions of a good money. Slaves and cattle cannot be sub-divided and have only a limited life; tea, tobacco and rice perish. They cannot be held indefinitely as a store of value. This is a great inconvenience, because people who sell things for money are not always in immediate need of the things they could get in exchange; they want something they can keep until they need to use it. Consequently, they must have as money something that can be put on one side for use at a later date without loss of value. From early times the precious metals, gold and silver, were found to be admirable for this purpose and gradually they came into general use, first as unshaped pieces of varying weights, but later in the form of coins of standard weight issued under the authority of the State and stamped with an easily recognisable device to testify to their genuineness.
Although a few countries, even in quite recent times, have preferred silver to gold, gold by the end of the nineteenth century was established as the money standard for practically the whole world. But gold is very expensive and, in addition, the supplies of the metal have become inadequate to meet the ever-increasing needs of exchange, particularly of international exchange. Hence paper money, representing a given amount of gold, came to be substituted for gold for internal use and the gold thus released was made available for monetary reserves and for making foreign payments.
Money
If you ask a boy what he regards as money, he will probably pull out of his pocket a penny or halfpenny or perhaps sixpence, and tell you that is money. Of course, he will add, there are £i and ios. notes, half-crowns and shillings, but he is not likely to mention sovereigns or half-sovereigns. He belongs to a generation that ha
s never seen gold in circulation. What is Money?
For small transactions in this country we use coins of nickel, copper and bronze. These coins are known as token money, because the value of the metal contained in each is less than the face value of the coin. If a shilling were melted down, there would not be a shillings worth of metal in the resulting metallic mixture. For our larger transactions we use paper money
Each of these forms of money is a medium of exchange, i.e., something that we can give in exchange for some article or service that we require. We sell our services for money in the form of wages or salaries, and use that money to buy things we want—food, clothing, shelter, cigarettes and seats at the cinema.
Money, therefore, is a means whereby we exchange our goods and services for the goods and services that we need to satisfy our wants. And the money we pay to the shopkeeper or cinema proprietor enables him, in turn, to exchange the goods or services he sells for other things that he needs. Money is, in fact, anything that is widely used and accepted within a community as a means of exchange.
Various Kinds of Money
Before money took the form of coins and paper notes, many other things were used as media of exchange. As a rule, such things were commodities in fairly general use or ownership. Cattle served that purpose in early pastoral communities, while slaves, furs, skins, shells, tea, tobacco and rice have been used at various times and in various places. But to us the use of any such things would appear to be highly inconvenient, and we should certainly not regard them as fulfilling the functions of a good money. Slaves and cattle cannot be sub-divided and have only a limited life; tea, tobacco and rice perish. They cannot be held indefinitely as a store of value. This is a great inconvenience, because people who sell things for money are not always in immediate need of the things they could get in exchange; they want something they can keep until they need to use it. Consequently, they must have as money something that can be put on one side for use at a later date without loss of value. From early times the precious metals, gold and silver, were found to be admirable for this purpose and gradually they came into general use, first as unshaped pieces of varying weights, but later in the form of coins of standard weight issued under the authority of the State and stamped with an easily recognisable device to testify to their genuineness.
Although a few countries, even in quite recent times, have preferred silver to gold, gold by the end of the nineteenth century was established as the money standard for practically the whole world. But gold is very expensive and, in addition, the supplies of the metal have become inadequate to meet the ever-increasing needs of exchange, particularly of international exchange. Hence paper money, representing a given amount of gold, came to be substituted for gold for internal use and the gold thus released was made available for monetary reserves and for making foreign payments.
THE MONEY WORK
What is the work that money is required to do? Broadly, money has to do two things : it must act as a medium of exchange or intermediary between goods and goods, and it must serve as a unit of account, i.e., a unit in terms of which business transactions can be measured and recorded. Without a medium of exchange we should have to exchange one article directly for another article : so much butter for a pound of tea; so much milk for a loaf of bread. Every time a hatter wanted a shave, he would have to find a barber who wanted a hat In other words, we should have to resort to barter, the direct exchange of goods and services for other goods and services, without the intervention of money. Obviously, this system is extremely inconvenient and not always possible. In a modern community there must be a medium of exchange, which people will freely accept for their goods and services and can keep until such time as they wish to use it for the purchase of other goods and services.
