Money: Meaning, Functions and Role

Read this essay to learn about the meaning, functions and role of money.
Meaning of Money:

Money has been defined differently by different economists. Some, like F.A. Walker, define it in terms of
its functions, while others like G.D.H. Cole, J.M. Keynes, Seligman and D.H. Robertson lay stress on the
„general acceptability‟ aspect of money.

According to Prof. D.H. Robertson, “anything which is widely accepted in payment for goods or in
discharge of other kinds of business obligation, is called money.” Seligman defines money as “one thing
that possesses general acceptability.” Prof. Ely says: “Money is anything that passes freely from hand to
hand as a medium of exchange and is generally received in final discharge of debts.”

Prof. A. Walker says “Money is that money does.” But these definitions are defective because they do not
lay proper emphasis on all the essential functions of money. Prof. Crowther‟s definition of money is
considered better as it takes into account all the important functions of money. He defines money as
“anything that is generally acceptable as a means of exchange (i.e., as a means of setting debts) and at the
same lime, acts as a measure and a store of value.”

It is a fact that although money was the first economic object to attract men‟s thoughtful attention…there
is at the present day not even an approximate agreement as to what ought to be designated by the
world…the business world makes use of the term in several senses; while amongst economists there are
almost as many different conceptions as there are writers on the subject.‟

Functions of Money:
Money is a matter of functions four, a medium, a measure, a standard, a store.

Money in a modern economy performs important functions which have been classified by
Kinley as follows:

(a) Primary functions also called fundamental and original functions like the medium of exchange and
measure of value.

(b) Secondary functions like standard of deferred payments, store of value and transfer of value.

(c) Contingent functions like distribution of income, measurement and maximisation of utility etc.
Medium of exchange:
Money serves as a medium of exchange and facilitates the buying and selling of goods, thereby
eliminating the need for double coincidence of wants as under barter. A man who wants to sell wheat in
exchange for rice can sell it for money and purchase rice.

Measure of value:
Money has also removed the difficulty of barter system by serving as a common measure of value. The
values of various commodities are expressed in terms of money. Money as a measure of value has made
transactions simple and easy. It may be understood that this function of money follows from the first
basic function (medium of exchange). It is because money is used as a medium to exchange goods, that
each good gets a value in terms of money (called price). As such, money also serves as a unit of account. In
India, the unit of account is the Rupee, in USA, the Dollar; in USSR, the Rouble and the Yen in Japan.

Store of Value:
Classical economists did not recognize the store of value function of money. Keynes laid stress on this
function of money. People store money to provide again the rainy day and to meet unforeseen
contingencies. According to Keynes, people also store money to take advantage of the changes in the rate
of interest. Money as a store preserves value through time and space. Money as a store of value through
time means the shifting of purchasing power from the present to the future and as such it serves as an
important link between the present and the future.

Money in this case is stored as a form of „asset‟. Money is an asset or a form of wealth because it is a claim.
It is the most convenient way of laying claim to such goods and services as one wishes to buy. Thus, rather
than keeping their wealth in the form of non-liquid assets like houses, shares, etc., people prefer to keep
their wealth in the form of money.

Money is the most liquid of all assets i.e., money can be readily exchanged for goods and services without
any difficulty and the price of money or its value is stable at least over a short period. In fact, all assets like
bonds, saving accounts, treasury bills, government securities, inventories and real estate do serve as
stores of value, but they differ in the degree of liquidity; money amongst these possesses highest degree of
liquidity and that is why people prefer it most as a store of value.

However, we should not give it undue importance because the value of money does not remain stable
through time. As prices rise, people try to get rid of money as its value falls. Moreover, in modern
economies storing wealth in the form of money is unimportant as it is done in the form of interest-bearing
securities.
Money as a store of value through space continues to be important; for instance, an Indian businessman
who sells his business and property and goes to USA and settles down there is a case of exporting value
through space. In ancient times, gold and silver coins were used as a store of value followed by currency
notes. In advanced countries today money is stored in the form of bank deposits.

Standard of Deferred Payments:

Money has always been used as a standard of deferred payment. This function of money has attained
more importance in modern times with the extension of trade based on credit. As a result of this function,
it has become possible to express future payments in terms of money. A borrower who borrows a certain
sum in the present undertakes to pay the same in future. Similarly, a person who purchases on credit
agrees to pay in future when his bills become due. Money as a standard of deferred payments is
performing useful function enabling the current and present transactions to be discharged in future.

