[Economy] Barter-Money-Bitcoin: Fungibility, Double coincidence of wants,

division of labour (Part 1)

Posted ByMrunalOn 24/12/2013 @ 9:27 pm In Economy | 110 Comments
1. Prologue
2. Bitcoins overview
3. Barter system
1. #1: Double coincidence of wants
2. #2: Division of Labour
3. #3: Divisibility of Value
4. #4: Fungibility
4. Bitcoin and Fungibility
5. Mock Questions

Prologue
Original plan was to write on Bitcoins. But for Bitcoin related MCQs, group discussion (GD) and interview
questions, one must know the basics of money itself. Only then you can see how Bitcoin is better or
worse than the money we use today- rupees, dollars or Euros. Hence a long series of articles.

1. In the first few of articles (total 3), we’ll see why did people start using traditional money (Rupee,
dollar), how is it better than bartering system. And how is bitcoin better or worse, on those parameters?
2. In the second batch of articles, we’ll see evolution of money system: from commodity money, metallic
coins, fiduciary money, gold backed paper currency, fiat money, bank money etc.-what were their
advantages and limitations. And how is bitcoin better or worse on those parameters.
3. And in the final articles, we’ll see what is bitcoin exactly? from where does it come? How does it
operate? Advantages, limitations, future applications and regulatory issues etc.

Bitcoins overview
 Bitcoin is a digital code. (Some) people use it as currency.
 Started in 2009 by Satoshi Nakomoto. He could be a man or a woman or a group of people- real identity
unknown.
There are two ways to get Bitcoins:

#1: Mining #2: Exchange

 Aluminum is hidden inside bauxite ore
in earth.
 Similarly, Bitcoins are hidden in data
“blocks” designed by Satoshi and spread If you don’t want to mine bitcoins, then simply find
across the internet. someone who has already mined bitcoins. then
 You can mine Bitcoins by solving those A. Offer him real money (rupee, dollar, euro) and get
datablocks using special computer bitcoins in return. Websites that facilitate such
softwares. transactions are called “Bitcoin exchanges”. OR
 Reward for solving one data block=25B. Sell him some goods/services, and earn Bitcoins in
bitcoins at the moment. return.
 Total number of Bitcoins in the system
=~21 million. Additional bitcoins cannot
be created beyond that.
 Once you’ve have bitcoins (BTC), you can use them to buy goods/service (But very few sellers accept
bitcoins.)
 OR you can just wait for the BTC vs.$ exchange rate to rise then sell your bitcoins to a third party.
 But what about anonymity and terrorist angle? what about money laundering? what about inflation? isn’t
this a ponzi/MLM scheme? We’ll all those things in detail later on. I gave the overview right now,
because for next 5-6 articles, atleast ^this much knowledge of bitcoin topic is required before we start
comparing Bitcoin system with barter system and money system. Now let’s start first article.

Barter system
 People have been trading with each other even before the advent of money, coin, cash, currency, rupee,
dollar, euro or Yuan.
 They simply exchanged goods and services with each other through barter system- 1 kg rice for a 200
gms tomatoes, 1 kg tomatoes for 50 gm almonds and so on

Barter system: advantages

1. Simplest form of exchange. Had all nations did foreign trade on barter system, there will be no headache
of foreign exchange rates and associated problems. Today if Dollar strengthens by some action of US
federal reserves (=American RBI), then it automatically becomes expensive for India to import oil from
Saudi=>everything else transported through petrol/diesel becomes expensive= inflation.
2. Less chances of overproduction, hoarding, profiteering etc. =less chances of inflation. Although it’ll be
wrong to say there will be no inflation in barter system- because war, famine and natural disasters can
create mismatch in supply and demand even in a barter system => lead to inflation.
3. Difficult to concentrate wealth= Less inequality of income, and all the social problems associated with it.
4. Barter system ensures “need” based production. In money system, firms create products to create
demand e.g. so many softdrinks and plastic bottles+ the subsequent harm to health and environment.
5. Barter system promotes personal contact among individuals, social harmony, and healthy community
life, joint families etc.
But Bartering system had many limitations, that’s why people shifted to the money system. So,

What are the limitations of Barter System?

#1: Double coincidence of wants

farmer I want you to cut my hairs just Amir Khan in Dhoom3. I’ll give you 5 kilos of rice
But I already have 200 kilos of rice from previous customers. I don’t want rice
barber
anymore! I’ll cut hairs only if you bring 1 kilo tomatoes as payment.
Another case

My son wants to get admission in your coaching class. I can give you 500 beer bottles
Mallya
as fees.
Sir I don’t drink at all! Although I do want new table and benches for my classroom.
But I don’t know any carpenter in this area, and even if I find one, there is no
Mallya
guarantee he’ll accept beer bottles as payment for making furniture!
 Thus, under barter system, the “wants” of two parties must coincide with each other, otherwise they
cannot trade with each other. This increases the transaction cost as everyone will have to waste time
and energy to find another party with double coincidence of wants.
 Money system solves this problem. Farmer can sell his rice for money, use that money to get a haircut,
and barber can use the same payment to buy tomatoes from another farmer.
 Money thus facilitates the exchange of goods and services, lessens the time and effort required to carry
on trade.

What about Bitcoins?

 Bitcoin also serves the same purpose but with some caveats

Fiat money Bitcoins


Bitcoins are not issued by any
 Fiat money= money issued by the government (or its government. Bitcoins are unique pieces
central bank) example Rupee, dollar, Yen, Yuan. of digital codes that (some) people
accept as ‘digital currency’.
 An IT professional in Banglore may
accept bitcoin payment for creating
 It is legally recognized money for settling all
software for some American
payments and debts within the territory.
businessman.
 If you walk with a 5 rupee coin to a tea-vendor, he
 But if the same techie offers to pay
must serve tea, irrespective of your race, religion,
house rent in bitcoins, the landlord is
color, caste, age or gender.
legally free to refuse this payment and
 If he refuses to serve tea, he’ll be in legal trouble.
can even order him to vacate the
property.
 Even better, you can get your rupees exchanged in a
 Bitcoin removes the ‘double
foreign currency and import any commodity from
coincidence of wants’ ONLY for the
any part of the world to India. So a fiat money
people who believe in bitcoin system,
(rupee) removes the “double coincidence of wants”
and not for everybody everywhere.
for the trade within country and abroad.
Let’s make comparison table:

FIAT
FEATURES BARTER BITCOIN
MONEY
trade can happen without double coincidence Yes, if two parties
No Yes
of wants? agree.

#2: Division of Labour

 In the barter system, buying/selling/trade can only happen, when two parties want each other’s stuff-
the double coincidence of wants e.g. farmer wants haircut and barber wants rice from that farmer.
 But that doesn’t always happen, so each household tries to produce all of its daily requirements- from
growing green tea, tomatoes, chilies in their backyard; raising cows and poultry for milk and eggs; even
making pickles, paper and papad for entire year.
So is this good or bad?
 Good from Gandhian principle of “self-reliance”.
 Food inflation is kept in check- because everyone is growing vegetables in their backyard.
But overall bad because:
 Everyone is wasting their time and energy to become jack of all trades, instead of becoming master of a
single trade -medicine, engineering, construction, accounting, teaching, singing, painting etc.
 Thus, a bartering economy is less likely to produce specialists like Alexander Graham Bell (telephone)=>
Vin Serf (Internet)=> Sergey Brin (Google) because everybody busy growing vegetables in their
backyard and trying to become self-reliant-jack-of-all-trades.
 And even if there are talented specialists, they won’t have the necessary capital or resources to continue
their research. Imagine how many parties with “Double coincidence of wants” you’ll need, for assembling
the parts of a Large Hadron Collider or a Param Supercomputer.
 Money system also facilitates savings to become ‘investment’ for the entrepreneurs => more
companies, more job, division of labor, optimal usage of manpower, good for economic growth, R&D and
international trade.
 And with the money thus earned, anyone can buy his daily necessities, doesn’t need to grow vegetables
or rear cows in the backyard.

What about Bitcoins?

Just like traditional money, Bitcoin also promotes division of labour, but it is limited by the factor that
not everyone accepts Bitcoins- especially the local milk-veggie sellers. So if a software professional
decides to live only on ‘bitcoin’, he’ll have to start growing vegetables and wheat in the backyard of his
house, arrange a goat/cow for milk, and so on, we are back to square one- everyone trying to become
jack of all trades like in Barter system.

However, in future, Bitcoin may promote Division of labour to a whole new level (when and if Bitcoin is
accepted by a large population):
 Imagine a laptop manufacturing company- owned and operated by an AI (or robot) that accepts bitcoin
payment, robots make and pack the laptops into parcel, and drones deliver them at your door step.
 AI uses these bitcoins for paying the cost of raw material, warehouse rent, electricity bill etc. to humans
(or other AIs).
 And whatever bitcoins ‘left’ (=profit), are reinvested in buying more drones, bigger servers and so on.
This is not possible in the present money system because legally- an AI or Robot doesn’t meet the “KYC
norms” for opening a bank account = impossible for them to pay electricity bills through netbanking or
creditcard!
Anyways, let’s update the table:

fiat money
Features barter Bitcoin
(Rs./$)
trade can happen without double coincidence
No yes Only if both parties agree.
of wants
Yes, lot possibilities in
Promotes division of Labour? No Yes
future.