It is also important that there should be a unit of account, to provide us with a standard by means of which we can measure and record the values of things exchanged. When we use money we express each thing entering into exchange as worth so many units of money, i.e., everything of value has a price, and by using money we can without difficulty compare the relative values of any two things. If a loaf of bread and a pint of milk each costs 6d., we know that in our community a 6d. loaf has the same value as a pint of milk. If a hat costs 30s. and a shave is. 6d., we know at once that the hat is worth twenty shaves, and so on.
Anything used as money must perform these two functions, but standard money, i.e., the money adopted as the basis of the monetary system of a country, e.g., the pound sterling, performs two further functions. It serves as a store of value, i.e., it can be put away until it is wanted without losing any of its value as a means of exchange for other goods. If I paint a picture and sell it to-day for five pounds which I do not require to use, say, for twelve months, I must be reasonably certain that the five pounds I receive will, in twelve months' time, be worth about the same amount of goods as they are to-day. I accept the five pounds because I know they can be relied upon as a store of value that will not vary with the passing of time.
Akin to this is the function of acting as a standard for deferred payments. The value of the money must keep steady over a period, or loans and deferred payments become very much of a gamble. Suppose, for instance, that I lend you to-day a unit of money with which I could buy ten loaves of bread, but that when you repay me in six months' time the unit will buy only five loaves. Clearly, I should lose on the transaction, for the value of the money unit will have fallen by 50 per cent. And that fall would, of course, adversely affect all those who, like myself, had made loans and advances. On the other hand, it would greatly benefit you and other debtors and borrowers, because you could repay your creditors in money whose value in terms of goods was only half of what it was when your debts were incurred.
Gold as Money
Gold is the best of all the commodities that have served as money. It is universally acceptable because it has alternative uses for adornment, in the arts, in dentistry, and so on. Gold is also easily recognised, portable and durable, whilst it can be divided into small pieces or coins of uniform quality without losing any of its value. Further, it has great value in small bulk, and over long periods its value is comparatively steady.
Other metals also have certain of these qualities, though to a less degree than gold. Silver, for example, is far more plentiful, and consequently far less expensive than gold, but its value has been subject to more marked fluctuations. Hence in practically all countries silver was gradually superseded by gold as the standard of value.
Paper Money
As gold coins are expensive to use and as there is not nearly enough gold in the world to settle all transactions, modern communities use as money paper notes of various denominations that actually or nominally represent gold held in reserve. Paper money may consist either of bank notes, i.e., notes issued by an authorised bank {e.g., the £5 notes of the Bank of England), or government notes, i.e., notes issued by the State, e.g., the £1 and 10/- notes issued by the British Treasury during the Great War, 1914-18.
Notes are convertible when the holder has a legal right to return them to the issuer for exchange into gold or silver, whichever is the standard metal. Notes are inconvertible when no such right exists. For many years before the Great War of 1914-1918, the Bank of England note was fully convertible into gold coin or bullion, and it remained convertible until the Gold Standard was suspended during that war. To-day, the Bank of England is not compelled to give gold in exchange for its notes, although it is compelled to keep a certain amount of gold in reserve as a backing for the notes it has issued. Like Britain, most other advanced States have paper money that is inconvertible but backed by reserves of gold in the hands of the government or central bank.
Legal Tender Money
Usually, the money that you carry in your pocket for buying things—money such as Bank of England notes, and coins—will be what is called legal tender. The law decrees that certain forms of money must be accepted by the person to whom you offer it in exchange for goods or services, or in payment of an outstanding account. In other words, it can be legally offered, or tendered, to your creditor, and your creditor cannot legally refuse to accept it, although he could refuse to accept money that was not legal tender, e.g., the notes of a private bank or the money of another country, or a cheque.
Money that is legal tender is known as currency, and the law may declare that a given form of money is 'egal tender for payment of any amount (i.e., unlimited legal tender), or legal tender for payments only up to a certain amount (i.e., limited legal tender). In Britain, Bank of England notes are unlimited tender; you can use them to pay a debt of any amount and your creditor prejudices his rights to payment if he refuses to accept them. Nickel coins, however, are legal tender only up to £2, and copper is legal tender only up to is. Therefore, if you owed a person £$ and offered to pay him loos, or I200<2., color="#ff6666" size="4">Credit Money
In practice, currency or cash (which is another name for currency) is used to settle transactions of only quite moderate amount. As a rule, currency is not used for settling larger business transactions. The majority of business payments are made by using what is called credit money (such as cheques or bills of exchange) which is not legal tender but is accepted by creditors in payment for goods or in settlement of debts, provided the drawer is considered to be reliable.
