Evolution of physical forms of money and three perspectives of its definition

Wenzhe Li

Published in China Finance, 1040(2), 91-92 on 16-January-2025 [1]

Money is important in the social-economic activities of humanities. A series of legal, economic, and statistical arrangements center around money in the modern economy. From commodity money to modern money, through stretched evolution, money reaches its current physical form mainly as bank deposits and could be defined on different levels or from different perspectives.

Three physical forms of money

Money, in essence, is a special merchandise with commonly accepted exchange value. It went through three overlapping development phrases, corresponding to three physical forms. In the first phase, it is commodity money. Typical representations include precious metals and coins minted by ancient nations and landlords. Commodity money has intrinsic value, constituting the primary foundation for its exchange value. In the second phase, it is banknote. Léon Walras, in his monument Éléments D’économie Politique Pure, Ou, Théorie De La Richesse, points out that “bank note is, in essence, a draft at sight payable to bearer …one can, in principle…pass them without endorsement or liability” (Walras, 1926)[2]. The banknote’s value comes from its interchangeability with commodity money and represents the credibility (trustworthiness) of the banknote issuer. In the third phase, it’s bank deposit. Money shrinks into a number on banks’ accounting books. Keynes (1930) points out in his A Treatise on Money that “Bank-Money is simply an acknowledgment of a private debt, expressed in the money-of-account, which is used by passing from one hand to another, alternatively with Money-Proper, to settle a transaction…Bank-Money (or non-legal-tender money) is mainly composed, nowadays, of Member Bank Deposits”[3]. He further states that a transfer of claim on money could be used in the settlement as a transfer of money. When the public is confident in this mechanism, they will be satisfied to possess a claim on money, not necessarily to cash out[4]. Hicks (1969) states in A Theory of Economic History that the development of the banking industry could be split into three phases: pure financial intermediary, taking deposits, and making deposits transferable by issuing cheques or notes. Only in the last phase does the banking industry gain the function of creating money. In this process, “Against the obligation of the borrower, to repay by some fixed date, it provides an obligation of its own, which is transferable upon demand, and for that reason has a money quality.”[5] The so-called obligation of its own by Hicks is bank deposit. Depositors are more willing to hold bank deposits instead of cash because compared with cash, deposits have several advantages, including free of theft, freedom to set payment amounts, automatic bookkeeping, etc., which are de facto additional services provided by banks to attract deposits (Towey, 1974).

Three levels of money definition

In modern society, mainly since the birth and development of the banking system, money, in a broad sense, simultaneously includes three physical forms. For different application scenarios, we could have three levels of money definition.

First, the legal definition of money. According to laws and regulations of different economies, money in the legal sense (legal tender) in most economies usually only includes banknotes and coins issued by central banks, both of which, in essence, are banknotes issued by central banks. Coins issued by central banks have low intrinsic value, which renders their primary value the purchasing power as legal tender. From this perspective, coins and banknotes have minor differences, meaning that coins could be viewed as “banknotes” made with metals.

Second, the economic definition of money. Fisher (1920) refers to this in The Purchasing Power of Money - Its Determination and Relation to Credit, Interest and Crises as commodities generally acceptable in exchange for goods[6]. These commodities should have a relatively stable value, rendering them suitable to act as a yardstick of the price tag. At the same time, they should also be highly liquid and interchangeable with legal tender with minimal cost. Most importantly, they should be widely accepted by broad market entities, which is the defining feature of payment media. If these commodities possess these monetary characteristics, they could be considered part of money economically.

The economic definition of money includes deposits, as deposits and legal tender have relatively strong interchangeability relations in the modern monetary system. The system typically constitutes two-tier banks, i.e., central bank and other depository corporations (ODC, primarily commercial banks), respectively, and are collectively named depository corporations (DC). Corporations and households put deposits into commercial banks, which further put deposits into central banks proportionally as reserve deposits. When corporations and households need to withdraw deposits into legal tender for payment purposes, commercial banks of these deposits need to have enough banknotes and coins in the vault. If not, commercial banks need to withdraw legal tender from the central bank at the expense of reserve deposit. Commercial banks can meet depositors' withdrawal demands if they have enough banknotes and coins in the vault or have enough reserve deposits. When corporations and households need to settle transactions by transferring deposits from their account to another entity, there are two different scenarios. If the payer and payee settle this transaction through their accounts at the same commercial bank, the bank could finish the transfer on its balance sheet without resorting to its banknotes and coins in the vault or reserve deposits at the central bank. In the other case, if the two counterparties have accounts at different commercial banks, and these two banks do not have other transactions to settle, then the payer’s bank needs to transfer its reserve deposit at the central bank to the account of the payee’s bank. If the payer’s bank has enough reserve deposits, it will be able to meet depositors’ transfer needs.

