Functional Definition of Money

The functional definition of money is lead by Prof. Coulbourn who

defines money as a means of valuation and of payment in terms of
the unit of account and exchange1. This is very wide. It includes
cheques, gold, coin, etc., so long as it can perform the functions of
valuation and payment. Sir John Hides (1967) says that money is
defined by it functions. Anything is money which is used as
money, implying in simple terms, Money is what money does.

Some have defined money based on the legal terms. Anything backed by
law to be accepted by everyone for payment is called money.

Let’s take a minute then to go through some of the primary and

secondary functions of money before we discuss the theoretical
definition of money.

Primary Functions of Money

The two primary functions of money are to act as a medium of

exchange/payment and as a unit of account.

(i) Money as a Medium of Exchange/Payment.

This function was traditionally called the medium of exchange.

According to Handa (2009), in a modern context however, in
which transactions can be conducted with credit cards, it is better
to refer to it as the medium of (final) payments. This is the primary
function of money because all the other functions of money are
developed from this function. By serving as a medium of payment,
money revokes the need for double coincidence of wants and the

1 Coulbourn, Macroeconomic Theory, McGraw-Hill, New York, 1963

inconveniences and difficulties associated with barter (which we
discuss later in this lecture). As a medium of payment, money acts
as an intermediary. It makes exchange possible. It helps
production indirectly through specialization and division of labour
which, in turn, increase efficiency and output. According to Prof.
Walters, money, therefore, serves as a ‘factor of production,
enabling output to increase and diversify. Money also facilitates
trade. When acting as the intermediary, it helps one good or
service to be traded indirectly for others.

(ii) Money as Unit of Account

The second primary function of money is to act as a unit of

account. Money is the standard for measuring value just as the
yard or meter is the standard for measuring length. The monetary
unit measures and expresses the values of all goods and services.
In fact, the monetary unit expresses the value of each good or
service in terms of price. Money is the common denominator
which determines the rate of exchange between goods and services
which are priced in terms of the monetary unit. There can be no
pricing process without a measure of value. As a matter of fact,
measuring the values of goods and services in the monetary unit
facilitates the problem of measuring the exchange values of goods
in the market. When values are expressed in terms of money, the
number of prices is reduced from n (n-1) in barter economy to (n
– 1) in monetary economy. Money as a unit of account also
facilitates accounting. “Assets of all kinds, liabilities of all kinds,
income of all kinds, and expenses of all kinds can be stated in terms
of common monetary units to be added or subtracted.”

Secondary Functions of Money

Money performs three other secondary functions: as a standard of

deferred payments, as a store of value, and a transfer of value. These
are discussed below
Money as a Store of Value: Another secondary function of money
is to act as a store of value. The commodity chosen as money is
always something which can be kept for long periods without
deterioration or wastage. It is a form in which wealth can be kept
intact from one year to the next. Money is a bridge from the
present to the future. It is therefore essential that the money
commodity should always be one which can be easily and wisely
stored. Obviously, we know money is not the only store of value.
This function can be served by any valuable asset. One can store
value for the future by holding short-term promissory notes, bonds,
mortgages, preferred stocks, household furniture, houses, land, or
any other kind of valuable goods. The principal advantages of
these other assets as a store of value are that they, unlike money,
ordinarily yield an income in the form of interest, profits, rent or
usefulness. And they sometimes rise in value in terms of money.
On the other hand, they have certain disadvantages as a store of
value, among which are the following: (1) They sometimes
involve storage costs; (2) they may depreciate in terms of money;
and (3) they are “illiquid” in varying degrees, for they are not
generally acceptable as money and it may be possible to convert
them into money quickly only by suffering a loss of value.”

Money as a Standard of Deferred Payments. The third function of

money is to act as a standard of deferred or postponed payments.
All debts are taken in money. It was easy under barter to take loans
in goats or grains but difficult to make repayments in such
perishable commodities in the future. Money has simplified both
the taking and repayment of loans because the unit of account is
durable.

Contingent Functions of Money

Also called the incidental functions. The contingent functions are based
on traditional functions (primary & secondary), made possible by Prof
David Kinsley. He outlined the functions as;

1. Money as the most liquid of all assets.

Wealth can be in the form of bonds, debentures, etc. There is an
opposite direction- meaning that money can be turned into the
other forms of wealth and the other forms of wealth can also be
turned into money. Savings can be kept in securities. Money aids
the functions of liquidity.