Credit money in its various forms (cheques, bills of exchange, promissory notes, postal orders and money orders) is used to settle an enormous number of transactions, and its use greatly economises legal tender currency. Credit instruments are all simply substitutes for legal tender money, and they are accepted because the person receiving them counts on being able to convert them into cash without difficulty if he wishes to do so.
The Value of Money
We have seen that the value of any commodity, i.e. its power of exchanging for other commodities, is determined by the interaction of demand and supply. Money is no different from any other commodity: its value, i.e., its power of exchanging for goods, or its purchasing power over commodities, also depends on demand and supply.
The Demand for Money is the quantity of money needed to effect business transactions; i.e., to effect the transfer or exchange of the goods and services offered for sale. Sellers want money for their goods and services; in other words, they are demanding money, and the more goods and services there are being exchanged, the greater is the demand for money.
The same article, as it passes from producer to wholesaler, wholesaler to retailer and retailer to consumer, may give rise to a demand for money from several people. The demand for money is, therefore, affected not only by the volume of goods and services being exchanged, but also by the frequency with which such goods are exchanged, as is indicated by the number of people through whose hands the goods pass before reaching the final consumer. The greater the activity of trade, i.e., the velocity of circulation of goods, as distinct from the volume of trade, the greater the demand for money.
The Supply of Money is the actual amount of money notes, coins, cheques, bills, etc. used for effecting exchanges. It includes all forms of money, standard money and token money and all forms of credit, that are doing the money-work. But in considering the supply of money, we must consider not merely the total quantity of money in use, but also the velocity of circulation of money, i.e., the number of separate transactions for which each unit of money is used. The shilling we give the milkman is passed by him to his wife, who in turn hands it over to the greengrocer in payment for a cabbage and potatoes. The same shilling used in ten transactions is really performing the same function as ten separate shillings each used in one transaction only. The velocity of circulation thus increases the supply of money engaged in doing the money work.
Now, at any moment there is a certain quantity of money being used to pay for a certain quantity of goods and services, and it is the relation between the total supply of goods and the total supply of money that determines the value of money. If the quantity of goods increases whilst the amount of money remains the same, each unit of money will purchase more goods, i.e., the value of money will rise or prices will fall. Every shilling now buys more goods than it did before; an article that previously cost, say, ios. can now be purchased for only 8s. If, on the other hand, the quantity of goods remains the same and more money is made available {e.g., by the issue of extra notes), the value of a unit of money falls, i.e., prices rise. Whereas previously we might have been able to buy 4 lb. of a commodity for 6s., we must now pay 8s.; every shilling buys less of the commodity and, of course, less of everything else.
The Quantity Theory of Money
This relationship between the supply of money, the demand for money and the value of money is expressed by Economists in the Quantity Theory of Money, which states that the value of money depends on the relation between the demand for money and its supply. In other words, the theory states that the value of money depends on the money-work to be done by the supply of money available.
If during any period of time there is no change in the supply of money but an increase in the number of exchanges to be made, then, according to the theory, the value of money will rise in proportion to the increase in the money-work to be performed; in other words, prices of commodities, measured in terms of money, will fall. Similarly, an increase in the supply of money, coupled with no change in the volume of transactions, will cause a fall in the value of money, i.e., a rise in general prices. If the demand for money increases more quickly than the supply, money will rise in value, i.e., the general level of prices will fall, whilst the converse will be true if the supply exceeds the demand.
PRICES
Price Index Numbers
As money is itself the measuring-rod by which we indicate and determine the value of all other things, we cannot express the value of money except in terms of commodities in general; that is, we can measure changes in the value of money only by changes in the general level of prices. These changes are difficult to measure, first, because money is used in a host of different ways apart from the purchase of goods; secondly, because the prices of some goods rise whilst the prices of others fall during the same period; and, thirdly, because goods change so much in quality and description over a period of years that we cannot be certain, when we are com paring the price of one unit at one time with its price at another time, whether we are dealing with exactly the same article. In practice, the prices of a large number of different commodities and of different grades or varieties of the same commodity are taken so as to ensure greater accuracy. Moreover, wholesale prices of food commodities {e.g., wheat and beef) and raw materials {e.g., wool and cotton) are selected for index numbers of general prices because they are more easily and accurately determined than retail prices, and because food commodities and raw materials change little in description from one year to another. Retail prices are, however, used as the basis of index numbers designed to indicate and record changes in the cost of living, because the commodities on which the earnings of workers are spent are purchased at retail prices.