Contingent Functions:
Besides, the primary and secondary functions of money, Prof. Kinley lays stress on the contingent
functions of money. Money facilitates the distribution of national income among the various factors of
production. Land, labour, capital and organization all co-operate in an act of production and the product
is the result of their joint efforts, which belongs to all of them.

Money makes the distribution of joint production, amongst various factors easy and paves the way for
economic progress. Further, a concept like utility is measured in terms of money. A consumer as well as a
producer measures the utilities of different goods and factors of production with the help of money and
try to get maximum satisfaction or maximum returns.

Again, credit is the basis of modern economic progress. Money constitutes the basis of credit. Banks
create credit not out of thin air but with the help of money. Moreover, money gives liquidity to various
forms of wealth. A person by keeping his wealth in the form of money renders it most liquid.

Thus, we find that money performs many functions—a medium of exchange, a measure of value, a store of
value, a standard of deferred payments and serves as a basis for credit and distribution of national
income. These functions of money are not all of the same importance. Of all the functions, the most
important function of money is that it serves as a medium of exchange and as such also becomes a means
of payment. Money in the form of a generally acceptable commodity, in the process of exchange between
goods, at once, becomes a unit of account and a measure of value. The following table clearly shows the
various functions of money.

Role of Money:
Money plays a vital role in the determination of income and employment. The basic problems of
macroeconomics are the determination of income, output, employment and the general price levels,
including the determination of the long-run rate of growth of income. As far as the growth theory is
concerned, the supply and demand for money have been largely ignored until recently, yet all but the very
simplest short-run income and price level determination models have a money market included in them.

As such, money becomes an economic force in its own right, which under certain circumstances,
powerfully affects economic activities. This is the main subject matter of monetary economics. Monetary
theory is that branch of economics which aims at discovering and explaining how the use of money in its
various forms affects production, consumption and distribution of goods. As a matter of fact, the
advocates of monetary theory plead that a large number of factors affect the volume of production,
consumption and distribution. To them, money is no more a veil, a medium to facilitate exchange of
goods: but something more vital, more crucial and more important, which affects the general level of
economic activity.

Monetary theorists hold that the use of money as a medium of exchange, as a store of value, as a measure
of value, as a standard of deferred payments along with its contingent functions has the capacity of
influencing the volume and direction of economic activity that would not occur in a barter economy. In a
monetary economy, according to Keynes, “money plays a part of its own and affects motives and decisions
and is, in short, one of the operative factors in the situation, so that the course of events cannot be
predicted, either in the long period or in the short, without a knowledge of the behaviour of money
between the first state and the last.” In such a world, money is not a neutral phenomenon rather a
phenomenon governed by principles very different from those that hold sway over the process of
production and exchange.
In modern income and employment analysis, these are two spheres of economic activity. There is, on the
one hand, the real or goods sector, which has to do with forces of aggregate demand and supply and the
conditions under which an equilibrium of output and employment is achieved. On the other hand, there is
the monetary sphere in which the economic forces at work are those centering around the demand for
money.

According to the modern view, the existence of a separate monetary sphere of activity is a fact of profound
significance; what takes place in the monetary sphere may suddenly and dramatically influence the level
of both output and employment. The method by which Keynes brings money into the picture is through
the development of a theory of interest in which the demand for money is dominant. The rate of interest is
the link between the real sphere and the monetary sphere. It is a factor around which the theory of
investment is constructed and investment expenditure is one of the key determinants of income and
employment.
Types of
Definition
Money

Fiat money is entirely backed by government orders

rather than a physical good. It gets its status as a
Fiat Money
medium of exchange because the government declared
it an official means of payment.

This is money that is an actual commodity that has value

Commodity outside of being a medium of exchange. Commodity
Money money can be precious metals, gemstones, spices, and
even coffee.

This is money that is based on trust rather than the

Fiduciary intrinsic value of the money itself with no government
Money backing. This form of payment relies on the trust or
promise that it will be accepted as a form of payment.

This is money in the economy in the form of debt created

Commercial by commercial banks. Banks loan out money based on
Bank Money the fiat money their customers deposited to other
customers to earn interest.
Types of Monetary Standards
A monetary standard is the framework that a country uses to manage its currency and establish
its value. The type of standard adopted influences currency stability, international trade, and
economic growth. Here are the primary types of monetary standards:

1. Commodity Standard- A monetary system where the currency's value is directly tied to a
specific commodity, usually gold or silver.

Features:

• Currency can be exchanged for a specified amount of the commodity.