#3: Divisibility of Value

 Under the barter system

JK Rowling Give me a cup of tea, I’ll give you two pages from the latest Harry Potter book.
chai-walla I don’t want just two pages, I want the whole book for my son!
 Even if chai-walla continues serving tea to Ms. Rowling for 300-400 days, gets all the pages of Harry
Potter book and staples them together => still that stapled book will not sell at the original value of a
brand new Harry potter book (which is say worth 30 kilos of rice).
Meaning:

 You cannot always divide the value

 You cannot always re-unite the divided values.
Other scenarios:

1. Jeweler wants a matchstick box. But it’s not possible to divide gold to such a micro-micro-micro quantity
where gold becomes proportional to the value of a matchbox.
2. Mallya wants to buy a pencil box for his son, offers 1 table-spoon of liquor for 1 pencil box but
stationary-walla will not accept because such low quantity of alcohol cannot give the kick.
3. To pay for a cup of tea, Picasso cannot cutout 1 mm2 of canvass from his original painting.
Fiat Money system (and Bitcoins) don’t suffer from this problem of ‘divisibility’, and hence facilitate the
trade.

currency smallest unit

Rupee (Rs.) 1 paisa=0.01 Rupee (that is 10-2)
Bitcoin (BTC) 1 Satoshi= 0.00000001 Bitcoin. (that is 10-8)
 You can see it is possible to divide 1 BTC into so many small parts, so even if new bitcoins are not
created, it can continue as mode of payment by lowering the corresponding values of commodities.
 e.g. if today MRP of 1 laptop =1 bitcoin then in 2050, MRP of 1 laptop may adjust itself to 0.00165
Bitcoins, if there is shortage of bitcoins.
 And still you can pay 0.00165 BTC to someone by simply typing that specific amount in your keyboard.
Same thing is not possible with rupee or dollars because of the chillar shortage in real life.

#4: Fungibility
Even if items are divisible, their fungibility is a problem under barter system.

Fungible items = those items whose individual units have same uniform value and mutually
exchangeable, inter-changeable. For example:

1. The ‘value’ of first five pages of harry potter book= Not same as the value of last five pages of the same
book. Because in the last pages you get the climax so they’re more precious= not fungible.
2. Value of one diamond of 100 carat = not equal to ten smaller diamonds of 10 carat each. In this case,
bigger the size, more precious. Even those 10 carat diamonds are not mutually interchangeable because
their individual value may vary depending on cut,color and clarity.= not fungible.
3. If Picasso’s painting was cut into nine equal square parts, then Central Square will be more precious
than others. So you cannot interchange them. And if you glue these torn parts together= its total value
will be far less than the original painting=not fungible.
4. Exception: Precious metal. Value of 1 kilo gold bar= Value of 100 gold coins of 10 grams each. You can
melt to reunite them, you can melt again to divide them. And those 100 gold coins will be
interchangeable because their individual value will be same.= fungible.
But by and large, goods are not fungible and this creates obstacle in barter trade, when two
commodities are not available in their standard weight/size. For example, Suppose the ongoing barter
rate is 5 kilo salt = one live hen weighing 500gms.

 A poultry farm owner wants to buy 2.5 kilo salt. He gives the whole live hen to shopkeeper.
 Common sense suggest that shopkeeper should give 2.5 kilo salt and cut half of the hen and return it.
 But which ‘half’? In non-veg cooking, the legs of chicken are considered more valuable than its head and
neck upper part. = dispute between customer and shopkeeper.
 Overall, the customers in a barter-trade will end up buying more than what they really need. (e.g. 5 kilo
salt even if he needs only 2.5 kilo.)= considerable wastage and sub-optimal use of resources.
Money system solves this via “fungibility”.

 Rs.1000 note= can be exchanged for 20 notes of Rs.50 each. And each of those 50 rupee notes have
equal purchasing power. A 50 rupee note in your pocket will buy as many ballpens, as the 50 rupee note
in my pocket. (as long as ballpens are of same brand-model.)
 Similarly ten notes of Rs.100 can be exchange for a single note of Rs.1000 and so on.
 But there is an exception: Someone might offer 1000 rupees for a single 10 rupee note that has unique
serial number like “ABCD-123456789”. but ignoring such exception, currency notes are fungible.
 So, if you give Rs.100 note to shopkeeper to purchase a ten rupee worth ballpen=> he’ll give you 10
rupee pen + one note of 50 Rs. + four notes of 10Rs.
Still Money system too has limitations:

 You cannot pay Rs.149.75 through notes and coins because 25 paisa is out of circulation. (Although
possible if you pay via credit card, debit card or internet banking)
 Persistent shortage of chillar coins. And if you cut a ten rupee note into ten parts using a scissors, it’ll
not become ten 1Rs. notes.
 Persistent looting by Shopping malls. Items priced @Rs.99, 499 or 999 – often, cashier won’t give you
one rupee coin back but instead gives a chocolate. (He is making additional profit because for him ‘cost
price’ of 1 chocolate is less than 1 rupee.)

Bitcoin and Fungibility

Bitcoins (BTC) are fungible because

1. Individual units are identical. 1 BTC in Raja’s Digital wallet will buy same amount of goods & services as
1 BTC from Kalmadi’s digital wallet. (Even if their unique digital codes are different.)
2. Mutual substitution possible. it doesn’t increase or decrease the value. e.g. 100 centibitcoins (cBTC)= 1
bitcoin (BTC).
As such chillar/change problem doesn’t arise in Bitcoin because you can pay exact amount to the seller.
E.g. if a pen valued at 0.4 BTC. you can type 0.4 in keyboard and eletronically transfer that amount to
seller. It’s not like you have to give him 1 Bitcoin(BTC) and he gives 1 pen + 0.6 BTC in return. This is a
digital transaction after all.
But there is trouble brewing:

 You may have read in newspapers that Bitcoin transactions are anonymous and hence can be used by
terrorists, druglords and tax evaders.
 Therefore, some experts have came up with the idea of coin validation. We’ll see about that in a
separate article later, but for the moment the gist is:- Through coin validation software, you can
separate GOOD BITCOINS (those earned through honest work) vs BAD BITCOINS (those earned
through hacking & other illegal activities) via analyzing their transaction history and origin.
This “coin validation” will destroy the fungibility of bitcoins. How?
 Because then most users will refuse to accept ‘bad bitcoins’.
 Some American users might even refuse to accept bitcoins originating from people of Cuba, Pakistan,
Afghanistan, North Korea or Iran-for the fear that later US authorities may persecute/harass them while
hunting for Bad Bitcoins/Al-Qaeda/Terrorists.
Anyways let’s update the table:

features barter Fiat money (Rs./$) Bitcoin

trade can happen without double
No Yes Yes, if both parties agree.
coincidence of wants
Yes, but limited @the
Promotes division of Labour Hardly yes
moment.
Not Yes but limitation e.g. Yes and less limitations
Divisible?
always Rs.14.199 than fiat money
Not
Fungible? Yes Yes, for now.
always
In the next article, we’ll see more on Barter vs Money vs Bitcoin, with reference to storing wealth,
account keeping, deferred payment, circular flow of income etc. parameters. click me

Mock Questions
Assertion reasoning instructions: Each of the following questions contain a set of Assertion (A) and
Reasoning (R) statements. Answer codes are as following
A. Both A and R correct and R is the correct explanation for A
B. Both A and R correct but R is not the correct explanation for A
C. A is correct but R is wrong
D. A is wrong but R is correct
Questions:
1. (A) Money brings down the cost of transaction in trade, compared to barter system. (R) Money promotes
division of labour.
2. (A) A trader is free to refuse payment in Bitcoins. (R) Bitcoin is not a fiat currency.
3. (A) A Barter economy is less likely to have to food inflation. (R) In Barter system, trade can happen
without double coincidence of wants.
MCQs
4. Correct Statement(s) about Bitcoins?
a. It is a digital fiat currency without fungibility.
b. It is not a fiat currency but has all the properties of a fiat currency.
c. Both A and B
d. Neither A nor B.
5. Find Incorrect Statement(s)
a. One fiat currency can be exchanged with other fiat currency.
b. Bitcoin cannot exchanged with fiat currency.
c. Both A and B
d. Neither A nor B
6. Correct set of fungible pairs?
a. One i-phone of 64 GB capacity vs Four Nexus phones of 16GB capacity each
b. 1 Bitcoin vs 108 Satoshis
c. 1 Rupee vs 100 cents
d. None of Above
Q7. Which of the following statement(s) is/are incorrect?
1. Bitcoin algorithm is designed to generate 21 million coins every year.
2. There are two types of Bitcoins: mined bitcoins and exchanged bitcoins, they’re not fungible among
themselves.
3. Smallest unit of Bitcoin is called Satoshi.
Choice

A. Only 1 and 2
B. Only 2 and 3
C. Only 1 and 3
D. All of them.
Q8. Which of the following is/are the benefit(s) of barter system over money system?
1. Trade is possible without double coincidence of wants.
2. It promotes division of labour
3. Bartered commodities are always fungible.
Choice

A. Only 1 and 2
B. Only 2 and 3
C. Only 1 and 3
D. None of Them.
Q9. If a Barter economy is transformed into Money economy, what will be the consequences?
1. Increased Economic Efficiency
2. Increased Transaction costs
3. Increased specialization among workers
Choice