2. Money is the basis of the credit system.

Behind or underneath every credit is money. Credit creation can expand

money supply through money multiplier. Whatever credit one receives,
one pays/receives it back in money (Cash).

Money has helped in the formation of capital or money market. These

are based on the fact that money performs the function of unit of account.

3. It brings about the equalization of marginal utility and productivity.

Within the indifference curve analysis, where MUx = λPx, given the
Px and λ marginal utility of good x (MUx) can be estimated. It also
helps in estimating the productivity of a firm and how much to pay
for wages, W of labour based on marginal productivity of labour
(MPL). i.e. W = MPL. But MPL determines the productivity of a
labour. Therefore, given wages of the individual, the MPL can be
measured in the perfect market.

4. Measurement of National Income

The National income (Y) couldn’t have been possible to be

calculated in the barter system. But with the use of money, it is
easy to estimate the total income, Y of a country to determine the
country’s welfare. It also helps in calculating the GDP.

5. In the distribution of National Income

Rewards to the factors of production in the form of wages, rent, interest

and profit are all determined and paid with money.
Theoretical Definition of Money

In 1962, Prof, Johnson in his book ‘Monetary Theory and Policy’ gave
four different schools of thought with regards to the definition of money.

The traditional definition of money is also known as the view of

the currency school. The traditional definition of money defines
money as currency and deposits or chequables. That is money is a
medium of exchange. Thus almost 100% liquid. Keynes in his
General Theory followed the traditional view and defined money
as currency and demand deposits. Hicks in his Critical Essays in
Monetary Theory points towards a threefold traditional
classification of the nature of money: thus to act as a unit of
account (or measure of value as Wicksell puts it), as a means of
payment and as a store of value. The Banking School criticized the
traditional definition of money as arbitrary. This view sees the
meaning of money as very narrow because there are other assets
which are equally acceptable as media of exchange. These include
time deposits of commercial banks, commercial bills of exchange,
etc

Other schools of thought like the banking school said that the
definition is narrow because it includes other things that money
can do and that there are other assets which are equally acceptable
as medium of exchange. Examples include, time deposits, drafts
bonds which are sometimes used as money. By ignoring these
assets, the traditional view is not in a position to analyse their
influence in increasing their velocity. Furthermore, by excluding
them from the definition of money, the Keynesians place greater
emphasis on the interest elasticity of the demand function for
money. Empirically, they forged a link between the stock of
money and output via the rate of interest. We present the detailed
position of classical and Keynesian economists below

According to classical economists money is just a medium of

exchange and it cannot influence the income and employment of a
country. In other words, the money supply which is in circulation
just performs the function of exchange of goods and services.
People keep money with themselves so that they could transact
goods and services. Thus, according to them money is just a token
and it has nothing to do with economic activity of a country. They
further say that money is like a veil which wraps the goods and
services in itself. Money has been accorded as a veil because it has
camouflaged the operation of real economic forces. Classical
economists do not rule out the act of savings or borrowing. They
think the savings, borrowings and lendings take place under the
shield of a veil. It means that they have attached the problems of
savings, borrowings and lendings with the transactive motive of
holding money. Whether any body purchases the goods or services
or borrows, both are similar functions. The funds are borrowed or
lent with the help of money but they do not influence the economic
activity in any way. In this respect, Adam Smith writes:

"Money is like a road which helps in transporting the goods and

services produced in a country to the market, but this road does not
itself produce any thing".

"Accord money like an agent which expedites the chemical action of

any process, but it can not change the components of chemical
action".

Thus, classical economists are of the view, that money facilitates

the transaction of goods and services, but it does not influence the
quantity of goods and services in any way. It means that money
cannot influence the real variables like production, income and
employment. It can only influence the monetary variables like
monetary wages and prices. In other words, if the supply of money
in a country is increased the income and employment will remain
unaffected. The increase in supply of money will lead to increase
the prices, hence monetary wages. When prices and wages
increase in the same proportion real wages will remain the same.
As a result, the employment and output will remain the same.

All above discussion shows that the ideology that money cannot
influence economy was a corner stone of classical economics. This
philosophy remained popular till before and after World War I. But
when classical utopia of nonintervention collapsed during 1970's
depression the concept of money as a veil disappeared and money
was accorded a dynamic element. AH the problems which
emerged during 1930's were attributed to money. Because of this
reason, "Money was accorded Evil Genius". The money which got
the importance by putting to an end the problems of barter system,
was later on accorded as veil and finally it was held responsible for
inflation and deflation.

