Definition of Money
Contrary to expectations, the question of the definition of money is not a straightforward issue that does not give rise to a diversity of opinion, and even controversy. In some way the difficulty arises out of technical considerations. In yet another, considerations of theory and ideology have also contributed, especially as part of the Keynesian/monetarist debate, although some leading proponents of either school have argued that this issue cannot and should not be settled on theoretical/ideological grounds (Coats and Khatkhate, 1980).
Although there is this diversity of opinion, there are some areas of agreement as to the functions of money, and to its evolution. Money serves three broad functions in the economy, namely as a unit of account, medium of exchange (or ‘means of payment’, Coghlan 1980), and store of value. Most economists agree that the distinguishing characteristic of money is that of the medium of exchange. In a barter economy goods are exchanged directly for other goods. If individual 1 wants to exchange good A for good B, which is held by individual 2, then they have to come together at an agreed place, at an agreed time, and swop the two goods. There is no intervening stage. The problems associated with this type of trade (i.e. barter) are well documented.
First, for trade to take place, there must be a ‘double coincidence of wants’. That is, individual 1 must want to exchange good A for good B held by individual 2, absolutely. But frequently individual 1 might want to exchange good A for good G held by individual 7, when individual 7 does not want good A, but instead wants good B. This problem is solved under indirect barter, when one commodity is used as an intermediate good (Rousseas, 1972). One good is exchanged for this commodity money (e.g. gold) and then this is used to purchase another good. This is merely an intermediate step that ultimately leads to the development of money as we know it today.
But the problems of the barter economy are by no means confined to the need for a double coincidence of wants. Because of the high costs of transacting (both in time and effort involved in trade), the volume and incidence of trade under barter is greatly restricted. Under indirect barter, with its slashing of transactions costs, the volume and incidence of trade is greatly increased.
Although commodity money serves well as a unit of account and a store of value, in some important respects it does not do so well as a means of payment. According to Coghlan (1980), money as a means of payment ‘must possess certain physical characteristics’: it must be durable, to act as a good store of value; it must be homogeneous; it must be generally recognisable and acceptable as money; in order to accommodate the different types and sizes of transactions that trade is comprised of, it must be divisible; it must be portable and it must have demand and supply conditions (Coghlan, 1980).
Clearly, on the last three characteristics commodity money does not stand well. First, First, there are limitations to the divisibility of certain commodities, especially those that have historically been used as money. Second, not all commodity money is easily portable, and there are generally great transportation and storage costs. For reasons of scarcity, and for political reasons, commodity money fails on the third and last characteristics. Thus, the introduction of paper and coins eliminates all these problems. That is, ‘modern’ money has all these characteristics and performs well as a means of payment, unit of account and store of value, although under inflationary conditions its function as a store of value tends to break down (Rousseas, 1972). More fundamentally, the introduction of modern money greatly increases the efficiency of the economy, thus permitting economic expansion and technological innovation to take place at an accelerated pace.
According to Coghlan (1980), the introduction of a modern monetary system results in the following:
- Improvements in efficiency resulting from the increased ability to take advantage of specialisation and division of labour in production and exchange.
- The release of resources previously engaged in the process of bartering and gathering information.
- A general reduction in uncertainty [which] should improve expectations of the future and encourage producers and consumers to adopt a more optimistic and expansionary approach (Coghlan, 1980).
Having dispensed with the issues of the definition of money at a ‘theoretical’ level, we now come to a definitional problem of a different kind. What asset or group of assets can be termed ‘money’, and how can they be measured? Here again there is great controversy. With regard to money as a medium of exchange some have argued that only notes and coins and demand deposits in commercial banks should be regarded as money. This narrow definition of money is what is usually termed M1. Others have argued for broader definitions of money to include savings deposits (M2) and time deposits and deposits with other financial institutions (M3). Monetary aggregates, however, are not confined to these three; many others have been defined (e.g. PSL2 in the United Kingdom). Different economists argue for the adoption of one or other aggregate, but according to Friedman and Schwartz, there is no principle involved in adopting any particular aggregate (Coats and Khatkhate, 1980). Coats and Khatkhate (1980) argue that this question is empirical in nature, and cannot be decided on theoretical grounds. They quote the Federal Reserve Bank of the United States’ (the Fed) report on “Improving the Monetary Aggregates” (June 1976), which argues that the choice of the aggregate should depend on ‘(1) how accurately the total can be measured; (2) how precisely, and at what costs including unwanted side effects, the Fed can control the total; and (3) how closely and reliably changes in the total are related to the ultimate policy objectives [of employment, output, the price level, etc. – author]’, “Improving the Monetary Aggregates”, Report of the Advisory Committee on Monetary Statistics, Board of Governors of the Federal Reserve System, June 1976 in Coats and Khatkhate, 1980.