A. Only 1 and 2
B. Only 2 and 3
C. Only 1 and 3
D. All of them
For more on Economy, visit Mrunal.org/Economy

- Mrunal - http://mrunal.org -
[Economy] Barter-Money-Bitcoin: Circular Flow of Income, Savings to Investment,
Time Value of Money, Deferred Payments (Part 2)
Posted ByMrunalOn 24/12/2013 @ 10:41 pm In Economy | 52 Comments
1. Prologue
2. #5: Difficult to store Value
3. #6: Savings don’t turn into investment
4. What is Circular flow of income?
5. #7: Account-keeping = mission impossible
6. #8: Lack product specialization
7. #9: Future contracts and deferred payments
8. Time value of money
9. Bitcoins and Smart Contracts
10. Mock Questions

Prologue
In the previous article (Part I), we evaluated Barter-Money-Bitcoin systems on four parameters:

Fiat money
features barter Bitcoin
(Rs./$)
#1: trade can happen without double
No Yes Yes, if both parties agree.
coincidence of wants?
Yes, but limited @the
#2: Promotes division of Labour? Hardly yes
moment.
Not Yes but upto Yes and more divisible than
#3: Divisible?
always 10-2 fiat money. 10-8
Not
#4: Fungible? Yes Yes, for now.
always
Let’s continue further, what are the limitation of bartering system? Why did people shift to money
system and how does Bitcoin fare on those parameters?

#5: Difficult to store Value

UNDER MONEY SYSTEM
 You earn money for providing goods and
services to others. This is the ‘value’ of
your labour.
 You can and save / invest this value
(money) in bank, Fixed deposit, shares, 
bonds, mutual funds etc. =possible to store
UNDER BARTER SYSTEM
If the value of your labour is paid in Perishable
commodities like milk, butter, rice, potato, fishes
etc., it cannot be stored beyond a few
weeks/months/years.
Same for livestock wealth -cows, bullocks,
buffaloes, horse, camel, elephant etc. you may
 the value of your ‘labour’ for a long period also need to pay their caretaker and veterinary
of time and become wealthy. doctor.
 Even for a relatively non-perishable commodity
like silk-it’s difficult to store value confidently:
what if someone invents synthetic fibers and the
demand for silk clothes suddenly falls down?
 Not always. E.g. dried fish will not generate
more fishes.
 Stored value generates more income e.g.  Exception1: stored wine because its quality
interest from savings account, dividend increases with time.
from shares.  Exception2: Gold, diamond, real estate etc.
things that are non-perishable and whose
demand increases with rise in population.
 Money is the most liquid asset- you can use
it for buying almost anything immediately.
 With gold/diamond/real-estate this is difficult.
 Even if you have 1 crore rupee in savings
They’re relatively less-liquid assets.
account, you can take out a few hundreds
and dine in a restaurant.
So far, money system is better than barter system, for storing the ‘value’ of your labour.

But the Main problem: Inflation erodes the value stored in money. For example:
 within 2013, the onion prices have rose from Rs.20/kg to almost Rs.100/kg= 400% price rise
 In a fixed deposit, you’ll barely get ~9% return in a year.
 So even if you prudently store the value of your labour (salary) in money, your purchasing power
declined.
Similarly, if government overprints currency notes for the sake of financing a war, bailouts of troubled
PSUs or running populist welfare schemes =that also creates inflation, and erodes the purchasing power
of money. Recall Rajiv Gandhi Suitcase Yojana.

What about Bitcoins?

Bitcoins are created by a mathematical algorithm, total amount of Bitcoins is finite (~21 million
Bitcoins). Nobody can overprint Bitcoins beyond that.

It is possible to store value of your labour in Bitcoins e.g. IT Professional makes new software for
American businessman and gets paid in Bitcoins. But…

 Bitcoin itself cannot buy many goods and services at the moment, because Bitcon is not a fiat currency
unlike Rupee, dollar or Euro.
 At some point, you’ll have to exchange Bitcoins for a fiat currency- when you want to buy milk,
vegetables or pay electricity bill.
And there comes the problem: the exchange rate between Bitcoin vs. fiat currency

year 2013 1 Bitcoin = ____ $

Last week of October ~190
first week of December ~1200
third week of December ~580
 As you can see, Bitcoin exchange rate is way too volatile / fluctuating. Fortunes are made and lost in a
matter of weeks.
 A Botson Economics professor even predicts that by June 2014, one Bitcoin will be worth less than
10$, based on its current downfall!
 Agreed that inflation (or overprinting) erodes the purchasing power of fiat currency such as dollars or
rupees.
 But you’ll never expect so much ‘erosion’ of value – in such a short period-like in first week of December
you could buy two iphones in $1200, but in second week of December, inflation is so increased you
cannot even buy one iphone!
 In a separate article, we’ll see more about the connection between money supply vs inflation/deflation
and how Bitcoin fits in that picture. but for the moment let’s just update the table

Fiat money
features barter Bitcoin
(Rs./$)
1. trade can happen without double
No Yes Yes, if both parties agree.
coincidence of wants
Yes, but limited @the
2. Promotes division of Labour Hardly yes
moment.
Not Yes but Yes and less limitations
3. Divisible?
always limitations than fiat money
Not
4. Fungible? Yes Yes, for now.
always
5. Possible to store value/wealth for a Not Yes, but volatile at the
Yes
long time? always moment.
Continuing with the original discussion: what were the limitations of barter system, that made people
switch to money system?

#6: Savings don’t turn into

investment
 Under Barter system, there is no common storage for value (i.e. currency)=> difficult to operate banks,
insurance companies and mutual funds.
 As a result, people can save very less and often they just hide their gold, silver and jewelry under a tree
or under their bed pillow.
 This type of savings doesn’t help the entrepreneurs get loans to start new business, hire more people,
produce more goods and service = not helpful for the economic growth.
Money system solves this problem through “Circular flow of Income”

What is Circular flow of income?

 Money system creates two entities

HOUSEHOLDS FIRMS
They produce goods & services and sell it
They buy goods and services from the firms.
to households.
they supply the factors services to the firms they pay for those factor services in terms
1. land of:
2. labor 1. Rent (for using land)
3. Capital (through their savings in banks, mutual2. Wages (for using labour)
funds etc.) 3. Interest, dividends (for using capital / loans)
 Firm’s profit = whatever money is left after paying the rent + wages + interest (+ tax + bribes).
 And firm can use that profit for buying additional factors (land, labour, capital) to produce even more
goods and services = even more income for the households (through rent, wages and interest)….this
cycle of income continues.
 Financial intermediaries such as bank, insurance companies and mutual funds, help running this cycle
by acting as a ‘middleman’ between the households and firms.
 On one hand they accept money from households and on the other, they help firms get the necessary
investment via debt (loans, bonds) or equity (IPOs, shares). For more on Debt vs Equity, click me.
Thus the money system and circular flow of income leads to more jobs, more business, and more
economic growth. This is not possible under barter system.

What about Bitcoins?

In theory, Bitcoins savings can also turn into investment and thus the whole ‘circular flow of (Bitcoin)
income =possible. But it is full of problem at the moment:-

 In recent times, many people have entered in the Bitcoin game out of speculative purpose that “in
December 2013, one Bitcoin=1200$ so may be in 2014 one Bitcoin=worth 2000-3000$ and I’ll become
a crorepati in no time, if I somehow get hold of a few Bitcoins! “
 So they go to online Bitcoin exchange website, and give their fiat money savings (Rs. or $) to buy
Bitcoins and just wait-n-watch hoping that Bitcoin to Dollar exchange rate will rise in future. In a way,
this is same like hiding gold under your pillow and hoping that its price will rise in future.
 According to the critiques of Bitcoin, ^this is not turning savings into investment but mostly speculative
gambling.
 For the circular flow of income, you need the savings of a household becoming investments in business
firms. And for that you need financial intermediaries like banks, mutual funds and insurance companies.
 but recently People’s Bank of China (=Chinese RBI) has issued following notice:
“Bitcoin is a specific virtual merchandise, which does not have the same legal status as currency,
and cannot and should not be used as currency in circulation in the market.”
 Meaning Chinese financial intermediaries and businessmen are officially prohibited from accepting
Bitcoins and thus ‘circular flow’ of Bitcoins is stopped in real life.
 Ofcourse some entrepreneurs have started companies with crowd funded Bitcoins, but one or two
Cinderella stories doesn’t mean “Circular flow of income”.
 Besides, even if an entrepreneur manages to get ‘loan’ of Bitcoins to start a business, he’ll have to
convert some Bitcoins into fiat money (Rs/$) to pay for office-rent, electricity bill, wages to laborers etc.
 But since Bitcoin vs dollar exchange rate is so volatile, it is hard to determine a reasonable interest rate
that a businessman should pay back to the household or the financial intermediary (who lent the
Bitcoins.)
Recently Winklevoss Brothers (facebook fame; they claimed Mark Zukerberg stole their idea), anyways
these Winklevoss Brothers have launched a Bitcoin investment Trust. To put their mechanism crudely:

1. Junta gives dollars to Winklevosse brothers, gets shares in return.

2. Brothers convert those dollars in Bitcoins, and invest in Bitcoin related startup companies.
3. Those startup Companies make profit, return Bitcoins loans to Winklevosse brothers.
4. Brothers convert those Bitcoins in real dollars, and all the junta gets dividend according to the number of
shares owned by them. And if a person cannot wait for that long, he can also sell those shares to others
at the stock exchange.
 A NewYork based company SecondMarket Inc. also launched similar Bitcoin investment fund but aam-
juntaa (retail investors) are not allowed. Only institutional investors (such as pension funds) can invest
in their fund.
Overall, these things are yet to pick up the momentum similar to a rupee or dollar based sharemarket
and mutual investment funds.

