Money as a Medium of Exchange & Modern Forms of Money

NCERT Understanding Economic Development | Chapter 3: Money and Credit

Why Is Money Called a Medium of Exchange — Barter to Currency

Money plays an indispensable role in our daily lives. If you observe carefully, you will notice numerous transactions involving money happening around you every single day. In many of these transactions, goods are being purchased and sold using money. In others, services are being exchanged for monetary payment. Sometimes, there is no immediate transfer of cash but rather a promise to pay at a later date.

But have you ever stopped to consider why people prefer using money for transactions? The answer lies in the concept of medium of exchange^?. A person who holds money can conveniently exchange it for any commodity or service they desire. Everyone prefers receiving payments in money because they can then use that money to purchase whatever they need.

The Problem of Barter

Consider a shoe manufacturer who wants to sell shoes and buy wheat. With money, the process is simple: sell shoes for money, then use that money to buy wheat. But imagine attempting this transaction without money. The shoe manufacturer would need to find a wheat-growing farmer who simultaneously wants to buy shoes. Both parties would need to want what the other has to offer.

In a barter system^?, where goods are directly exchanged without money, double coincidence of wants is an essential requirement. This makes transactions extremely difficult and time-consuming. Money eliminates this problem by serving as an intermediate step. The shoe manufacturer does not need to find someone who simultaneously sells wheat and wants shoes. They simply sell shoes to anyone willing to buy, receive money, and use that money to purchase wheat from any seller.

What Are Modern Forms of Money — Currency, Deposits and Cheques

Before the introduction of coins, people used a variety of objects as money. In ancient India, for instance, grains and cattle served as a medium of exchange. Later, metallic coins made of gold, silver, and copper came into use and remained common for many centuries.

Currency: Paper Notes and Coins

Modern forms of money include currency^? — that is, paper notes and coins. Unlike earlier forms of money, modern currency is not made from precious metals like gold or silver. Nor is it a commodity with everyday use value like grain or cattle. Modern currency, by itself, has no intrinsic value.

Why, then, is it accepted as a medium of exchange? The answer is that currency is authorised by the government of the country. In India, the Reserve Bank of India (RBI)^? issues currency notes on behalf of the central government. No other individual or organisation is permitted to issue currency. Furthermore, Indian law makes the rupee a legally valid medium of payment that cannot be refused for settling transactions within the country.

Deposits with Banks (Demand Deposits)

Besides holding currency, people also hold their money as deposits in bank accounts. At any given time, most people need only a portion of their money in the form of cash for daily needs. For example, a salaried worker may have extra cash at the beginning of each month. This surplus money is deposited in a bank account.

Banks accept these deposits and pay interest^? on them. This means people's money is kept safely while also earning a return. People retain the ability to withdraw their money whenever they need it. Because these deposits can be withdrawn on demand, they are known as demand deposits^?.

Payments by Cheque

Demand deposits offer an important facility that gives them the characteristics of money. Payments can be made using cheques^? instead of cash. A cheque is a paper instruction directing the bank to pay a specific amount from the account holder's account to the person named on the cheque.

Since demand deposits are widely accepted as a means of payment, they constitute money in the modern economy alongside physical currency. The modern forms of money — currency and demand deposits — are closely linked to the functioning of the banking system.

How Do Banks Use Deposits for Lending — Loan Activities Explained

What do banks do with the deposits they receive from the public? An interesting mechanism operates here. Banks keep only a small fraction of their total deposits as cash reserves. In India, banks typically hold around 5 per cent of their deposits as cash. This reserve is maintained so that depositors who come to withdraw money on any given day can be served.

Since only a small number of depositors withdraw money at any particular time, the bank can function smoothly with this limited cash reserve. The major portion of the deposits is used by banks to extend loans. There is a huge demand for loans for various economic activities — farming, business, housing, education, and more.

Banks charge a higher interest rate on loans than the rate they pay on deposits. The difference between the interest earned from borrowers and the interest paid to depositors is the bank's main source of income.

Demonetisation and Digital Transactions

In November 2016, the Indian government declared that currency notes of Rs 500 and Rs 1,000 denominations would no longer be valid. People were asked to surrender these notes to banks within a specified period and receive new denominations (Rs 500 and Rs 2,000) in exchange. This process is known as demonetisation^?.

Following demonetisation, the government encouraged people to use bank deposits rather than cash for their transactions. This led to a significant rise in digital transactions through methods such as internet banking, mobile phone-based transfers, cheques, ATM cards, credit cards, and Point of Sale (POS) swipe machines. Digital transactions help reduce the dependence on physical cash and also serve as a measure to control corruption.