• The value of the currency fluctuates with the value of the commodity.

Types:

• Gold Standard: The currency is based on a fixed quantity of gold.

• Silver Standard: Similar to the gold standard but based on silver.
• Bimetallic Standard: Currency can be exchanged for either gold or silver at a
predetermined ratio.

Advantages:

• Limits inflation as the currency supply is restricted by the amount of gold or silver
reserves.
• Increases confidence in the currency due to its tangible backing.

Disadvantages:

• Limits economic growth as currency expansion is dependent on the supply of the

commodity.
• Vulnerable to price fluctuations in the commodity market.
• Difficult to maintain during economic crises or war.

2. Fiat Money Standard- A monetary system where the currency has no intrinsic value and is
not backed by a physical commodity. Instead, it is issued by the government and has value
because people have faith in the government’s authority to regulate it.

Features:

• The government controls the currency supply and can implement monetary policies to
stabilize the economy.
• The value of the currency is influenced by demand and supply in the currency market.
Advantages:

• Greater flexibility in monetary policy, allowing governments to adjust the money supply
to respond to economic conditions.
• No constraints on money supply based on physical commodities, enabling economic
growth.

Disadvantages:

• Higher risk of inflation, as the government might increase the money supply excessively.
• Currency value can depreciate significantly in cases of political instability or poor
economic management.

3. Gold Exchange Standard- A modified version of the gold standard where only central
banks or governments can exchange currency for gold. Private individuals cannot directly
exchange currency for gold.

Features:

• The currency is indirectly backed by gold, but people rely on the central bank's reserves
rather than holding gold themselves.
• Nations with strong economies act as "gold-reserve nations," holding gold and offering
currency stability for other countries.

Advantages:

• Offers some of the stability associated with the gold standard without requiring a full
commodity-backed currency for everyday transactions.
• Allows countries to keep their reserves in gold indirectly while maintaining fiat
currencies domestically.

Disadvantages:

• Still depends on gold reserves, making it vulnerable to issues related to gold supply.
• Less flexibility for monetary policy than a pure fiat system, as central banks still maintain
some adherence to gold reserves.

4. Paper Currency Standard- A system where the currency exists only as paper money and
coins, without backing from commodities like gold or silver.

Features:

• Purely based on the government's guarantee and economic strength.

• Most modern economies use this standard.
Advantages:

• Offers full flexibility for governments in controlling the money supply and implementing
monetary policies.
• Not limited by physical commodities, allowing for expansive economic growth.

Disadvantages:

• Prone to hyperinflation if the government mismanages the money supply.

• Dependent on the public's trust in the government's economic management and
stability.

5. Managed Currency Standard- A currency system where a central authority, like a central
bank, actively manages the currency’s value and the money supply according to specific
economic goals.

Features:

• Combines aspects of the fiat system and direct central bank intervention.
• The central bank uses tools such as interest rates, reserve requirements, and open
market operations to manage the money supply and stabilize the economy.

Advantages:

• Highly flexible and can respond to changing economic conditions to stabilize currency
value and control inflation.
• Can support targeted economic growth and employment objectives.

Disadvantages:

• Requires strong and credible institutions to avoid misuse of monetary tools.

• Risk of currency devaluation if the public loses confidence in the central bank's policies.

6. Cryptocurrency-Based Standard (Emerging)- A system where currency is digital and

backed by cryptographic algorithms rather than physical commodities or governmental
guarantees.

Features:

• Decentralized, not controlled by a single entity like a government or central bank.

• Currency value is determined by market demand and supply, as well as the underlying
technology's popularity and trust.

Advantages:
 • Transparency and lower risk of governmental inflationary policies.
• Can be more secure and private due to cryptographic techniques.

Disadvantages:

• High volatility, as value is often driven by market speculation.

• Limited use in traditional monetary policy or economic control, as it's decentralized and
not widely accepted.