Weighting
In the example of an index number given above, it was assumed for simplicity that the commodities, bread, butter and meat, are of equal importance in the general scheme of consumption in the community. Actually, however, commodities are far from being of equal importance, so that an index number that is to be of any value must make some allowance for the relative importance of the different commodities on which we spend our money. If one commodity occupies a position of little importance in our general expenditure, a rise in its price should not influence disproportionately an index number that purports to indicate changes in the general level of prices; in other words, a rise in the price of that commodity should not be given too much " weight " in our index. On the other hand, commodities that are of importance must be allowed for according to their prominence in the expenditure of the average person.
For this reason, the compilers of index numbers attempt to allow for the different importance of the commodities whose price-changes they are measuring by assigning to them " weights " that correspond to their relative significance in the average family " budget" or average distribution of expenditure.
Changes in the Price Level
Individual prices are, of course, constantly changing, some rising and others falling. But, as a rule, these changes offset one another and have little serious effect. Changes in the general level of prices as indicated by an index number are, however, much more important and far more serious in their results.
Rising Prices are said to be good for trade. They encourage business men to expand their businesses because rising commodity prices usually mean greater profit margins, for the reason that the manufacturer's fixed charges (such as rent, rates and interest on debentures) do not rise at all, or rise less than the prices of the goods he sells. Rising prices, therefore, usually mean that industrial plant is more fully employed, and that there is a reduction in overhead costs per unit of output.
There is also an increase in employment, directly because the expanding businesses require additional labour, and indirectly because people generally have more to spend and more goods and services have to be produced for sale. In this way prosperity is diffused throughout the community. The producing classes are, on the whole, the debtors of the community, and, as a rise in prices reduces the real burden of their debts and interest payments (because each unit of money they have to pay away represents less goods than before), they can more easily and successfully carry on their activities.
Rising prices are specially advantageous to an industrial nation, so long as the rise is not violent. But where prices rise violently, owing to excessive inflation, considerable harm is caused, mainly because the resultant uncertainty as to the ultimate level of prices is one of the greatest hindrances to business stability and development.
Falling Prices have depressing effects on economic activity: they are bad for trade. By reducing or destroying profit margins, they tend to discourage enterprise and restrict production.
When prices are falling, goods already produced have to be sold at lower prices than were anticipated when production was put in hand. Profits are, therefore, reduced or completely fail to materialise, production is restricted, wages become a heavier burden to industry, for they do not fall as rapidly as prices (owing to the difficulty of getting labour to accept lower rates of pay— wage rates always " lag" behind prices), overhead charges per unit of output increase, costs of production become greater relative to selling prices, plant has to be left idle, unemployment ensues and dividends are reduced. In general, therefore, there is a fall in the general purchasing power of the community, and the depression extends throughout industry. Debts and interest payments become greater burdens at the very time when producers are least able to carry them, and many failures result.
Thus rapid and marked changes in the value of a currency, whether in an upward or downward direction, breed great uncertainty and lead to widespread loss of confidence. International trade also is hampered because the value of the currency cannot be estimated with any certainty, and buyers and sellers in other countries are reluctant to enter into transactions measured in terms of a currency of indefinite and rapidly-changing value.
BANKING
As the economic system has expanded and grown, the financial mechanism has become more complicated, credit transactions have enormously increased, and most business transactions of any magnitude now pass through the hands of the banks.
The Functions of a Bank
The British Banking System, in particular, is renowned for its high efficiency and for the variety of services it renders to the community. Originally, a bank was a place where people took their valuables foi safe keeping; now it fulfils a number of other highly important functions. It receives deposits from customers on current account, i.e., repayable on demand by cheque and bearing no interest, or on deposit account, repayable only after a period of notice and usually bearing interest ; it makes fixed loans to its customers on loan account or gives them fluctuating overdrafts on current account; it discounts bills of exchange and promissory notes at market rates, and accepts bills of exchange on behalf of its customers and correspondents.
Most modern banks also undertake important agency services on behalf of their customers and other banks, as, for example, in the safe custody of valuables; in collecting cheques, dividends, coupons and foreign bills; in undertaking stock and share transactions and foreign exchange operations; and in carrying out the duties of attorney, executor, trustee, or referee as to the standing and integrity of customers.