From the above analysis, we can see that deposits' capacity to play the role of payment media is backed up by commercial banks’ banknotes and coins in vaults and reserve deposits, with the latter doing the most work. Backed deposits of corporations and households act nearly the same as legal tender in payment transactions. Interchangeability between deposits and legal tender is affected by several factors. First is the reserve requirement ratio (RRR). Second, the central bank’s willingness to supply reserves. Third, in economies with deposit insurance regimes, the withdrawal capability of commercial banks from the central bank surpasses the limit of reserve deposits, enhancing interchangeability.

Third, the statistical definition of money. This definition is used explicitly in economic research and daily economic activities. The most common concept of money is broad money. Broad money does not imply including all financial assets with monetary characteristics. International Monetary Fund (2000) states that those assets included in the monetary statistics of the central bank have to meet several specific conditions as listed in the “Monetary and Financial Statistics Manual,” such as fixed face value, divisibility, etc., and leaves national definitions of money to the discretion of central banks[7]. Which kinds of financial assets should be included in statistical coverage of money? International Monetary Fund (2016) further points out in “Monetary and Financial Statistics Manual and Compilation Guide” that central banks need to decide whether the mentioned financial asset closely correlates with economic growth, inflation, and other macroeconomic indicators. Practically speaking, to include a certain kind of financial asset also has to be statistically feasible. If including some assets only marginally benefits in increasing the correlation of monetary statistics with macroeconomic indicators and significantly increases statistical complexity, not including these assets might be a feasible choice.

Because of these considerations, financial assets included in monetary statistics vary across economies, and many undergo several modifications (Sheng and Zhai, 2015). According to publications of major central banks, these differences fall into the following three categories.

The first category is different levels of monetary aggregates. Different levels represent different liquidity of respective financial assets, i.e., their capability to be interchanged into cash. Two differences stand here. First, the narrowest money concept, i.e., currency in circulation, is named differently, resulting from different economies' monetary histories. In China, M0 is defined as simply Currency in Circulation. However, Economies, including the United States, Euro Area, Japan, and the United Kingdom, only have currency in circulation without naming it as M0[8]. Contrarily, India uses M0 to refer to the monetary base. Second, there are different levels of monetary aggregates beyond currency in circulation to reflect different levels of liquidity in the economy. China has M1 and M2; the U.S. has M1 and M2 and once had M3, which has not been published since 2006. U.K. has M2 and M4 (with M1 and M3 no longer published). Euro Area and India have M1, M2, and M3. Japan has M1, M2, M3 and L. Brazil sets M1, M2, M3, and M4. Korea has M1, M2, and Lf (Liquidity of Financial Institutions).

The second category is different attributes of included financial assets. More financial assets gain money-like characteristics with economic and financial development and the deepening of financial innovation. U.S. Federal Reserve includes financial assets based not only on which assets could function as payment media and store of value but also on whether these assets are correlated with macroeconomic indicators (Porter, Simpson, and Mauskopf, 1979; Simpson and Porter, 1980; Walter, 1989). Central banks adopt similar criteria when making inclusion decisions.

Three differences fall into this category. First, different financial asset types. For example, regarding the money market fund, the U.K., Japan, Brazil, and India do not include it in monetary aggregates. In contrast, the U.S., Korea, and China (after 2018) include it in M2, and the Euro Area includes it in M3. Regarding financial bonds, China, the U.S., Japan, and India do not include it in monetary aggregates, while the U.K., Euro Area, Korea, and Brazil include. There are further distinctive practices. China includes digital RMB into M0 and other monetary aggregates after December 2022, and the Euro Area includes repo in M3. Second, different maturity of assets. For example, M2 in China, the U.S., and Japan, and M4 in the U.K. include term deposits with all maturities. However, M2 in the Euro Area only includes term deposits up to 2 years and deposits redeemable at notice of up to three months. U.S. has one distinctive practice in this regard, as M2 in the U.S. only includes term deposits with a balance of up to 100,000 dollars, while few other central banks use balance as an inclusion criterion. Third, different currency composition. Korea, the Euro Area, and Japan include deposits denominated in foreign currencies into monetary aggregates, while China and the U.K. do not. The U.S. excludes these deposits through estimation.

The third category is different money-holding sectors. Three differences stand here. First, whether to include non-residents. Global common practice typically takes non-resident as a money-neutral sector. U.S., Euro Area, U.K., Japan, and other major economies do not include non-residents in the holding sector. However, the IMF regards it as suitable to include non-residents partially in several unique circumstances[9]. Second, whether to include local government. Regarding the governmental sector, major economies usually do not include the central government as part of the holding sector, i.e., implying that the central government is money-neutral[10]. In practice, the U.S., Euro Area, Japan, and Korea include local governments in the money-holding sector, while China and the U.K. do not. Third, non-depository financial institutions (non-DFI). U.S., Euro Area, U.K., Korea, and China (after 2011) list non-DFI as money-holding sectors, while Japan excludes all financial corporations.