However in a futuristic society, there may be financial intermediaries owned and operated by Artificial
intelligence (AI) outside the control of government and if Bitcoin is accepted as global currency, then
perhaps Bitcoin savings could really turn into a decent investment.
 Anyways, let’s update our table:

Fiat money
features barter Bitcoin
(Rs./$)
1. trade can happen without double
No Yes Yes, if both parties agree.
coincidence of wants?
Yes, but limited @the
2. Promotes division of Labour? Hardly yes
moment.
Not Yes but Yes and less limitations than
3. Divisible?
always limitations fiat money
Not
4. Fungible? Yes Yes, for now.
always
5. Possible to store value/wealth for a Not Yes, but volatile @the
Yes
long time? always moment.
6. Circular flow of income? Can savings Possible but difficult@the
Difficult easily possible
become investment? moment.
Continuing with our original topic: what are the limitations of barter system, why did people switch to
money system and how does Bitcoin fare on those parameters?

#7: Account-keeping = mission

impossible
 In a barter economy, If there are 1,000 different goods and services in the market, then the value of
each would have to be stated in terms of 999 others. = no meaningful accounting system is possible.
 A farmer may be able to keep track of his income, expense, profit and land revenue liability (Lagaan)
because he uses very few inputs and produce only one or two crops per year.
 But imagine the plight of the Samsung company. They use so many inputs- screws of various size and
shapes, precious metals, circuit boards, plastic, glass, paint and produce three dozen type of galaxy
smartphones+ the cost of their marketing, transport, service-centers..….it is impossible to keep track of
income, expenditure, profit and tax.
 And account keeping is not just for tax calculation. It is essential to measure your assets, liability and
revenue stream to make future business strategies accordingly.
 Another problem: If there are “n” tradable commodities products in a barter system, the total number
of MRPs will be [n(n-1)/2] (Think of the total handshake question under permutation- combination.)
 =difficult to run a ‘kirana’ store in a Barter village because you’ve to remember so many MRPs!
Money system solves these problems. You can express value of each and every item- no matter how big
or small -in terms of rupees/dollars/euros= thus, account keeping is easy as pie.

What about Bitcoins?

Account keeping easier in Bitcoin system than in Money system because,

Money system account keeping Bitcoin Account Keeping (BTC)

 Manual records have to be kept= inefficient, prone All transactions are digital / electronic in
to errors. nature.
 Even if you buy and sell everything using Credit  Bitcoins= electronic transactions= no
card/netbanking still rickshaw fare, wages to petty need to manually enter any records in
laborers etc. will have to paid in paper the paper account books.
currency=manual records need to be kept.  And you can utilize softwares that

 often you’ve to round off the figures e.g.
Rs15.40=>Rs.15/-. On a macro-scale it leads to a
considerable loss/gain.
 For example, if a bank rounds off interest rate of
Rs.15.40 to Rs.15= every savings account holder is
paid 40 paisaa less, if bank had one lakh account 
holders, it could save could save Rs.40,000 by just
rounding off=considerable loss to customers as a
whole.
automatically calculate income, expense,
profit etc.= more efficient, less chances
of mistakes, less harm to environment
than paper based account keeping.
No need to round off any figures. You
can even transfer 0.00006995
BTC. Recall smallest unit of Bitcoin is
Satoshi. 1 Satoshi=10-8 BTC
Thus, accurate calculation of transfer of
value, profit, loss, tax liability, interest
rate, depreciation etc. possible.

#8: Lack product specialization

In the barter system, buying/selling/trade can happen only when two parties want each other’s stuff.
So, to increase the chances of this ‘double coincidence of wants’, people only produce goods/services
that are likely to be “wanted” by a larger population.

UNDER MONEY SYSTEM UNDER BARTER SYSTEM

Procter & Gamble (P&G)- a
FMCG (Fast moving consumer
goods) type MNC.
 They produce “Tide” detergent First of all, an MNC like Procter and Gamble cannot exist
for lower middle class and middle in barter system because account keeping is a mission
class consumers. impossible.
 They produce “Ariel” detergent so, there will be many small players but all selling just one
for the upper middle and rich variety of washing powder and that too with average
class. quality because they can’t afford R&D for stain removal
 Within Ariel: they’ve separate technologies, new fragrances etc.
sub-brands for top-loading
washing machines and front
loading washing machines.
variety of toothpastes  Just plain white toothpaste. because the toothpaste maker
 Gel toothpastes for youth cannot risk to waste time in finding the target audience
(e.g.Closeup) who ‘wants’ his special toothpaste and who is ready to
 Special toothpastes for getting offer something in return that toothpaste maker ‘wants’.
your teeth whiter
 Special toothpaste for cold
sensitive teeth
 +Variety of mouthwashes and so
on.
 authors will produce many genres authors will only focus on comics, astrology, sms-jokes-
of fiction: comedy, crime, shaayari type of booklets.
detective, mystery, fantasy,  Because those are more likely to be ‘wanted’ by majority
horror, romance, sci-fi etc. of junta in exchange of rice, tomatoes and milk.
What about Bitcoins?
Bitcoin will promote product specialization to a whole new level of ‘smart’ products.
 Imagine a futuristic laptop -if it stops working because of warranty covered defects, then its ‘blackbox’
will send automatic distress signal to Mother Company. And equivalent amount of Bitcoins can be
automatically refunded to your digital wallet. =No headache of talking with service station employees.
 Variety self-service products. Imagine a 3D printer-robot. You can email it product design image, with a
pre-payment of xyz Bitcoins. It’ll automatically print the customized product for you and ship it @your
home.
 Variety of pay and use products. Imagine a futuristic shopping mall, you walk in & pickup xbox360 or
playstation but instead of paying 30-40 thousand rupees upfront, you bring it home, play as much as
you like and return back. Only the Bitcoins equivalent of playing hours will be cut from your digital
wallet. Same for cars, bikes etc. with microchips, that’ll only function if you pay Bitcoins.
Possibilities are limitless but let’s update our table.

Fiat money
features barter Bitcoin
(Rs./$)
1. trade can happen without double
No Yes Yes, if both parties agree.
coincidence of wants?
2. Promotes division of Labour? Hardly yes Yes, but limited @the moment.
Not Yes but upto Yes and more divisible than fiat
3. Divisible?
always 10-2 money. 1 Satoshi=10-8 BTC
Not
4. Fungible? Yes Yes, for now.
always
5. Possible to store value/wealth for a Not
Yes Yes, but volatile at the moment.
long time? always
6. Circular flow of income? Can easily
Difficult Possible but difficult@the moment.
savings become investment? possible
7. Account keeping difficult easy easier than fiat money.
8. Product specialization hardly yes even better than Fiat money
Continuing with our original topic: what are the limitations of barter system, why did people switch to
money system and how does Bitcoin fare on those parameters?

#9: Future contracts and

deferred payments
Deferred payment = you get the goods/ services right now, but pay for them in future. Example-
Monthly bill of newspaper, electricity, telephones.
 This is difficult under Barter system.

Sonu
(Orders a cup of tea)
Nigam
Chai-
How’ll you pay?
walla
Sonu
I’ll sing any song of your choice for two minutes.
Nigam
Sounds like a fair exchange. But I’m not in a mood of music at the moment. So, How
Chai-
about this: I give you tea right now but you perform that two minutes song, after two
walla
years, during my daughter’s wedding!
Sorry, I can’t accept that contract because:
1. during the wedding season, I can perform @some rich man’s reception and earn gold
Sonu
equivalent to 1000-2000 cups of tea.
Nigam
2. After two years, my own reputation would have increased and at that time 1 cup of tea
won’t even equal to ten seconds of my performance!
SECOND CASE

JK
Orders a cup of tea, offers two pages from her Harry potter book.
Rowling
Chai- well my son likes Harry potter series but two pages are useless, I want the entire
walla book.
JK ok, How about you serve me one cup of tea every morning for next 300 days, and
Rowling then I’ll give you the entire Harry Potter book!
Sorry madam, I cannot accept, because
1. Raw material- sugar, tea, milk, and kerosene- are becoming expensive every
month. Today, 1 tea=2 book pages but three months from now, 1 tea=3 pages
Chai- perhaps! So, I deserve the entire book, much before 300 days.
walla 2. In 300 days, you might release second part of that Harry Potter book series and in
the meantime, my son would have read the first part borrowing book from a friend.
3. Ultimately first part of novel will become useless. I cannot even sell it to others
because they will also want the latest part.
Similar problems when:

 Farmer offers to give his bullock as payment, after 2 years but value of bullock declines as it grows older
and weaker.
 Quality of wine improves with time. Value of art increases after the artist’s death and so on.
Thus, it is very difficult to make deferred payments under barter system because:

1. Contracts can happen only when both parties agree on which specific commodity to use for repayment.
(double coincidence of wants)
2. Both parties face the risk that the commodity to be repaid would increase or decrease seriously in value
over the duration of the contract.
3. Either party will dispute the method of calculating the exact increase/decrease in the value of a
commodity over time.
All this makes credit / lending / borrowing / deferred payments =almost impossible in bartering
economy except a few basic contracts like farmer borrows from money lender and agrees to give a part
in the wheat produced.
 But the advanced contracts on wages, salaries, interests, rents, and other prices extending over a period
of time= again mission impossible in a barter system.