The majority of banks in this country are banks of deposit, and the function of note issue, once of paramount importance in British banking, is confined in England, and Wales to the Bank of England, and in Scotland and Ireland to the long-established banks of those countries,
Thr Utility of Banking to the Community
A consideration of the functions discussed in the preceding paragraphs will indicate at once that bankers render services of inestimable value to the trade and industry of the country. In acting as intermediaries between large numbers of depositors or lenders on the one hand and of equally numerous borrowers on the other, banks mobilise capital and make its use effective. They may be regarded as great reservoirs of loanable money into which flow a myriad small streams of liquid funds, and from which are distributed throughout the country, at the times when they are most needed and in the places where they can be most efficiently used, supplies of capital which are rightly regarded as sources of further wealth. Countless small sums of money are rendered productive which would otherwise remain in " idle hoard ", and in this way the banking organisation assists the transfer of the wealth of large and small capitalists in a rich locality to other areas where that wealth can be efficiently and profitably employed, to the ultimate benefit of the community as a whole.
The facility with which loans can be obtained from banks acts as a stimulus to production and as an incentive to industrial enterprise. Manufacturers and traders know that they can rely upon the banks for financial accommodation in difficult periods, and are therefore able to utilise their own working capital to the fullest extent.
In general, the existence of a sound and well-developed banking system provides safety for small and large savings, enables payments to be made, even over great distances, with safety and dispatch, and so facilitates all types of financial operations. Hence, the existence of a sound and efficient banking system is in itself an encouragement to saving, thrift and economy. The small depositor is brought to appreciate the facilities for safe investment which the banks provide and thus we find that, in a modern community, even the poorer classes keep accounts at a savings bank if not at a joint stock bank.
Conditions such as these must ultimately react to the general well-being of the community, and when it is remembered to what extent time, money and labour are saved by the cheque system, and by the general utility services of our banking institutions, it will be readily conceded that a country with a sound banking system is possessed of one of the firmest foundations of prosperity.
What is the work that money is required to do? Broadly, money has to do two things : it must act as a medium of exchange or intermediary between goods and goods, and it must serve as a unit of account, i.e., a unit in terms of which business transactions can be measured and recorded. Without a medium of exchange we should have to exchange one article directly for another article : so much butter for a pound of tea; so much milk for a loaf of bread. Every time a hatter wanted a shave, he would have to find a barber who wanted a hat In other words, we should have to resort to barter, the direct exchange of goods and services for other goods and services, without the intervention of money. Obviously, this system is extremely inconvenient and not always possible. In a modern community there must be a medium of exchange, which people will freely accept for their goods and services and can keep until such time as they wish to use it for the purchase of other goods and services.
It is also important that there should be a unit of account, to provide us with a standard by means of which we can measure and record the values of things exchanged. When we use money we express each thing entering into exchange as worth so many units of money, i.e., everything of value has a price, and by using money we can without difficulty compare the relative values of any two things. If a loaf of bread and a pint of milk each costs 6d., we know that in our community a 6d. loaf has the same value as a pint of milk. If a hat costs 30s. and a shave is. 6d., we know at once that the hat is worth twenty shaves, and so on.
Anything used as money must perform these two functions, but standard money, i.e., the money adopted as the basis of the monetary system of a country, e.g., the pound sterling, performs two further functions. It serves as a store of value, i.e., it can be put away until it is wanted without losing any of its value as a means of exchange for other goods. If I paint a picture and sell it to-day for five pounds which I do not require to use, say, for twelve months, I must be reasonably certain that the five pounds I receive will, in twelve months' time, be worth about the same amount of goods as they are to-day. I accept the five pounds because I know they can be relied upon as a store of value that will not vary with the passing of time.
Akin to this is the function of acting as a standard for deferred payments. The value of the money must keep steady over a period, or loans and deferred payments become very much of a gamble. Suppose, for instance, that I lend you to-day a unit of money with which I could buy ten loaves of bread, but that when you repay me in six months' time the unit will buy only five loaves. Clearly, I should lose on the transaction, for the value of the money unit will have fallen by 50 per cent. And that fall would, of course, adversely affect all those who, like myself, had made loans and advances. On the other hand, it would greatly benefit you and other debtors and borrowers, because you could repay your creditors in money whose value in terms of goods was only half of what it was when your debts were incurred.
Gold as Money
Gold is the best of all the commodities that have served as money. It is universally acceptable because it has alternative uses for adornment, in the arts, in dentistry, and so on. Gold is also easily recognised, portable and durable, whilst it can be divided into small pieces or coins of uniform quality without losing any of its value. Further, it has great value in small bulk, and over long periods its value is comparatively steady.