When analyzing and comparing money in different economies, these differences mean we should pay attention to statistical differences. As the economic system develops with more complex financial activities, the physical form of money could evolve deeply. For example, digital currency could have more substantial payment functions, and new payment methods might have enriched application scenarios. The new physical forms of money and payment methods could affect the three traditional perspectives of money definition, with the corresponding evolvement of the monetary system. The legal, economic, and statistical arrangements relevant to money should actively cope with these new developments.

REFERENCES

Fisher, Irving. 1920. The Purchasing Power of Money - Its Determination and Relation to Credit, Interest and Crises. 2nd Edition. THE MACMILLAN COMPANY, New York.

Hicks, John. 1969. A Theory of Economic History. London: Oxford University Press.

International Monetary Fund. 2000. Monetary and Financial Statistics Manual. Washington, DC, USA. https://www.imf.org/external/pubs/ft/mfs/manual/pdf/mmfsft.pdf

International Monetary Fund. 2016. Monetary and Financial Statistics Manual and Compilation Guide. Washington, DC, U.S.A. https://www.elibrary.imf.org/display/book/9781513579191/9781513579191.xml.

Keynes, John Maynard. 1930. A Treatise on Money. Cambridge University Press for the Royal Economic Society & MACMILLAN AND CO., LIMITED.

Porter, Richard D, Thomas D Simpson, and Eileen Mauskopf. 1979. Financial innovation and the monetary aggregates. Brookings Papers on Economic Activity, 1979(1), 213-229. https://doi.org/10.2307/2534309.

Sheng, Songcheng and Chun Zhai (2015). Central Bank and Money Supply. Beijing: China Financial Publishing House. 

Simpson, Thomas D, and Richard D Porter. 1980. Some issues involving the definition and interpretation of the monetary aggregates. Federal Reserve Bank of Boston Conference Series, 23,161-234. https://www.bostonfed.org/-/media/Documents/conference/23/conf23d.pdf.

Walras, Léon. 1926. Éléments D’économie Politique Pure, Ou, Théorie De La Richesse (Elements of Pure Economics, or the theory of social wealth). London: George Allen and Unwin Ltd. (English translation by William Jaffé in 1954), and Commercial Press, China (Chinese translation by Shoubai Cai in 1989).

Walter, John R. 1989. Monetary aggregates: A user's guide. FRB Richmond Economic Review, 75(1), 20-28. https://www.richmondfed.org/-/media/RichmondFedOrg/publications/research/economic_review/1989/pdf/er750102.pdf.

Towey, Richard E. 1974. Money creation and the theory of the banking firm. The Journal of Finance, 29(1), 57-72. https://doi.org/10.2307/2978214.

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[1] Wenzhe Li, the People’s Bank of China, Ph.D. in Economics from Tsinghua University. Email: liwenzhe@tsinghua.org.cn. The views and analysis expressed in this paper are those of the author, and do not necessarily represent the views of the People’s Bank of China.

[2] See Walras (1926), pp.363–364.

[3] See Keynes (1930), pp.6–7.

[4] See ibid., p.23.

[5] See Hicks (1969), p.96.

[6] See Fisher (1920), p.8.

[7] See International Monetary Fund (2000), p.57.

[8] Sources for comparison of coverage difference of money in major economies include:

United States (Federal Reserve): https://www.federalreserve.gov/releases/h6/current/default.htm.

United States (Federal Reserve, Technical Q&A on money stock measures): https://www.federalreserve.gov/releases/h6/h6_technical_qa.htm.

China (The People’s Bank of China): http://www.pbc.gov.cn/diaochatongjisi/resource/cms/2023/01/2023011616255071886.htm.

Euro Area (European Central Bank): https://www.ecb.europa.eu/stats/money_credit_banking/monetary_aggregates/html/index.en.html.

Japan (Bank of Japan, BOJ): https://www.boj.or.jp/en/statistics/outline/exp/exms01.htm.

United Kingdom (Bank of England): https://www.bankofengland.co.uk/statistics/details/further-details-about-m4-data.

United Kingdom (Bank of England, historical change of UK monetary aggregates): http://webarchive.nationalarchives.gov.uk/20160601184656/http://www.bankofengland.co.uk/statistics/Documents/ms/articles/art2jul03.pdf.

India (monetary and financial statistics): https://mospi.gov.in/102-monetary-and-financial-statistics.

Brazil (Banco Central do Brasil): https://www.bcb.gov.br/content/indeco/economicindicators/Glossarioindecoi.xlsx.

Korea (Bank of Korea, monetary and liquidity aggregates): https://www.bok.or.kr/eng/bbs/E0000634/view.do?nttId=10077870&menuNo=400069&pageIndex=1.

[9] See International Monetary Fund (2016), pp.188-189, and International Monetary Fund (2000), p.63.

[10] See International Monetary Fund (2016), p.189.