Money system makes it possible because:

 Household savings =>investment. And household earns ‘interest’ on it (say ~4% in savings
account, ~9% in fixed deposit and ~11% in mutual funds per annum.)
 These interest-rates or “rate of return”, help us determine the ‘time value of money’ and hence makes it
easy to create future contracts and deferred payments.

Time value of money

Often you’ve seen the receptionist @coaching center say following:

1. Entire year’s fees is 10,000 rupees, you can pay it in five installments of two thousand each.
2. But if you want to pay entire sum right now, we’ll give you discount of Rs.500/-
So, why is she offering this ‘loss making’ proposition. Why is she ready to accept 9500 right now rather
than waiting for 10000 at the end of one year? The answer is: time value of money.

1. If they accept payment in ‘installment’, there is always ‘risk’ that you stop coming to class after 5-6
months and don’t pay the remaining fee installments.
2. You pay them 9500 right now, they put it in a fix deposit for 1 year @9% interest rate=> get
Rs.10384.29*. So even by accepting less than 10,000 right now, they’ll earn more than 10,000 in
future.
*under fixed deposits, Indian banks usually give compound interest rate at each quarter i.e. 9% is paid
@every 3 months.

Same concept works in following cases:

1. In Gujarati dining halls, if you buy coupons for entire month, they’ll either give you discount or a 5-10
additional coupons for free.
2. Magazines offer higher discounts if you subscribe for more years.
3. In DishTV/Tata sky, if you pay 6-months or entire year’s subscription at once, they’ll give you discount /
a few more channels for free.
Thus money system facilitates future contracts, deferred payments, debt obligations.

What about Bitcoins?

At present, it is difficult to estimate the time value of Bitcoin because

1. BTC to Dollar exchange rate is volatile and unpredictable. in First week of December 2013:
1BTC=~1200 USD but in Third week of December 1BTC=~580 USD.
2. Real life Banks don’t accept Bitcoins in savings account or Fixed deposits. China has imposed a specific
ban.
3. Of course there are some random website claiming to give interest on Bitcoins, lending out peer-to-peer
loans to small business etc. But they’re not time tested (for a period of 10-20 years). No guarantee, he’ll
shut down the server and run away to Nepal/Dubai after exchanging the Bitcoins to dollars when
exchange rate dramatically fluctuates.
But in a futuristic society, when more real-life trustworthy financial intermediaries accept Bitcoins as a
currency, then it’ll be possible to predict the time value of Bitcoins.

Bitcoins and Smart Contracts

As such, the Bitcoin system enables more ‘smarter’ contracts because of computer programing.
 You can have conditional-scripting capabilities. e.g. “IF Event “A” happens, Pay “B” number of Bitcoins to
Mr.”C”’s digital wallet on “D” date at HH:MM:ss time..”.

Thus, it possible to create smart contracts and deferred payments based on Bitcoin transactions. Future
applications are numerous for example:

under conventional money (currency) system under Bitcoin system

 Imagine a Tatasky set-top box with an
embedded microchip connected with your
digital Bitcoin wallet account.
 You paid Rs.300 to Tatasky, and under the This chip will monitor: what channels did you
contract, company is obliged to show you watch- and for how many hours, minutes and
150 channels for 30 days (=720 hours.) seconds?
  Then only corresponding amount of Bitcoins
But in reality, you will not be watching TV
for non-stop 720 hours. will be taken from your digital wallet. (and not
 most families just watch few specific shows for entire 30 days or 720 hours.)
between 7PM to 10PM.  The fact that you can pay any denomination –
even 0.00884 Bitcoins =makes this type of
conditional TV usage contract easy to
implement.
 You’ll be paying only for the service that you
 You’re overpaying for the services.
actually used.
Counter argument: what if a person hacks/tempers the set-top box so even if he watches for 100
hours, the chip will say on 10 hours watched? (Counter-counter argument: what if someone puts a
gun on his head and orders him to take out all money from ATM? Just because there is a possibility of
misuse doesn’t mean technology shouldn’t be used.)

under conventional money (currency) system under Bitcoin system

 Imagine vehicles have GPS-Bitcoin enabled
You sit in a rickshaw/taxi. Driver deliberately meter boxes. It’ll suggest driver the most
takes a longer route to destination. And / or economical route to destination (say 10kms
he tempers the meterbox in such way that worth 0.05 Bitcoins.).
you’ve to pay more fare than what you  Even he takes longer route, still the meterbox
actually travelled. will only debit the 0.05 Bitcoins from your
digital wallet.
Petrol pump owner gives you adulterated Vehicle fuel tank has Bitcoin enabled petrol-
petrol mixed with kerosense OR he tempers analyzer. It’ll measure both the quantity and
with instrument so even if meter says “1 quality of petrol and make payment
liter” while in reality only 950ml is accordingly from your digital wallet. If less
transferred. petrol is transferred then less payment.
Anyways let’s update our table:

features barter Fiat money (Rs,$) Bitcoin (BTC)

1. Trade can happen without
No Yes Yes, if both parties agree.
double coincidence of wants?
2. Promotes division of Labour? Hardly yes Yes, but limited @the moment.
Not Yes but limitations Yes and more divisible than fiat
3. Divisible?
always e.g. Rs14.05897 money (1Satoshi= 10-8 BTC)
4. Fungible? Not Yes Yes, for now.
 always
5. Possible to store value/wealth Not
Yes Yes, but volatile at the moment.
for a long time? always
6. Circular flow of income? Can Possible but difficult@the
Difficult easily possible
savings become investment? moment.
7. Account keeping Difficult easy Easier than Fiat money.
More possibilities than Fiat
8. Product specialization hardly yes
money.
9. Deferred Payment, Future More possibilities than Fiat
Difficult easy
contracts money.
In the next articles, we’ll see the functions of money, then evolution of money: from commodity money,
metallic money, fiduciary money, gold backed paper currency, fiat currency, bank money; and then
we’ll see how Bitcoins system works.

Mock Questions
Assertion reasoning instructions: Each of the following questions contain a set of Assertion (A) and
Reasoning (R) statements. Answer codes are as following:
a. Both the statements are individually true and Statement R is the correct explanation of Statement A
b. Both the statements are individually true but Statement R is not the correct explanation of Statement A
c. Statement A is true but Statement R is false
d. Statement A is false but Statement R is true
Question Statements:
1. (A) Money system is conducive for deferred payments. (R) In a barter system, cost of living generally
increases with time.
2. (A) Money system facilitates the circular flow of income more than the Barter system. (R) Presence of
financial intermediaries impedes the circular flow of money from households to business firms.
3. (A) In Money system, it is possible to store the value of labour for a long period of time. (R) It is easier
to maintain accounts and ledgers in a Money system than in Barter system.
Direct MCQs
4. inflation will not erode the value of your savings, IF
a. If You invest it in Bitcoins
b. If You invest it in inflation indexed bonds.
c. If You invest it in a fixed deposit.
d. None of above.
5. Barter system could have continued to function successfully, IF
a. If majority of the people remained illiterate.
b. If Computers were used for maintaining accounts and display boards for barter trades, to facilitate the
meeting between parties with double coincidence of wants.
c. If the needs of society were limited to only bare essential food, clothing and shelter.
d. If empires were governed on communist principles.
6. What do you understand by term “Circular flow of income”?
a. For every flow of factor service from businessfirms to households, there is counter flow of rent, wages,
interest and profit from households to businessfirms.
b. For every flow of factor service from households to businessfirms, there is counter flow of rent, wages,
interest and profit from businessfirms to households.
c. Households provide rent, wages, interest and profit to financial intermediaries, who in turn give it to
business firms.
d. It is the theoretical mechanism that prevents the concentration of wealth in the hands of few.
Q7. IF _______, then it’d would facilitate the circular flow of income through Bitcoins.
1. if Bitcoin became a fiat currency
2. If more financial intermediaries accepted Bitcoins.
3. If the mathematical algorithm was changed to release more Bitcoins in the system.
Answer choice:

A. only 1 and 2
B. only 2 and 3
C. only 1 and 3
D. All 1, 2 and 3
Q8. Which of the following, make(s) Bitcoins a superior system than Indian Rupee system
1. Theoretically, it is possible to maintain accounts more efficiently and accurately in a Bitcoin system than
in rupee system.
2. Bitcoin to US Dollar exchange rate is more stable than Indian Rupee to Dollar exchange rate.
3. At present, it is easier to calculate time value of money in the Bitcoin system than in Rupee system.
Answer choice:

A. Only 1 and 2
B. Only 2 and 3
C. Only 1
D. None of above
Q9. What do you understand by the term “Time Value of Money”?
1. That inflation erodes the value of money.
2. That money today is more valuable than the same amount of money in future.
3. That any amount of money is worth more, the sooner it is received.
Answer choices

A. Only 1 and 2
B. Only 2
C. Only 2 and 3
D. All of them
Aptitude questions for timepass:
Assume that interest rate is 7% compounded annually, which of the following is a better deal?