Analogously, money may be defined as that ‘financial aggregate whose demand is empirically most stable’ (Coats and Khatkhate, 1980). Furthermore, ‘empirical validation is necessary for each country’. To us, this approach looks to be the more promising one. There is no a priori decision as to which monetary aggregate to use, but the question is deferred to empirical testing.
Theories of the Demand for Money
There are two main approaches to the demand for money, one being neoclassical and the other being Keynesian. The neoclassical approach stems mainly from Milton Friedman’s restatement of the quantity theory of money. But it is also argued that Friedman’s theory of the demand for money was in many ways a restatement [also] of Keynes’ theory of the demand for money (Gowland, 1985; Coghlan, 1980).
According to the neoclassical approach, money is considered a normal good. Therefore, the demand for money should behave like that of any other normal good. That is, it should have positive income elasticity and negative price elasticity (Gowland, 1985). The price of money, that is the opportunity cost of holding it, is considered to be the rate of return on alternatives to money. Since both financial and real assets are alternatives to money, the demand for money should depend on the rates of return available on these. In addition, of course, it should also depend on the price level, and the level of real income.
Gowland identifies six variables on which the demand for money should depend:
- The general price level, with a positive elasticity. (With respect to the price level, the demand for money is considered to be homogeneous of degree one);
- The level of real wealth, with a positive elasticity;
- The level of real income (or output), with a positive elasticity;
- The rate of interest on short-term financial assets, with a negative elasticity;
- The rate of return on other assets, including real assets, with a negative elasticity;
- The own rate of return, with a positive elasticity (Gowland, 1985)
The Keynesian approach postulates motives for holding money, namely the transactions, precautionary and speculative motives. The transactions motive for holding money derives from money’s function as a medium of exchange or means of payment. Individuals will hold money in order to carry out current transactions. Although according to Hicks this is really not a demand, but a “requirement” for money, Coghlan (1980) argues that this “ignores the temporal aspect of exchange, the lags in the system between receipts and payments. Once these are taken into account it is only sensible to consider a demand for transactions balances” (Coghlan, 1980). This transactions demand is a function of expected income, and it has positive income elasticity.
The precautionary demand is also a transactions demand, but it differs from the above insofar as it is a forward-looking concept. That is, individuals will hold certain money balances as a precaution against unforeseen future expenditures. It caters for the uncertainty in transactions to be carried out in the future. It also depends on expected income, with a positive elasticity.
The last motive for holding money is the speculative motive. In the Keynesian view, there are only two kinds of assets, money and bonds. Bonds are government debt (that is, they are claims on the government), and they pay their holder a fixed coupon rate. Because of this, bond prices move inversely with interest rates and so their attractiveness is affected by the movement of interest rates (Gowland, 1985). Therefore, when interest rates are falling, individuals will move out of bonds and into money. This is because individuals have a view about the ‘normal’ rate of interest, and hence when rates fell below this rate, they were expected to rise. Thus, when bond prices are rising, bondholders would sell, with the view of buying them at a lower price when prices have fallen. This, then, was the speculative demand for money. It was postulated to depend on the rate of interest, with an almost infinite interest elasticity (Gowland, 1985; Coghlan, 1980).
Although the different ‘motives’ have been attacked on specific issues, a general criticism is also levelled at the motives approach. If money is a normal good, then its demand should be analysed like that of any other normal good. Using the demand for television sets as an example, Gowland (1985) argues that just as we postulate a downward sloping demand curve for television sets, without specifically analysing “the ‘news demand’, the ‘opera demand’, …” we should postulate a downward sloping demand for money function, without analysing the motives for holding it (Gowland, 1985).
But the monetarist-Keynesian debate regarding the demand for money does not end there. There is also disagreement about the nature of assets that can be regarded as substitutes for money. Keynesians regard only short-term financial assets as substitutes for money. Hence, for them the opportunity cost of holding money is the rate of interest on these assets.
For monetarists, no financial assets are close substitutes for money. If individuals want to alter their money balances in response to a change in income, they would just as much sell/purchase financial assets, both short and long-term, as sell/purchase real assets, including consumer durables (Coghlan, 1980; Gowland, 1985). Therefore, the opportunity cost of holding money is the rate of return on all these alternative assets. The nominal rate of return on real assets is proxied by the expected rate of inflation on the grounds that the two should move in line (Gowland, 1985).
