Meaning and Functions of Money

Meaning of Money
Money is any medium of exchange that is widely accepted in transactions for goods,
services, and debt settlements. It serves as a unit of account, store of value, and standard
of deferred payment.

De nitions of Money

• Prof. Crowther: “Money is anything that is generally acceptable as a means of

exchange and that at the same time acts as a measure and store of value.”
• F.A. Walker: “Money is what money does.”
Characteristics of Money

✔ Divisibility – Can be divided into smaller units (e.g., ₹1, ₹2, ₹5, ₹10 coins).
✔ Durability – Long-lasting and not easily damaged.
✔ Portability – Easy to carry and use.
✔ Stability – Maintains its value over time.
✔ Acceptability – Recognized as a means of payment.

Functions of Money
Money performs static and dynamic functions in an economy.

1. Static Functions of Money (Traditional Functions)

These functions remain constant and essential for economic transactions.

✔ Medium of Exchange – Facilitates the buying and selling of goods and services,
eliminating the limitations of the barter system.
✔ Measure of Value (Unit of Account) – Prices of goods and services are expressed in
terms of money (e.g., ₹100 for a product).
✔ Store of Value – Money retains its purchasing power over time, allowing individuals to
save.
✔ Standard of Deferred Payment – Enables future transactions like loans, credit
payments, and mortgages.

2. Dynamic Functions of Money (Modern Functions)

These functions help in the growth and development of an economy.

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 ✔ Helps in Capital Formation – Money encourages savings and investments, leading to
economic growth.
✔ Promotes Trade and Commerce – Facilitates both domestic and international trade by
simplifying payments.
✔ In uences Monetary Policy – Central banks control money supply to regulate in ation,
interest rates, and economic stability.
✔ Enhances Production & Distribution – Money allows rms to invest in technology,
labor, and raw materials, boosting production.
✔ Facilitates Economic Development – Ef cient money management helps in poverty
reduction, employment generation, and infrastructure growth.

Conclusion
Money plays a crucial role in economic stability and growth by serving both static (basic)
and dynamic (advanced) functions. While static functions make trade and savings possible,
dynamic functions help in economic expansion, trade, and investment. The proper
management of money through monetary policy is essential for a balanced economy.

Money: Evolution, Classi cation, Qualities of Good

Money & Role in Economy

1. Evolution of Money
Money has evolved over time to address the limitations of the barter system, which suffered
from the lack of a common measure of value, double coincidence of wants, and dif culty
in storing wealth.

Stages in the Evolution of Money

1. Barter System – Exchange of goods for goods (e.g., wheat for cloth).
2. Commodity Money – Use of items like gold, silver, salt, and cattle as money.
3. Metallic Money – Coins made from gold, silver, and copper.
4. Paper Money – Currency notes issued by the government or central bank.
5. Credit Money – Bank deposits, cheques, and promissory notes.
6. Electronic Money (Digital Money) – Debit cards, credit cards, online banking,
cryptocurrencies (Bitcoin, UPI, etc.).

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 2. Classi cation of Money
Money is classi ed based on tangibility, legality, and acceptability.

A. On the Basis of Material

✔ Commodity Money – Objects like gold, silver, salt, cattle.

✔ Metallic Money – Coins made of precious or base metals.
✔ Paper Money – Currency notes issued by governments or banks.
✔ Credit Money – Bank deposits, cheques, promissory notes.
✔ Digital Money – UPI, e-wallets, cryptocurrencies.

B. On the Basis of Legal Acceptance

✔ Legal Tender Money – Must be accepted by law (e.g., rupee notes, coins).
✔ Non-Legal Tender Money – Optional acceptance (e.g., cheques, credit cards).

C. On the Basis of Convertibility

✔ Convertible Money – Can be exchanged for gold or foreign currency.

✔ Inconvertible Money – Cannot be exchanged for gold (modern at money).

D. On the Basis of Circulation

✔ Full-Bodied Money – Value of the material = face value (e.g., gold coins).
✔ Token Money – Face value > intrinsic value (e.g., ₹10 coin).

3. Qualities of Good Money

For money to function effectively, it should possess certain qualities:

✔ General Acceptability – Widely accepted in exchange.

✔ Durability – Long-lasting and resistant to damage.
✔ Portability – Easy to carry and use.
✔ Divisibility – Can be broken into smaller units.
✔ Stability of Value – Should not uctuate too much.
✔ Recognizability – Easily identi able and dif cult to counterfeit.
✔ Uniformity – All units should have the same value.

4. Role of Money in a Developing Economy

A developing economy requires money to stimulate growth, trade, and industrialization.

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 ✔ Capital Formation – Encourages savings and investments.
✔ Industrial & Agricultural Growth – Facilitates buying inputs and machinery.
✔ Monetary Policy Control – Helps central banks regulate in ation and growth.
✔ Encourages Foreign Investment – Stable currency attracts global investors.
✔ Employment Generation – Financial systems provide loans for businesses and startups.

5. Role of Money in a Mixed Economy

A mixed economy (combining both capitalism and socialism) uses money for market
transactions and government planning.