1. (A) Accept 100 rupees right now OR (B) Accept 200 after 10 years.
2. (A) Accept Rs.50,000 per year for next 20 years OR (B) Accept Rs.40,000 right now.
For more on Economy, Visit Mrunal.org/Economy
 [Economy] Money-Bitcoin: Functions of Money, Exchange Medium, Transfer
Value-NEFT-RTGS-Bitcoins, Money Illusion, Overcapitalization (Part 3)
Posted ByMrunalOn 26/12/2013 @ 10:50 pm In Economy | 34 Comments
1. Prologue
2. Money: functions
1. Primary functions of money
1. #P1: As a medium of exchange
2. #P2: As a measure of value
2. Secondary Functions / Derivative functions
1. #S1: As a store of value
2. #S2: Transfer of Value / Purchasing Power
1. Transfer of Value in Bitcoin System
2. Transfer of Value: NEFT vs RTGS vs Bitcoin
3. #S3: as a standard of deferred payment
3. Contingent Functions
1. #C1: Basis of Credit
2. #C2: Distribution of National Income
3. #C3: Equalizes Marginal utility of Expenditure
4. Other functions/utilities
3. Money limitations/drawbacks
1. #1: Inflation & Deflation
2. #2: Money illusion
3. #3: Price stickness
4. Bitcoins vs Money illusion
5. #4: Overcapitalization
4. Mock Questions

Prologue
Before proceeding further, make sure you’ve read earlier two parts in this series:

1. Barter-Money-Bitcoin: Fungibility, Double coincidence of wants, division of labour (Part 1)

2. Barter-Money-Bitcoin: Circular Flow of Income, Savings to Investment, Time Value of Money, Deferred
Payments (Part 2)
From those two articles, we concluded that both Money system (and Bitcoin system) are superior to
Barter system. So now Barter system is out of equation.

 Now, only two contenders remain: Money vs Bitcoins.

 In this article, we’ll see the functions and limitations of money-system. Of course everyone knows the
function of money= you need money to buy stuff- that is common sense. But to solve theory based
MCQs, particularly for UPSC and RBI exams, a bit more refined understanding is necessary.
 In the upcoming articles after this, we’ll look at the evolution of money (commodity money, metallic
money, fiduciary money, gold backed paper currency, fiat currency, bank money.)
 And then we’ll see how Bitcoins system works, its own benefits and limitation.

Money: functions
 From the discussion so far, we’ve learned that Money was invented to overcome the limitations of barter
system. Overall, money serves following functions:

1. A Medium of Exchange
Primary functions
2. A measure of Value
Derivative functions 1. A Store of Value
 Derived from the primary functions. 2. Transfer of Value
 also called Secondary functions 3. A Standard of Deferred Payments
Contingent Functions 1. Basis of Credit
 they arise because of the stage of economic life we live2. Income distribution
in. 3. Equalize Marginal utility
Let’s check these functions and how Bitcoin fares on these parameters.

Primary functions of money

If a given thing cannot perform the primary functions, we cannot call it money. If something wants to
call itself “money” then it must ALWAYS perform following two functions, irrespective of time and place.

#P1: As a medium of exchange

 Money is the medium through which goods and services are traded.
 Money provides ‘freedom of choice’ in purchase. You don’t need ‘double coincidence of wants’. Vijay
Mallya can send his son to any coaching class, irrespective of the fact whether “sir” drinks beer or not.
 But to become the ‘medium of exchange’, money must meet following conditions:

Condition Fiat Currency (Rs. $) Bitcoin

Not yet. Since Bitcoin is not issued by
government, most people don’t trust
yes because it is issued by the it.You already know how Chinese RBI
1. Readily
government (or its (People’s bank of China) has issued
acceptable.
Central Bank) warning against use of Bitcoins.
Similarly, a day before Christmas,
even Indian RBI issued warning against
 Bitcoin use (click me to read the press
statement).
Even more durable than paper currency.
yes (unless someone burns or
2. Durability (Unless someone shuts down the entire
tears it apart)
internet.)
Yes, even illiterate people can
Less. Because illiterate cannot recognize
recognize and differentiate
it. Even a literate person will require
3. Cognizable between currency notes based
computer, special software and internet to
on their dimension, color and
recognize & use Bitcoin.
images.
4. Easily Divisible Yes Even more.
5. Fungible Yes Yes, for now.
Hard but not impossible. ISI Bitcoins are created by crypto-currency
6. Hard to even runs PG Diploma course in mathematical algorithm= Harder to
counterfeit? how to counterfeit Indian counterfeit, but not impossible once the
currency. Quantam Computers are invented.
Answer is both yes and no.
1. Yes because Bitcoin is a digital currency,
can be used via mobile, tablet, laptop etc.
as long as you know the password (private
7. Easy to carry /
yes key.)
Portable
2. No, because Bitcoin system cannot work
without electricity, internet connection.
It’ll not work if you forget the password
(private key).
As you can see, Bitcoin doesn’t fully meet the all the conditions. Therefore,

1. Bitcoin =less reliable “Medium of exchange” at the moment.

2. And since Bitcoin is less unreliable “medium of exchange” => therefore, Bitcoin sucks at all the
remaining primary, secondary and contingent functions of money e.g. deferred payment, storing wealth,
distributing income etc. (atleast for now)

#P2: As a measure of value

Length centimeter, meter
Weight gram, kilogram
Value Of Goods n Services Rupee, dollar or any other currency.
 Money serves a “measure” or “unit” by which, we can measure the value of goods and services.
 This also helps comparing between various goods and services.
Money’s function as “a measure/unit of value”, helps in following ways:

1. To compare two products more rationally e.g which car is more fuel efficient, which refrigerator is more
energy efficient and so on.
2. To maintain accounts, keep track of income, expense, rents, wages, interest, profit, loss, tax liabilities.
3. To measure the GDP of every country: Within that, how much is coming from primary, secondary and
tertiary activities.
4. To Measure income distribution among various families, to find the impact of welfare policies, labor laws
etc. and amend policies/acts/schemes/subsidies accordingly.
What about Bitcoin?
 Yes, possible to measure value of everything in Bitcoin
 Theoretically, accounting keeping even more efficient in Bitcoin than in fiat currency, as we saw in
Article Part II.
 But difficult at the moment because (1) Bitcoins are not readily accepted. (2) exchange rate volatile.

Secondary Functions /
Derivative functions
These are functions/utilities derived from the primary functions of money viz. (1) Medium of exchange
(2) Measure of Value.

#S1: As a store of value

 Money= medium of exchange, measure of value, durable, takes little space, most liquid among all
assets, readily accepted=> hence money is a reliable store of value.
 When you store money, you’re storing the “value” of your labor spent in production of any goods /
services.
 This is also called “asset function” of money.
What about Bitcoin?
 Yes in theory, it is possible to store value in Bitcoin, but it is full of problems, as we saw in Part II.
 And if you think from another angle: why is Bitcoin not a reliable store of value? Answer: Because
Bitcoin is not fully serving the two primary functions of money viz. (1) Medium of Exchange (2)
Measure of value.

#S2: Transfer of Value / Purchasing Power

 Money takes little space + durable =>cost of transporting money is very less (compared to sending that
much “value” payment in form of wheat or sugarcane in a barter economy).
 Earlier, in barter system, most trading activities were confined within village or tehsil because of the
value-transfer problem over long distance.
 But now, with Money + Modern banking system = interstate and international trade possible.
 A trader in Tamilnadu can order Apples from Himachal and pay via cheque, money order, bank draft,
credit card, netbanking etc. and that too without meeting the seller face to face.
 Thus, the transfer value of money, has extended the radius within which we can perform trade.

Transfer of Value in Bitcoin System

Similar to email exchange, but with slight modification.

EMAIL TRANSFER BITCOIN TRANSFER

You need an email account You need a digital wallet /e-wallet.
Your email account has a unique Your digital wallet has unique public address. For example:
address <raja@gmail.com> “17c9gwurQ41noaNoMyb9QDjVfDvceTP5SD”
In the email client (e.g.Outlook),
you enter recipient’s email in the Digital wallet software, you enter recipient’s public
address, subject and body. Hit address, amount of BTC to send and hit “send” button and
“Send” button and message is money is sent.
sent.
The “central authority” (Google)
 Bitcoin system doesn’t have a central authority.
will monitor and validate such But there is an electronic public ledger called “Block
email exchanges. Chain”.
 When did the email originate? This blockchain contains record of every transaction ever
(DD:HH:MM:ss); processed, allowing a user’s computer to verify the validity
 From where did the email of each transaction.
originate? (IP Address);
 To whom it was sent?
(To,CC,BCC)
  Double spending not possible.
Raja can forward the same email
to any number of contacts.  Each transaction is cross-verified with that public ledger
 In other words, “Double (Blockchain).
sending” possible.  Raja cannot ‘forward’ the same bitcoin to two people.
 Email is delivered within  Double-spend Verification process can take upto ten
seconds. minutes.
Lost/Forgotten password can be
Not possible.
recovered.
so, in theory, yes it is possible to transfer value using Bitcoins.