Other metals also have certain of these qualities, though to a less degree than gold. Silver, for example, is far more plentiful, and consequently far less expensive than gold, but its value has been subject to more marked fluctuations. Hence in practically all countries silver was gradually superseded by gold as the standard of value.
Paper Money
As gold coins are expensive to use and as there is not nearly enough gold in the world to settle all transactions, modern communities use as money paper notes of various denominations that actually or nominally represent gold held in reserve. Paper money may consist either of bank notes, i.e., notes issued by an authorised bank {e.g., the £5 notes of the Bank of England), or government notes, i.e., notes issued by the State, e.g., the £1 and 10/- notes issued by the British Treasury during the Great War, 1914-18.
Notes are convertible when the holder has a legal right to return them to the issuer for exchange into gold or silver, whichever is the standard metal. Notes are inconvertible when no such right exists. For many years before the Great War of 1914-1918, the Bank of England note was fully convertible into gold coin or bullion, and it remained convertible until the Gold Standard was suspended during that war. To-day, the Bank of England is not compelled to give gold in exchange for its notes, although it is compelled to keep a certain amount of gold in reserve as a backing for the notes it has issued. Like Britain, most other advanced States have paper money that is inconvertible but backed by reserves of gold in the hands of the government or central bank.
Legal Tender Money
Usually, the money that you carry in your pocket for buying things—money such as Bank of England notes, and coins—will be what is called legal tender. The law decrees that certain forms of money must be accepted by the person to whom you offer it in exchange for goods or services, or in payment of an outstanding account. In other words, it can be legally offered, or tendered, to your creditor, and your creditor cannot legally refuse to accept it, although he could refuse to accept money that was not legal tender, e.g., the notes of a private bank or the money of another country, or a cheque.
Money that is legal tender is known as currency, and the law may declare that a given form of money is 'egal tender for payment of any amount (i.e., unlimited legal tender), or legal tender for payments only up to a certain amount (i.e., limited legal tender). In Britain, Bank of England notes are unlimited tender; you can use them to pay a debt of any amount and your creditor prejudices his rights to payment if he refuses to accept them. Nickel coins, however, are legal tender only up to £2, and copper is legal tender only up to is. Therefore, if you owed a person £$ and offered to pay him loos, or I200<2., color="#ff6666" size="4">Credit Money
In practice, currency or cash (which is another name for currency) is used to settle transactions of only quite moderate amount. As a rule, currency is not used for settling larger business transactions. The majority of business payments are made by using what is called credit money (such as cheques or bills of exchange) which is not legal tender but is accepted by creditors in payment for goods or in settlement of debts, provided the drawer is considered to be reliable.
Credit money in its various forms (cheques, bills of exchange, promissory notes, postal orders and money orders) is used to settle an enormous number of transactions, and its use greatly economises legal tender currency. Credit instruments are all simply substitutes for legal tender money, and they are accepted because the person receiving them counts on being able to convert them into cash without difficulty if he wishes to do so.
The Value of Money
We have seen that the value of any commodity, i.e. its power of exchanging for other commodities, is determined by the interaction of demand and supply. Money is no different from any other commodity: its value, i.e., its power of exchanging for goods, or its purchasing power over commodities, also depends on demand and supply.
The Demand for Money is the quantity of money needed to effect business transactions; i.e., to effect the transfer or exchange of the goods and services offered for sale. Sellers want money for their goods and services; in other words, they are demanding money, and the more goods and services there are being exchanged, the greater is the demand for money.
The same article, as it passes from producer to wholesaler, wholesaler to retailer and retailer to consumer, may give rise to a demand for money from several people. The demand for money is, therefore, affected not only by the volume of goods and services being exchanged, but also by the frequency with which such goods are exchanged, as is indicated by the number of people through whose hands the goods pass before reaching the final consumer. The greater the activity of trade, i.e., the velocity of circulation of goods, as distinct from the volume of trade, the greater the demand for money.
The Supply of Money is the actual amount of money notes, coins, cheques, bills, etc. used for effecting exchanges. It includes all forms of money, standard money and token money and all forms of credit, that are doing the money-work. But in considering the supply of money, we must consider not merely the total quantity of money in use, but also the velocity of circulation of money, i.e., the number of separate transactions for which each unit of money is used. The shilling we give the milkman is passed by him to his wife, who in turn hands it over to the greengrocer in payment for a cabbage and potatoes. The same shilling used in ten transactions is really performing the same function as ten separate shillings each used in one transaction only. The velocity of circulation thus increases the supply of money engaged in doing the money work.