According to Keynesian Economists money has another role to

play which is as a store of value. They said that due to this role of
money a link is established between present and future. And
because of this role money can influence the economic activity,
level of income and employment. Quite against classical neutrality
of money, Keynes thinks that money can alter the level of income
and employment of an economy. Classical economists had
integrated both the real and monetary sectors of the economy. But
Keynes clearly bifurcated the monetary and real sectors of the
economy. They said that in monetary sector rate of interest is
determined by demand for money and supply of money. However,
They stressed upon demand for money while the demand for
money rises for two motives: (i) Transactive Demand for Money
and (ii) Speculative Demand for Money.

The transaction demand for money depends upon income levels of

the people. While speculative demand for money depends upon
rate of interest. The speculative demand for money is concerned
with money as a store of value. Thus, according to Keynes money
is not just demanded for transaction purposes but it is also
demanded to take advantage by the liquidity of money. In addition
to monetary sector, Keynes also presented their views regarding
real sector. They said that equilibrium level of national income is
determined where aggregate demand is equal to aggregate supply.
They said that it is not necessary that equilibrium level of national
income will be determined at the level of full employment. Rather
equilibrium level of national income may be at full employment,
may be at below full employment and may be at above full
employment.
Below full employment represents deflation while above full
employment represents inflation. Both inflation and
unemployment are undesirable. Therefore, to remove them state
will have to interfere with fiscal and monetary policies. All this
means that according to Keynes money can be used to change the
level of income and employment. In this respect, he establishes a
relationship between real and monetary sectors of the economy. As
if supply of money is increased the rate of interest will decrease.
Hence investment .national income and employment will be
boosted up removing unemployment. Moreover, through fiscal
action by printing new notes or borrowing from banks govt. can
initiate public works program. They will also have the effect of
removing the unemployment. All this shows that in Keynes
economics money can influence the level of employment.

Turning to the definition of money according to Friedman or Monetarists

which has also being described as the modern definition of Money or the
Chicago school of thought, the scope of money is much broader than the
traditional definitions. In his book “ Employment, growth and price”,
Freidman (1959) defined money literally as the number of dollars people
carry around in their pockets as well as the number of dollars they have
to their credit at banks in the form of demand deposits and time deposit.
In effect, he defines money as currency plus all adjusted deposits in
commercial banks. He extended his definition to time deposits-you
notify the bank before one can withdraw. Usually time deposit is not
included when classifying liquid assets.

However, this definition is criticized as being too narrow since in

most empirical studies the definition of money goes beyond time
and demand deposits because of sophistications in financial
transactions.

Based on this criticism, Freidman reframed his definition of money

as “Any asset capable of serving as a temporally abode of
purchasing power” or anything that can serves as a purchasing
power or a means of buying.
The controversy didn’t end there. Many scholars still criticized this
definition and Friedman was compelled to restate that the
definition of money shouldn’t be based on theory but how useful
it is. The monetarists which are known as modern friends of
classical economists have much more similarity regarding
different issues. However, they also differ in certain fields. In
connection with money monetarists say: "Money Matters Very
Much". This means that according to monetarists money in an
economy plays a very vital role. They say that aggregate
expenditures of the economy are influenced by the changes in the
rate of interest As a result, the level of income and employment
can be affected. But it is confined to just short run. In case of long
run there is always existing a natural rate of unemployment. It
means that whenever through easy fiscal and monetary policies
aggregate demand is increased, the level of unemployment will
come down. But whenever aggregate demand is controlled prices
will be stabilized, but economy will experience the same level of
unemployment which the economy faced before increase in
aggregate demand.

There are also other well acceptable definitions in the literature

such as The Radcliff Definition and The Gurley –Shaw (1960)
Definition. The former is actually the outcome of the committees
set up to work on the Money system. The report of the committee
defined money as notes plus bank deposits. This includes only
those assets that are commonly used as a medium of exchange. The
bank deposits included demand and time deposits. Even though we
can use other things as money, their convertibility requires extra
cost. Theirs is a quite different from Radcliff. They regard a
substantial volume of liquid assets held by financial intermediaries
and the liabilities of non-bank financial intermediaries as close
substitutes for money. NBFIs do not perform the functions of bank
but rather intermediates.