Transfer of Value: NEFT vs RTGS vs Bitcoin

 NEFT and RTGS are two facilities offered by RBI.
 They help transfer money using internet from one bank account to another.

RTGS: Real Time Gross NEFT: National Electronic Fund

Bitcoin
Settlement Transfer
Processing fees between 25-
Processing fees: 2.50-25 rupees No such processing fees or
55 rupees.
(includes SERVICE TAX) service tax.*
(includes SERVICE TAX)
Net Transfers at interval of “1

hour” cycles. Instant transfer like
Money transferred instantly.
 Meaning, if you send money email.but ‘double spend
Just like email from one
@9.15AM then it’ll reflect in verification’ can take upto
account to another.
recipients account @ next interval 10 minutes.
i.e. @10AM.
 Weekdays: 9 to 4:30PM  **Weekdays: 8AM to 6:30PM Round the clock, 24/7. also
 Saturday: 9 to 1:30PM  Saturday: 8AM to 12:30PM works on holidays.
Centralized monitoring by RBI It’s a decentralized system.
Only need the “public
 You need recipients (1) Bank account number and (2) Bank
address” of recipient’s
Branch code (IFSC).**
digital wallet.
Anyone can open a digital
Both sender and receiver must have bank account.= must meet wallet account. You don’t
“KYC norms” even need an email address.
Even a Robot / AI can open.
Ceilings on Money transfer:SBI Retail Banking: NEFT Rs.0 to
2 lakhs; RTGS: 2 lakh to 5 lakh. No such ceilings.
Higher limits for corporate banking.

*this is one of the reasons why Banks hate Bitcoins because they can’t earn commission on money
transfer- like in traditional netbanking and credit card.

** IFSC or Indian Financial System Code is an alpha-numeric code that uniquely identifies a bank-
branch participating in the NEFT system.
 #S3: as a standard of deferred payment
 Deferred payment = when you buy a goods/services right now but promise to pay at future date. e.g car
on EMI
 Money=ideal store of value, it is durable, divisible, has greater acceptability. And we already learned
about the ‘time value of money’. Hence:
1. Money makes borrowing and lending less risky.
2. Money can be used as a standard of deferred payment / future transection.
What about Bitcoins? Yes in theory, Bitcoin can serve as a standard of deferred payments, as we saw
in Part II.
But at the moment it is full of problems because Bitcoin is not fully serving the primary functions
viz. (Medium Exchange + Measure of Value)

Contingent Functions
#C1: Basis of Credit
 Today, majority of business activities are done on credit.
 Households save money in bank=> bank lends it to business firms.
 Even the other credit instruments like cheque, drafts, credit card, promissory notes are also backed by
money.
 Banks could never create this ‘credit / loan’ if Households did not provide the money. and IF money did
not serve the earlier primary and secondary functions.
What about Bitcoins? Same answer as earlier. Possible in theory, but difficult at the moment.
(because Bitcoin is not fully serving the two primary functions of money).

#C2: Distribution of National Income

 Producing even a single toothpaste requires joint effort of many- from the chemist who designs the
formula, to laborer who pours ingredients in the assembly line, to the engineer who handles the
machines, to the manager who supervises over all them and so on….
 In a barter system, difficult to determine the how much each of them should earn from the total
production.
 But money’s primary function =”measure of value”. Makes it possible to determine the share of
individual worker in the total production and pay him accordingly.
 Anyone who provides any of the four factors of production (land, labour, capital, entrepreneurship) =he
will earn money (as rent, wage, interest or profit) = less chances of exploitation (compared to the Barter
system, feudal times, Zamindari bonded labours.)
 Thus, money helps in distribution of income among various factors of production.
What about Bitcoins? Same answer as earlier. Possible in theory, but difficult at the moment.
(because Bitcoin is not fully serving the two primary functions of money).

#C3: Equalizes Marginal utility of

Expenditure
 Diminishing Marginal utility= the more we have of one item, every new additional unit gives less
satisfaction.
 For example: A farmer grows sugarcane- first few kilos he can use for himself and his family.
 But they’ll get tired chewing sugarcane for lunch, dinner and breakfast every day. So, each new kilo of
sugarcane brings them less satisfaction.
 At some point, they’ll get so fed-up with the sweet taste, they’ll just want to throw away all the
sugarcanes.
 Under barter system, this could lead to distress sale:- farmer ready to exchange 100 kilos sugar just for
few grams of chilli powder because for him:-
o marginal utility of sugarcane= zero or even negative
o marginal utility of chilli powder = high.
Money system solves this problem:

 Money = measure of value = helps the consumer to measure the marginal utilities of the commodities
based on their price-tags = he can spend money such that each unit of money spent bring him goods of
same marginal utility.
 In our case, farmer could sell the sugarcanes to sugarmill owner then use the money @local kirana-store
to purchase
o just enough sugar for making tea (marginal utility of sugar=high)
o just enough chili-power for cooking daal-sabji etc. (marginal utility of chilli=high)
 Money facilitates the consumer to equalize the marginal utilities obtainable from different commodities =
opportunity to get “maximum satisfaction” from each purchase.
What about Bitcoins? Same answer as earlier. Possible in theory, but difficult at the moment.
(because Bitcoin is not fully serving the two primary functions of money).

Other functions/utilities
Gives liquidity to Capital
 Money is the most liquid asset among all assets. You can easy convert money into any type of asset
according to your needs. If your hotel is not running fine, sell it and use the money to setup a shopping
mall.
 If a mutual fund manager is not giving best return on your investment, ditch him and invest money
somewhere else.
 Because of this ‘liquid’ quality of money=> capital is transferred from less productive areas to more
productive areas.
 In a barter system, sick firms will continue to run sickly. But money system will kill them and transfer
the capital to more productive firms of the economy.

Tool to measure aukaat:

 In a Barter economy, Mallya could impress other business parties through his lavish lifestyle and media
image. So, even if his company was making losses, he was on a verge of #epic-business-fail, he could
still make new business deals to his advantage.
 This is not possible in money system. Before merge-acquisition-partnership, the other party will demand
to see your account books, assets, liabilities, bank balance, everything.
 Recall money’s primary function “measure of value”= can easily find if give firm is solvent or bankrupt.
Money as a tool of Social empowerment
 In barter system, all the power was concentrated in the hands of rural elites, Zamindar, Feudal lords
who owned land and cattle.
 Money system creates more jobs, and provides more opportunities to Women/SC/ST/OBC/PH. A
person’s status is no longer tied to caste/race/religion/gender/appearance but to his ability to earn
money.
Other functions that we already saw:

1. Money Promotes division of labor => higher production.

2. Money turns savings into investments (through circular flow of money.) Thus, both households and
business firms benefit from each other.
 Money limitations/drawbacks
So far we only learned the positive things about money. Now let’s check some negative aspects:

#1: Inflation & Deflation

 Overprinting / Excessive supply of money without increase in production of goods and
services=> inflation (prices increased)
 Excessive fall in the supply of money= money becomes ‘dear’, borrowing cost increases=production
level declines=> deflation (prices fall down).
in a separate article later, we’ll see issue of inflation/deflation with respect to money supply in Fiat
currency vs Bitcoin. Otherwise the current article will become too long. So, let’s move on to next
limitation of money:

#2: Money illusion

For money, real value and face value is not always the same.

Face value of money Real value money

Face value is what is written on the Real value of money= how much can it ‘really’ buy?
piece of currency paper. What is the purchasing power of money?
A fifty rupee note Can fifty rupee note buy you a litre of petrol?
 Reads “50” in 2008  Ans. Yes (in 2008)
 Reads “50” even in 2013.  Ans. No (in 2013)
Money illusion comes when people start valuing their wealth in terms of ‘face value’ of money rather
than on ‘real value’ of money. For example:

 2008: A worker’s monthly salary was Rs.5,000 and at that time, cost of one litre petrol was Rs.50
 2013: factory owner hikes the worker’s salary to Rs.7000. Worker get really happy. But the cost of one
liter petrol has rose to Rs.70-80 and similarly prices of all essential commodities have increased.
Worker’s real purchasing power hasn’t increased. But he’s happy, because he is suffering from money
illusion.
 2014: suppose petrol price goes down to Rs.50 again and similarly prices of all essential commodities
have gone down to the 2008’s level. BUT if now factory owner tries to decrease the salary of worker
back to Rs.5000=> workers’ morale will go down, they’ll protest-strike-dharnaa-pradarshan-
gherao. Because they’re suffering from money illusion.

Why is this money illusion a bad thing?