Now, at any moment there is a certain quantity of money being used to pay for a certain quantity of goods and services, and it is the relation between the total supply of goods and the total supply of money that determines the value of money. If the quantity of goods increases whilst the amount of money remains the same, each unit of money will purchase more goods, i.e., the value of money will rise or prices will fall. Every shilling now buys more goods than it did before; an article that previously cost, say, ios. can now be purchased for only 8s. If, on the other hand, the quantity of goods remains the same and more money is made available {e.g., by the issue of extra notes), the value of a unit of money falls, i.e., prices rise. Whereas previously we might have been able to buy 4 lb. of a commodity for 6s., we must now pay 8s.; every shilling buys less of the commodity and, of course, less of everything else.
The Quantity Theory of Money
This relationship between the supply of money, the demand for money and the value of money is expressed by Economists in the Quantity Theory of Money, which states that the value of money depends on the relation between the demand for money and its supply. In other words, the theory states that the value of money depends on the money-work to be done by the supply of money available.
If during any period of time there is no change in the supply of money but an increase in the number of exchanges to be made, then, according to the theory, the value of money will rise in proportion to the increase in the money-work to be performed; in other words, prices of commodities, measured in terms of money, will fall. Similarly, an increase in the supply of money, coupled with no change in the volume of transactions, will cause a fall in the value of money, i.e., a rise in general prices. If the demand for money increases more quickly than the supply, money will rise in value, i.e., the general level of prices will fall, whilst the converse will be true if the supply exceeds the demand.
PRICES
Price Index Numbers
As money is itself the measuring-rod by which we indicate and determine the value of all other things, we cannot express the value of money except in terms of commodities in general; that is, we can measure changes in the value of money only by changes in the general level of prices. These changes are difficult to measure, first, because money is used in a host of different ways apart from the purchase of goods; secondly, because the prices of some goods rise whilst the prices of others fall during the same period; and, thirdly, because goods change so much in quality and description over a period of years that we cannot be certain, when we are com paring the price of one unit at one time with its price at another time, whether we are dealing with exactly the same article. In practice, the prices of a large number of different commodities and of different grades or varieties of the same commodity are taken so as to ensure greater accuracy. Moreover, wholesale prices of food commodities {e.g., wheat and beef) and raw materials {e.g., wool and cotton) are selected for index numbers of general prices because they are more easily and accurately determined than retail prices, and because food commodities and raw materials change little in description from one year to another. Retail prices are, however, used as the basis of index numbers designed to indicate and record changes in the cost of living, because the commodities on which the earnings of workers are spent are purchased at retail prices.
Weighting
In the example of an index number given above, it was assumed for simplicity that the commodities, bread, butter and meat, are of equal importance in the general scheme of consumption in the community. Actually, however, commodities are far from being of equal importance, so that an index number that is to be of any value must make some allowance for the relative importance of the different commodities on which we spend our money. If one commodity occupies a position of little importance in our general expenditure, a rise in its price should not influence disproportionately an index number that purports to indicate changes in the general level of prices; in other words, a rise in the price of that commodity should not be given too much " weight " in our index. On the other hand, commodities that are of importance must be allowed for according to their prominence in the expenditure of the average person.
For this reason, the compilers of index numbers attempt to allow for the different importance of the commodities whose price-changes they are measuring by assigning to them " weights " that correspond to their relative significance in the average family " budget" or average distribution of expenditure.
Changes in the Price Level
Individual prices are, of course, constantly changing, some rising and others falling. But, as a rule, these changes offset one another and have little serious effect. Changes in the general level of prices as indicated by an index number are, however, much more important and far more serious in their results.
Rising Prices are said to be good for trade. They encourage business men to expand their businesses because rising commodity prices usually mean greater profit margins, for the reason that the manufacturer's fixed charges (such as rent, rates and interest on debentures) do not rise at all, or rise less than the prices of the goods he sells. Rising prices, therefore, usually mean that industrial plant is more fully employed, and that there is a reduction in overhead costs per unit of output.
There is also an increase in employment, directly because the expanding businesses require additional labour, and indirectly because people generally have more to spend and more goods and services have to be produced for sale. In this way prosperity is diffused throughout the community. The producing classes are, on the whole, the debtors of the community, and, as a rise in prices reduces the real burden of their debts and interest payments (because each unit of money they have to pay away represents less goods than before), they can more easily and successfully carry on their activities.