✔ Balances Public & Private Sectors – Money facilitates government welfare programs
and private business activities.
✔ Ef cient Resource Allocation – Helps in the smooth functioning of market forces and
state intervention.
✔ Income Redistribution – Government uses money for taxation, subsidies, and social
welfare to reduce inequalities.
✔ Promotes Economic Growth – Money supports industrialization, trade, and infrastructure
development.
✔ Ensures Price Stability – Monetary policies help control in ation and de ation.

Conclusion
Money has evolved from barter to digital transactions, improving economic activities
worldwide. A good money system ensures stability, acceptability, and ef ciency. In a
developing and mixed economy, money plays a crucial role in growth, stability, income
distribution, and market ef ciency, making it a vital tool for economic progress.

De nition of Money

Money is any medium of exchange that is widely accepted for transactions of goods,
services, and settlement of debts. It serves as a unit of account, store of value, medium of
exchange, and standard of deferred payment.

✔ Prof. Crowther: “Money is anything that is generally acceptable as a means of exchange

and that at the same time acts as a measure and store of value.”
✔ F.A. Walker: “Money is what money does.”

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 De nition of Near Money

Near money refers to nancial assets that are not actual currency but can be quickly
converted into cash with minimal loss of value. These assets are highly liquid but do not
serve as an immediate medium of exchange.

✔ Examples of Near Money:

• Savings accounts
• Fixed deposits
• Treasury bills
• Government bonds
• Mutual funds
• Money market instruments

Differences Between Money and Near Money

Feature Money Near Money

Highly liquid but needs conversion
Liquidity Fully liquid, used for transactions
to cash
Medium of Directly used for buying goods and Cannot be used directly for
Exchange services transactions
Examples Currency notes, coins, demand Fixed deposits, bonds, treasury
deposits bills
Role in Economy Facilitates daily transactions Helps in savings and investments

Conclusion

Money is the primary medium of exchange, while near money includes liquid assets that
can be converted into cash when needed. Both play a crucial role in the nancial system by
ensuring smooth transactions and economic stability.

Comparison of Fisher’s and Cambridge Versions of the

Quantity Theory of Money

The Quantity Theory of Money (QTM) explains the relationship between money supply
and price levels in an economy. Two major versions of this theory are:

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 1. Fisher’s Transaction Approach
2. Cambridge Cash Balance Approach

1. Fisher’s Transaction Approach

✔ Developed by Irving Fisher in his book "The Purchasing Power of Money" (1911).
✔ Emphasizes money supply and velocity in determining price levels.
✔ Expressed in the equation of exchange:

MV=PT
Where:

• M = Money supply
• V = Velocity of money (how often money circulates)
• P = Price level
• T = Total transactions (goods & services exchanged)
Key Features:

✔ Assumes V and T are constant, so price level P depends on M.

✔ Focuses on money’s role in transactions.
✔ Views in ation as a direct result of excess money supply.

Criticism:
✖ Over-simpli ed – Assumes V and T remain constant, which is unrealistic.
✖ Ignores demand for money – Focuses only on supply.

2. Cambridge Cash Balance Approach

✔ Developed by Marshall, Pigou, and Keynes.
✔ Focuses on money demand (cash holdings) rather than transactions.
✔ Expressed as:

M=kPY
Where:

• M = Money supply
• k = Fraction of income people want to hold as cash
• P = Price level
• Y = National income
Key Features:

✔ Recognizes money as a store of value, not just a medium of exchange.

✔ k (cash holding preference) varies based on economic conditions.
✔ Money demand depends on income levels, expectations, and interest rates.

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 Criticism:
✖ Does not fully explain changes in velocity (V).
✖ Focuses on individual behavior but ignores macroeconomic factors.

3. Comparison: Fisher vs. Cambridge

Fisher’s Version (Transaction Cambridge Version (Cash Balance
Aspect
Approach) Approach)
Focus Money’s role in transactions Money demand (cash holdings)

Formula
MV=PT M=kPY
Assumptions Constant V and T k is variable (depends on behavior)
Cause of
Increase in M directly raises P Demand for money in uences P
In ation
Limitations Ignores money demand Does not fully explain velocity changes

4. Which Theory is Superior?

The Cambridge approach is superior because:
✔ It recognizes money demand, unlike Fisher’s rigid supply-focused model.
✔ More realistic assumptions – People’s cash-holding preferences change, affecting
money circulation.
✔ Provides a better link between money supply, income, and in ation.
✔ Forms the basis for Keynesian liquidity preference theory, which improved monetary
policy analysis.

However, Fisher’s equation is useful for simple monetary analysis and explaining long-run
in ation trends. But for modern economics, the Cambridge approach is more practical
and exible.

Gresham’s Law: "Bad Money Drives Out Good Money"

Gresham's Law states that "bad money drives out good money from circulation." This
economic principle was formulated by Sir Thomas Gresham, a 16th-century nancial
advisor to Queen Elizabeth I of England. It explains how, when two types of money circulate
together, the one with higher intrinsic value ("good money") disappears, while the one with
lower intrinsic value ("bad money") remains in use.