Value of Money and its determinants

The concept of the "value of money" is essential in economics and finance, as it
determines how much purchasing power a unit of currency holds, influencing
both domestic economic activities and international trade. Here’s a
comprehensive look into why the value of money matters and the factors that
influence it.
The value of money primarily reflects its purchasing power, which is the amount
of goods or services that can be bought with one unit of currency. This concept
has both internal implications (within a country) and external impacts (in
international markets).
Why the Value of Money Matters?
• Consumer Purchasing Power: When the value of money is stable,
consumers can plan and save confidently, knowing their money will hold its
purchasing power over time. If money loses value (inflation), people need
more money for the same goods, reducing their purchasing ability.
• Economic Planning: Businesses rely on predictable money value for
planning investments, pricing, and profit forecasting. Inflation or deflation
disrupts cost stability, making financial planning challenging.
• International Competitiveness: The relative value of a country’s currency
impacts its global trade position. A stronger currency makes imports
cheaper but can reduce export competitiveness, while a weaker currency
can make exports more attractive but increase import costs.
 • Investment and Financial Markets: Stable money value promotes
investment as it allows for predictable returns. High inflation or fluctuating
currency values deter investors due to potential losses in real returns.
Factors Determining the Value of Money
The value of money is determined by various factors that influence both its
demand and supply. The primary factors are:
A. Demand and Supply of Money
Demand for Money: This is the desire to hold cash rather than investing or
spending it immediately. Factors influencing money demand include:
• Income Levels: Higher income levels increase spending, leading to a higher
demand for money.
• Interest Rates: When interest rates are high, people save more to benefit
from returns, reducing the demand for cash. Lower rates can increase
spending and the demand for money.
• Price Levels: If prices are high (inflation), people need more money to buy
the same goods, increasing the demand for money.
Supply of Money: Managed by the central bank, money supply directly impacts
the value of currency.
• Central Bank Policies: Central banks, like the Federal Reserve in the US or
the Reserve Bank of India, use policy tools to control money supply,
including adjusting interest rates and conducting open market operations.
• Money Creation: Through lending activities and government spending,
central banks create more money, influencing the supply and impacting
value over time.
B. Inflation and Deflation
• Inflation: When money supply grows faster than the demand for goods,
inflation occurs, reducing money’s purchasing power. For instance,
excessive printing of currency can flood the economy, causing prices to rise.
• Deflation: The opposite of inflation, deflation occurs when money supply is
restricted, increasing purchasing power. Deflation can lead to lower
 consumer spending as people wait for prices to drop further, which can
slow economic growth.
C. Interest Rates- Central banks control interest rates to either encourage or
discourage spending. Higher interest rates typically increase demand for the
currency as foreign investors seek returns, strengthening its value. Lower interest
rates make the currency less attractive globally, reducing its value. This
manipulation of interest rates is a common tool in managing inflation and
economic growth.
D. Economic Policies
• Monetary Policy: By adjusting the money supply and interest rates, central
banks influence inflation and currency value. For example, quantitative
easing, where central banks purchase securities to increase money supply,
can reduce a currency’s value.
• Fiscal Policy: Government policies related to spending and taxation also
impact money’s value. For example, high government spending without
equivalent revenue can lead to deficit financing, which may increase money
supply and reduce currency value if it leads to inflation.
E. Exchange Rates and International Markets
Exchange Rates: The relative value of currencies in the foreign exchange market
can impact a country’s currency strength.
• Trade Balances: A country with strong exports may see increased demand
for its currency, raising its value.
• Foreign Investment: When investors invest in a country’s assets (like real
estate or bonds), demand for the local currency increases, strengthening it.
• Political Stability: Countries with stable governments tend to have stronger
currencies, as they are seen as safer for investment.
Global Economic Conditions: Global events, such as recessions, pandemics, or
international conflicts, can lead to fluctuations in currency values as investors
seek stable “safe haven” currencies like the US dollar.
F. Public Perception and Confidence- The value of money also depends on the
public's confidence in it. During periods of economic uncertainty or political
instability, people may lose faith in their currency’s stability, causing demand to
drop. Hyperinflation scenarios, like those in Venezuela or Zimbabwe, show that
when public confidence plummets, people often turn to foreign currencies or
barter systems.
Measuring the Value of Money
The value of money is often measured through specific indices and theories that
track purchasing power and currency strength.
• Consumer Price Index (CPI): Measures inflation by tracking changes in the
prices of a standardized basket of goods. An increasing CPI indicates
inflation, reflecting a decrease in money’s value.
• Purchasing Power Parity (PPP): This economic theory suggests that
exchange rates should adjust so that identical goods cost the same across
different countries. PPP is used as a comparison tool to assess if a currency
is overvalued or undervalued.
• Exchange Rates: Foreign exchange markets provide a direct measure of a
currency’s value against others. Exchange rates fluctuate based on demand,
supply, and economic policies, indicating a currency’s global purchasing
power.
• Interest Rate Parity (IRP): This theory relates interest rates to exchange
rates, stating that currency values adjust to offset differences in interest
rates across countries. IRP helps in understanding how interest rates affect
international investments and currency strength.