Rising prices are specially advantageous to an industrial nation, so long as the rise is not violent. But where prices rise violently, owing to excessive inflation, considerable harm is caused, mainly because the resultant uncertainty as to the ultimate level of prices is one of the greatest hindrances to business stability and development.
Falling Prices have depressing effects on economic activity: they are bad for trade. By reducing or destroying profit margins, they tend to discourage enterprise and restrict production.
When prices are falling, goods already produced have to be sold at lower prices than were anticipated when production was put in hand. Profits are, therefore, reduced or completely fail to materialise, production is restricted, wages become a heavier burden to industry, for they do not fall as rapidly as prices (owing to the difficulty of getting labour to accept lower rates of pay— wage rates always " lag" behind prices), overhead charges per unit of output increase, costs of production become greater relative to selling prices, plant has to be left idle, unemployment ensues and dividends are reduced. In general, therefore, there is a fall in the general purchasing power of the community, and the depression extends throughout industry. Debts and interest payments become greater burdens at the very time when producers are least able to carry them, and many failures result.
Thus rapid and marked changes in the value of a currency, whether in an upward or downward direction, breed great uncertainty and lead to widespread loss of confidence. International trade also is hampered because the value of the currency cannot be estimated with any certainty, and buyers and sellers in other countries are reluctant to enter into transactions measured in terms of a currency of indefinite and rapidly-changing value.
BANKING
As the economic system has expanded and grown, the financial mechanism has become more complicated, credit transactions have enormously increased, and most business transactions of any magnitude now pass through the hands of the banks.
The Functions of a Bank
The British Banking System, in particular, is renowned for its high efficiency and for the variety of services it renders to the community. Originally, a bank was a place where people took their valuables foi safe keeping; now it fulfils a number of other highly important functions. It receives deposits from customers on current account, i.e., repayable on demand by cheque and bearing no interest, or on deposit account, repayable only after a period of notice and usually bearing interest ; it makes fixed loans to its customers on loan account or gives them fluctuating overdrafts on current account; it discounts bills of exchange and promissory notes at market rates, and accepts bills of exchange on behalf of its customers and correspondents.
Most modern banks also undertake important agency services on behalf of their customers and other banks, as, for example, in the safe custody of valuables; in collecting cheques, dividends, coupons and foreign bills; in undertaking stock and share transactions and foreign exchange operations; and in carrying out the duties of attorney, executor, trustee, or referee as to the standing and integrity of customers.
The majority of banks in this country are banks of deposit, and the function of note issue, once of paramount importance in British banking, is confined in England, and Wales to the Bank of England, and in Scotland and Ireland to the long-established banks of those countries,
Thr Utility of Banking to the Community
A consideration of the functions discussed in the preceding paragraphs will indicate at once that bankers render services of inestimable value to the trade and industry of the country. In acting as intermediaries between large numbers of depositors or lenders on the one hand and of equally numerous borrowers on the other, banks mobilise capital and make its use effective. They may be regarded as great reservoirs of loanable money into which flow a myriad small streams of liquid funds, and from which are distributed throughout the country, at the times when they are most needed and in the places where they can be most efficiently used, supplies of capital which are rightly regarded as sources of further wealth. Countless small sums of money are rendered productive which would otherwise remain in " idle hoard ", and in this way the banking organisation assists the transfer of the wealth of large and small capitalists in a rich locality to other areas where that wealth can be efficiently and profitably employed, to the ultimate benefit of the community as a whole.
The facility with which loans can be obtained from banks acts as a stimulus to production and as an incentive to industrial enterprise. Manufacturers and traders know that they can rely upon the banks for financial accommodation in difficult periods, and are therefore able to utilise their own working capital to the fullest extent.
In general, the existence of a sound and well-developed banking system provides safety for small and large savings, enables payments to be made, even over great distances, with safety and dispatch, and so facilitates all types of financial operations. Hence, the existence of a sound and efficient banking system is in itself an encouragement to saving, thrift and economy. The small depositor is brought to appreciate the facilities for safe investment which the banks provide and thus we find that, in a modern community, even the poorer classes keep accounts at a savings bank if not at a joint stock bank.
Conditions such as these must ultimately react to the general well-being of the community, and when it is remembered to what extent time, money and labour are saved by the cheque system, and by the general utility services of our banking institutions, it will be readily conceded that a country with a sound banking system is possessed of one of the firmest foundations of prosperity.