This controversy about the nature of assets that can be regarded as substitutes for money is also at the core of another disagreement, this time about the transmission mechanism of monetary policy. Because Keynesians believe short-term financial assets are direct alternatives to holding money, their transmission mechanism is an indirect one, acting through the interest rate. Therefore, as a policy prescription, Keynesians advocate ‘the’ interest rate as an intermediate target. On the other hand, because they view financial as well as real assets as alternatives to money, the monetarist transmission mechanism is a more direct one. If, in response to a change in their levels of real income and wealth, individuals desire to change their money balances, then they will as much move into or out of financial assets (both short and long-term) as they will alter their patterns and levels of expenditures on real assets, including consumer durables. If the economy is at full employment (that is, at its long-run equilibrium), then these changes of expenditures will have repercussions on the price level. Thus, at full employment, an increase in the level of income, ceteris paribus, will boost aggregate demand and so lead to inflation. Because monetarists believe that money causes income, therefore at the policy level they advocate the money stock as an intermediate target.
A controversy of a different kind has been over technical considerations. First, and largely stemming from the disagreement over the composition of substitutes to money, there is disagreement over the arguments to be included in the demand for money function. Second, there is no agreement over the form of lag to be incorporated in the demand function, and also on the form of expectations. Third, there is no agreement over the appropriate measure of the monetary aggregate to be considered. As Coghlan argues, the matter of the definition is very important as this affects the estimation approach (Coghlan, 1980). Also, empirical studies in the United Kingdom have shown that adopting different measures of money (that is, M1, M2, etc.) produces different coefficients, as do short and long-term interest rates (see, inter alia, Coghlan (1980)). However, according to Coghlan (1980), no study has as yet attempted to take explicit account of the problem of definition of money.
But, in the view of Coats and Khatkhate (1980), the issue of the definition of money should be decided on empirical grounds. That is, no a priori decision can be made on which monetary aggregate to use; “empirical validation is necessary for each country” (Coats and Khatkhate, (1980), see also section 2.1 above).
Monetisation
According to Chandavarkar, monetisation is “the enlargement of the sphere of the monetary economy…. It involves the extension through time and space of the use of money in all its aspects…to the non-monetised (subsistence and barter) sector” (Chandavarkar, 1977). Historically, the widespread use of, and familiarity with, money has not proceeded at the same pace in all parts of the economy. Certain parts of the economy, namely and mainly the urban centres, have come to embrace the use of money more than other parts. This worked to produce or to exacerbate the ‘duality’ between the urban and rural sectors of the economy. This is probably where the concept of monetisation was born to describe the process whereby the widespread use of money was extended to other parts of the economy, chiefly the rural sectors.
In developing economies a large part of the rural sector engages in subsistence activity. In this context, therefore, monetisation linked to two other simultaneous processes, namely ‘commercialisation’ and financial intermediation. Commercialisation is defined as “the pervasiveness of the behavioural assumption of profit maximisation”. Financial intermediation is simply the process whereby institutions mediate in the process of lending/borrowing and saving/investing. Although the two other phenomena are simultaneous with monetisation, it is essential that they be separated analytically and empirically (Chandavarkar, 1977).
Because monetisation means the extension of the use of money to other parts of the economy, thus bringing in activities that have hitherto been non-monetised, it is bound to have an impact on the demand for money. Simply put, ceteris paribus, monetisation increases the demand for money.
Thus, it has been argued, the level and rate of monetisation should be taken into account when estimating the demand for money function for a developing economy. According to Coats and Khatkhate, when estimating the demand for money function it is simplest to use income data from the monetised sector only, “as then the non-monetised, which uses and demands no money by definition, can simply be ignored” (Coats and Khatkhate, 1980).
In the past there were attempts to proxy the rate of monetisation with such socioeconomic factors as urbanisation’s industrial employment and production of cash crops. But these are not suitable indicators of the rate of monetisation (Chandavarkar, 1977). Also, the ratio of money supply to national income has been suggested as an appropriate proxy. But Chandavarkar points out that this is also not a suitable proxy because an increase in the supply of money might be confined to (or originate from) the already monetised sector. He suggests, instead, the use of the monetisation ratio. This is defined as “the proportion of the total goods and services of an economy that is monetised, in the sense of being paid for in money by the purchaser”, in relation to one of the gross domestic product (GDP), gross national product (GNP), population, etc.