 Most insurance/Mutual Funds/child-plan-investment companies fool their customers.……after 10 years
your money will double……if you deposit 10 rupees per day in our scheme, then after twenty years you’ll
get 50 lakh rupees and you child’s future is secured.
 But often, such money-return calculations are not linked with inflation. 50 lakh is a big amount right now
but after 20 years, you can’t even buy a one room-kitchen apartment with it even in city.
 All private companies fool their employees by hiking the salary at a rate less than the inflation rate.
 Most contracts are not linked objectively with ‘real value of money’ or inflation. Consider house leasing
agreement. Suppose you live in a rented house that cost Rs.7000 per month. Next year, you can be
damn sure the landlord will demand higher rent arbitrarily without considering the overall rise or fall in
the wages/inflation rates for service class employees in the given city.
 Media and political parties confuse the face value of money with real value of money. Lot of hype is
created even when price of petrol goes up or down by 1-2 rupees. Hence government will withhold the
price hike before state-elections. This type of election-centric economic policies hurt in long term.
 Election commission will not allow political parties to spend more money on campaign, with respect to
the food and fuel inflation. While the crook politicians will still spend crores, the honest politicians suffer
because they’ve to stick to the official limit on expenditure.
 And more importantly, Money illusion causes price stickness.

#3: Price stickness

 It is the tendency of prices to remain sticky (same), irrespective of whether the cost of production has
increased or decreased. for example:
Chocolate business and Price stickness:
 Most of the chocolates cost 50 paisa to 1 rupee. This was the MRP in 2001, and hasn’t changed even
now in 2013, while the sugar price, cocoa beans and transportation cost has skyrocketed. So, ideally,
price of chocolates/peppermints should also increase.
 But since chocolate is a non-essential commodity, business is highly competitive, and customers suffer
from money illusion=> no firm can dare to raise the MRP of chocolates. This price stickness leads to
many negative consequences:
1. Adulteration, using cheap but harmful colors and artificial sweeteners to keep to production cost down.
2. tax evasion to keep the profit levels same.
3. Laying off workers to reduce the cost of operation.
Airline industry and Price stickness:
 Airline business is highly competitive, so even when aviation fuel becomes more expensive, even if
government doesn’t reduce taxes on it, still the airlines cannot increase the ticket prices much.
 Besides even when Air-India makes losses, government will save them, so Air India won’t hike the ticket
prices, and if private airlines want to remain in business, they’ll have to sell tickets at that same or lower
price rate than AirIndia.
 Thus, all airlines are bleeding dry and making losses.
 The extreme manifestation of this price stickness =Kingfisher airline’s #epicfail, staff doesn’t get salary
even for Diwali.

Bitcoins vs Money illusion

 Money illusion (and price stickness) comes when people confuse face value of money with real
value (purchasing power) of money.
 Real value of bitcoin=how much petrol, pizza or desi-liquor can you really buy using bitcoins? That will
keep changing as per the laws of supply and demand.
 Besides, most of the shops don’t accept bitcoins. so, even if you earn in Bitcoins, at some point you’ll
have to get it converted to a fiat currency (like rupee, dollar, euro, yen or Yuan) to purchase daily
necessities.
 But since fiat currency has the problem of money illusion and price stickiness, therefore, bitcoin will
indirectly have the same.

#4: Overcapitalization
 As we saw earlier, money system facilitates savings to become investments, and the whole ‘circular flow
of income’. But this blessing also becomes a curse during ‘overcapitalization’.
 Overcapitalization= A company has more capital than what is optimally required production of goods
and services.
Ok but why is it bad? Recall There are two ways to raise capital: Debt vs Equity.
Case #1: Imagine an Overcapitalized Company setup entirely on equity (shares). But and on each of
these shares, company has to pay dividend. As a result
1. Individual shareholder’s ‘share’ in profit declines, because company is not fully utilizing the capital.
(Imagine a person with Rs.5000 salary and 50 kids: how much food will be there in every plate?)
2. Hence the market value of these shares decline = shareholder cannot even profitably sell them to a third
party and ‘exit’ from the game.
What’s the solution: company should buyback some of the shares from shareholders.
Case #2: Imagine an Overcapitalized company setup entirely through debt (loans/bonds). But on such
debt, Company has to pay interest regularly, as a result:
1. Company has to raise the MRP of its products to raise the profit levels=>loses in price war with rival
companies.
2. If company tries to cut down wages to raise profit=>labour unrest.
3. So save costs, company may postpone repair and service of machinery => risk of industrial accident and
other long term problems.
4. Company starts manipulating account books, borrows more debt to pay previous debt- gets stuck in this
cycle.
Overall
1. Overcapitalized company’s capital is not effectively utilized = constant decline in earnings.
2. And since capital = finite + scare=> Overcapitalization in one company, also starves other efficient
companies in the market from necessary capital.
What about Bitcoins? Well companies in bitcoin system can also suffer from overcapitalization, if idiots
or crooks are running the company.

Money as the root of all evil

 And finally the most negative thing about money: that money is considered the root of all evils- theft,
robbery, frauds, embezzlement, corruption, buying votes through money, the rising divide between
India and Bharat, labour exploitation, prostitution, drug-trafficking, hoarding and all other moral, social
and political evils.
 But even if we were living in a barter system, it is unlikely that Raja or Kalmadi would have been honest
men.
 Infact, peasants were more oppressed by kings and nobility during Barter system. So money is not the
root of all evil. Greed/Desire/Lust= root of all evil.

Mock Questions
1. In a modern economy, trade can happen without double coincidence of wants. This is possible
because, _____.
a. Money is a store of value.
b. Money is a medium of exchange
c. money is a measure of value
d. money is a standard of deferred payment
2. When a debtors makes a promise to pay on some future date, Money is serving the function
as a _____ .
a. store of value.
b. medium of exchange
c. measure of value
d. standard of deferred payment
3. What is/are the primary function(s) of money?
a. Money is a medium of exchange
b. money is a measure of value
c. Both A and B
d. Neither A nor B
4. Incorrect statement(s)
a. Money equalizes the marginal utility of various goods.
b. Money guarantees liquidity to all types of wealth.
c. Both A and B
d. Neither A nor B
5. What do you understand by the term “Price Stickness”?
a. A trader refusing to give discount on MRP, even if his competitors are giving discounts.
b. The graphs of the price of a commodity and the graph of inflation will run parallel, as if inflation and
prices were stuck together by an invisible bond.
c. Price persistence of a good or service despite changes in broad economic conditions.
d. None of Above
6. A person is said to suffering from Money illusion, when he _____ .
a. Invests in bitcoins and other virtual currencies.
b. Measures his wealth on face value of money.
c. Measures his wealth on real value of money.
d. None of above.
7. Efficient Functioning of Bitcoin rests on a system called “Blockchain”. What do you
understand by the term blockchain?
a. It is the private key that User needs to open his digital wallet.
b. It is the public address of user’s digital wallet account.
c. It is a public ledger that keeps record of all bitcoin transactions.
d. None of above.
8. Which of the following factors make Bitcoin system far superior than Rupee system?
a. Bitcoin’s face value and real value is same.
b. In Bitcoin system, the prices of all goods and services always move in tandem with the laws of supply
and demand and broad conditions of economy.
c. Both A and B
d. Neither A nor B
Assertion-Reasoning type MCQs
Assertion reasoning instructions: Each of the following questions contain a set of Assertion (A) and
Reasoning (R) statements. Use appropriate Answer codes from following:
A. Both A and R correct and R is the correct explanation for A
B. Both A and R correct but R is not the correct explanation for A
C. A is correct but R is wrong
D. A is wrong but R is correct
Question sets:
9. (A) In a modern economy, trade can happen without double coincidence of wants (R) Money functions a
unit to measure the value of all goods and services.
10. (A) A worker will feel happy even if his pay increase merely brings his real wage in line with rising
prices. (R) Most workers suffer from money illusion.
11. (A) Money system is more efficient in the distribution of income than Barter system. (R) Money
equalizes the marginal utility of various goods and services.
12. (A) Money increases the mobility of capital. (R) Money is the most liquid asset among all assets.
Q13. What are the secondary functions of money?
1. Money is a store of value.
2. Money is a medium of exchange
3. money is a measure of value
4. money is a standard of deferred payment
choice

A. only 1 and 2
B. only 2 and 3
C. only 1 and 4
D. only 3 and 4
Q14. What do you understand by the term “Money Illusion”?
1. It is the strategy used by MLM (Multi level marketing) schemes to attract gullible investors.
2. That most people focus more on the amount of money they possess rather than what is actual worth of
that money.
3. That money today is more valuable than the same amount of money in future.
Answer choices

A. Only 1 and 2
B. Only 2
C. Only 2 and 3
D. All of them
Q15. How is RTGS similar to Bitcoin system?
1. RTGS Works on 24/7 basis just like Bitcoin transfer.
2. RTGS doesn’t attract service tax just like Bitcoin transfer.
3. RTGS Can be used to transfer any amount of money just like Bitcoin transfer.
Choice:

A. Only 1 and 2
B. Only 1 and 3
C. Only 2 and 3
D. None of above.
Q16. Bitcoin could be used as a store of value / wealth, IF ____.
1. Everyone accepted Bitcoin as a medium of exchange.
2. Bitcoin did not have the lag of 10 minutes per transaction.
3. Everyone accepted Bitcoin as a measure of value.
4. Its algorithm allowed recovery of lost/forgotten passwords.
Choice:

A. Only 1 and 2
B. Only 2 and 3
C. Only 1 and 3
D. Only 1 and 4
Q17. A Bitcoin system is immune from
1. Price stickness
2. Overcapitalization
3. Money illusion
Answer choices
A. Only 1 and 2
B. Only 1 and 3
C. Only 2 and 3
D. None of above.
Visit Mrunal.org/Economy For more on Economy.