Meaning and Functions of Money

Meaning of Money

Money is a thing that is commonly accepted as a medium of exchange. It is an instrument that serves as a medium of exchange, a measure of value, a store of value, and a standard for deferred payments.


What is Barter System?

The barter system is a system where goods were exchanged for goods in the olden days. The sale and purchase of goods occur at the same time, and their value also remains equal at that point. After the money came into existence, a person could purchase or sell goods with cash without selling or purchasing any goods at that point. Thus, the act of purchase and sale was separated.

Difficulties of Barter System

  • Lack of double coincidence of wants: A person with a particular good has to find a person who has the good of his wants and he should also possess the wanted good of the other person. Hence, the exchange of goods is not possible without the double coincidence of wants.
  • Lack of store of value: Wealth is stored in terms of goods as there was no money in existence, storage of goods cost, loss of value and movement of transfer. Hence, it is not practically possible to store people’s purchasing power.
  • Lack of divisibility: All types of goods cannot be divided and subdivided. In the absence of a common medium of exchange, a problem arises when a big indivisible commodity is to be exchanged for a smaller commodity.
  • Lack of deferred payment: Money has made deferred payments easier. When money is borrowed, the principal and interest amounts have to be returned to the lender. However, these transactions are not possible in goods and services.
  • The problem of storing wealth: In the absence of money, individuals have to store wealth. The value of stored commodities may change in the due course of time. Storing a particular good for a longer period is more expensive.

Evolution of Money

The evolution of money has passed through various stages with time, place, and circumstances.

  • Commodity money: Various commodities used as money is known as commodity money. It is the most primitive form of it. However, certain problems such as improper standardization, indivisibility and storage difficulty made this form of it an unsuitable medium of exchange.
  • Metallic money: Mono-metallism and bi-metallism, i.e. valuable metals such as gold and silver, were used as a medium of exchange. As society progressed, different sections of people agreed to consider some precious metals as a common medium of exchange. The gold coin was introduced in India by King Kanishka of the Kushan Dynasty during the first century AD.
  • Paper money: The paper currency system is a system where coins and currency notes are used as a medium of exchange. For example, rupee notes and coins are legal tenders.
  • Bank money: At the final stage of its evolution of it, demand deposits with commercial banks are considered bank money. Demand deposits are current account deposits with banks or other financial institutions which are payable on demand by cheques. Thus, cheques drawn on the demand deposits of commercial banks can be used as a medium of exchange.

Narrow and Broad Definitions of Money

Currency, demand and time deposits in commercial banks and other types of deposits are the total amount of money in an economy. The definition of supply of money varies depending on the components which are included and excluded.

Narrow definition of Money

M1 = Currency with the public + demand deposits with the commercial banks + deposits kept by commercial banks with the Reserve Bank M1 = C + DD + OD

Broad definition of Money

M2 = M1 + Savings deposits with post office savings banks

M3 = M2 + Term deposits in commercial banks

M4 = M3 + Savings with the post office other than in the form of National Saving Certificates

Demand deposits are current account deposits with banks or other financial institutions that are payable on demand by cheques. Banks do not provide interest payments on deposits.

Time deposits are fixed-term deposits with a fixed maturity period and their term of deposit varying from 7 days to 10 years. These deposits cannot avail the benefits of issuing cheques against them and cannot be payable on demand, but time deposits can avail interest towards the deposited amount.

Features of Money

  • General acceptability: It should be accepted by people freely in exchange for goods and services.
  • Divisibility: It should be easily divisible into smaller parts to facilitate the transaction more easily.
  • Durability: Currency notes and coins are used repeatedly and continue for many years.
  • Cognisability: It must be easily recognized and have certain distinct marks to avoid confusion by the receiving person.
  • Portability: It can be transferred easily from one place to another at a lot.
  • Homogeneity: Various units of it must be homogeneous in quality.
  • Stability: It should be stable in value to serve as a measure of value.

Functions of Money

Primary Functions of Money

  • It acts as a medium of exchange. The major function of money is to facilitate the process of exchange by removing the defects of the barter system.
  • It is the measure of value. It is the monetary expression of the market value of goods and services.

Secondary Functions of Money

  • Standard of deferred payments: Deferred payments refer to those payments which are made in the future. Money has made deferred payments easier. When money is borrowed, the principal and interest amounts have to be returned to the lender. However, these transactions are not possible in goods and services. Money performs this function more effectively.
  • Store of value: People keep their wealth in the form of money because it is the most liquid form of wealth. Savings in the form of money is maintained for purchasing commodities with savings in the future. In this case, the values of commodities are stored. Hence, it acts as a store of value.
  • Transfer of value: It is also a means of transferring a given value from one person to another. If any person purchases a commodity, then the value of that commodity can easily be transferred from the buyer to the seller through a payment in terms of money.

Contingent Functions of Money

  • Assisting production decisions: The producers have to decide the number of factors of production to make their profit. They have to make factor payments to those factors of production in terms of money. Thus, the money prices of those factors help the producer to make necessary decisions.
  • Assisting consumption decisions: The consumption of the consumer depends on the income level and money prices of the commodities in the market. Thus, the income of the consumer and money prices of the commodities influence the consumption decision of individuals.
  • Assisting distribution of national income: The owners of various factors of production sell their factors at market prices. They receive money from wages, interest, rent and profits as factor incomes. All these incomes constitute the national income of a country. Hence, the distributions of national income among the owners of different factors are determined by the money prices of those factors.
  • Assisting the operation of a credit system: It forms the basis of credit operations performed by the business and financial institutions in a country.

Importance of Money

When there is a development of an economy, there is an abnormal increase in economic transactions. As money is generally acceptable, it is essential as a medium of exchange. It is considered a dynamic factor because of the following reasons:

  • It facilitates exchange beyond limits.
  • It facilitates the accumulation of wealth for the purpose of investment.
  • It facilitates the flow of capital from one place to another within and outside countries.
  • It helps in economic stability and promotes the growth of the nation

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