However, this is a temporal indicator, and it should be used in conjunction with “time series of national accounts at constant prices, since this alone can establish the rate of monetisation (the annual percentage increase in the share of the monetised sector) as distinct from its level” (Chandavarkar, 1977).
While Chandavarkar goes further than others and actually suggests economic indicators of monetisation, there is no attempt to formulate a demand for money function that takes into account the suggested rate of monetisation. He suggests that “the net increase in the demand for money from monetisation per se would be much smaller, compared with the demand arising from an increase of economic activity in the monetised sector [although] in practice it would be difficult to disaggregate the increase between these two components…”
The portfolio effects of an increase in monetisation would be an increase in the demand for currency rather than for bank deposits. This is so because there is a “high ratio of currency to money supply in most developing economies”, while banking facilities are inadequate and the banking habit is backward. Even where the impact of monetisation is on bank deposits, it is more likely to affect savings deposits than demand deposits, given the greater number of savings banks in rural areas compared to commercial banks and “also given the greater expense and sophistication of checking accounts”.
The Demand for Money
The demand for money function captures the relationship between the intermediate target (the nominal money stock) and the ultimate objectives of monetary policy, namely employment, output, the price level, etc. Although there is disagreement over the specific functional form of the demand for money, there is agreement regarding some of the arguments to be included. The demand for money function is postulated to depend on expected real income, permanent wealth, the expected rates of return on alternatives to money, the expected price level and some other factors (like institutional rigidities). In functional form this may be stated as
Where 
desired nominal money balances;
The partial derivatives 
have the following hypothesised relationships with desired nominal money balances,
These partials indicate the signs of the elasticities of demand of the different variables. That is, desired money balances depend on expected real income, with a positive elasticity; on the expected price level, with a positive elasticity; on permanent wealth, with a positive elasticity; and on expected rates of return on alternatives to money, with negative elasticities. For simplicity, the expected variables will be represented by the current values Y, P, R. Following Guma and Coghlan (1980), we shall specify the following functional form,
If there is partial adjustment of actual money balances, 
, to this desired level, 
, then this lagged adjustment may be represented as follows,
Where 
actual money balances;
Taking logarithms of (2) and (3) above gives,
and
Where the lower-case letters denote the logs of the respective variables.
Substituting (3) into (4) and rearranging gives,
Let the 
be replaced by 
; therefore, (6) becomes
These coefficients will give estimates of the short-run elasticities.
This functional form gives the demand for nominal money balances in the short-run. In the long-run, of course, actual and desired money balances are identical, which implies that no adjustments to money balances are necessary. The long-run coefficients are given by the 
,
i.e. 
Crypto Currency
‘Crypto’ ‘Currency’ refers to digital assets created by private actors for the purpose of creating wealth and facilitating online transactions that are purportedly more secure than monetary or bank facilitated transactions. These digital assets do not meet the traditional definition of money or currency, although in a sense they do fit into the evolution of money. This is so because they do store value and they facilitate transactions. They, however, fail primarily because their use is restricted to a small number of economic actors, cutting out the majority who do not have access to digital infrastructure. They are essentially a novelty.
Their ‘crypto’-ness is also in question. Being digital instruments, albeit supposedly very secure, they may be vulnerable to hacking and theft. It is also the case that if you lose or forget your digital ‘crypto’ password you may permanently lose your ‘currency’ or money. It may also be argued that in reality they ‘solve’ a nonexistent problem. Fiat money is secure: in its legal tender status, it is guaranteed by the issuing authority (i.e. the central bank); bank deposits and bank facilitated transactions are guaranteed by the banks, who are typically very financially sound, and they in turn are guaranteed by insurers or the central bank and the state. Although bank deposits are linked to an identity, however money in your pocket or under your mattress is completely anonymous. It may burn or be stolen, but it is not linked to any specific identity, and therefore by that nature ‘crypto’.
This does not mean, however, that ‘crypto’ assets have no role to play as a form of money. After all, in its early days money or currencies also had challenges, including public mistrust and defaults. As they evolve, these mediums of exchange will most likely become more robust, gain wider acceptance, and solve their other weaknesses. Instead of being opposed to them, central banks should be investing resources to understand them better and devising regulatory frameworks that will facilitate their wider use and security. Indeed, a forward-looking central bank or banking system might consider creating their own crypto assets, that would then enjoy the status of fiat money.