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 Understanding Gresham’s Law

The law applies when:

✔ Two forms of money circulate together.
✔ One type has higher intrinsic value (e.g., gold or silver coins).
✔ The other type has lower intrinsic value (e.g., debased or paper money).

When people realize that one type of money is more valuable than the other, they tend to:
✔ Hoard "good money" (save or melt down valuable coins).
✔ Spend "bad money" (use less valuable currency in daily transactions).

Example of Gresham’s Law in Action

✔ Gold & Silver Coins vs. Paper Money:

•
If gold and silver coins circulate along with depreciating paper money, people
hoard gold and silver and use only paper money for transactions.
✔ Debasement of Coins:

•
If a government reduces gold/silver content in coins, the public will save the older,
purer coins and use the debased ones in trade.
✔ Bimetallism (U.S. 19th Century):

• The U.S. once used both gold and silver for currency. When silver was overvalued
by the government, gold coins disappeared, and silver became the dominant
currency.

Exceptions to Gresham’s Law

✔ If people trust both forms of money equally, they may continue using "good money."
✔ In times of in ation or crisis, even "bad money" may be hoarded if the alternative is
losing value.

Conclusion

Gresham's Law explains why high-value currency disappears from circulation when
inferior currency is introduced. This principle remains relevant today, in uencing monetary
policies, in ation control, and cryptocurrency markets.

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 Keynes' Theory of Demand for Money
John Maynard Keynes, in his book The General Theory of Employment, Interest, and Money
(1936), introduced a liquidity preference theory, which explains why people demand
money (hold cash) instead of investing or spending it.

De nition

Keynes de ned demand for money as the preference for liquidity (holding money in cash
form) rather than investing in assets. He argued that money is not just a medium of
exchange but also a store of value, and people hold it for three main motives.

Motives for Holding Money (Liquidity Preference)

1. Transactions Motive

✔ People need money for day-to-day expenses (food, rent, bills).

✔ Depends on income—higher income leads to more spending, increasing demand for
money.

Example: A salaried employee keeps cash for monthly expenses.

2. Precautionary Motive

✔ People hold money as a safety reserve for unexpected expenses (medical emergencies, job
loss).
✔ Also depends on income levels—higher income means a larger buffer.

Example: A family keeps extra savings in case of unexpected hospital bills.

3. Speculative Motive

✔ People hold money to take advantage of future investment opportunities.

✔ The demand depends on interest rates:

• If interest rates are low, people prefer holding cash instead of investing.
• If interest rates are high, people invest in bonds and stocks, reducing their cash
holdings.
Example: A businessman may hold cash if stock prices are expected to fall, waiting for a
better opportunity to invest.

Keynes’ Liquidity Preference Function

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Keynes formulated money demand as:

Md =L(T,P,S)
Where:

• M_d = Demand for money

• L = Liquidity preference
• T = Transactions motive (depends on income)
• P = Precautionary motive (depends on income)
• S = Speculative motive (depends on interest rate)
Thus, demand for money is positively related to income (T, P) and negatively related to
interest rates (S).

Criticism of Keynes’ Theory

✖ Overemphasis on interest rates—modern economists argue other factors like in ation
also impact money demand.
✖ Ignores the role of nancial innovations (credit cards, online banking reduce need for
cash).
✖ Assumes rational decision-making, but real-world behavior is often irrational.

Conclusion
Keynes' liquidity preference theory remains a foundational concept in monetary
economics. It highlights how income and interest rates in uence money demand, shaping
monetary policy decisions in modern economies.

Fisher’s Transactions Approach vs. Cambridge Cash

Balance Approach

The Quantity Theory of Money (QTM) explains the relationship between money supply
and price levels. Two major versions of this theory are:

1. Fisher’s Transactions Approach (Irving Fisher)

2. Cambridge Cash Balance Approach (Marshall, Pigou, Keynes)

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 1. Fisher’s Transactions Approach
✔ Developed by Irving Fisher in The Purchasing Power of Money (1911).
✔ Focuses on money supply and velocity in determining the price level.
✔ Expressed in the Equation of Exchange:

MV=PT
Where:

• M = Money supply
• V = Velocity of money (how often money circulates)
• P = Price level
• T = Total transactions (goods & services exchanged)
Key Features

✔ Assumes V and T are constant, so P depends on M (directly proportional).

✔ Views in ation as a result of excess money supply.
✔ Focuses on the role of money in transactions only.

Criticism

✖ Ignores demand for money—assumes money is only used for transactions.

✖ Assumes V and T remain constant, which is unrealistic.
✖ Does not explain why people hold money instead of spending it.

2. Cambridge Cash Balance Approach

✔ Developed by Marshall, Pigou, and Keynes.
✔ Focuses on money demand (how much cash people want to hold) instead of
transactions.
✔ Expressed as:

M=kPY
Where:

• M = Money supply
• k = Fraction of income people hold as cash
• P = Price level
• Y = National income
Key Features

✔ Recognizes money as a store of value, not just a medium of exchange.

✔ The demand for money (k) depends on factors like:

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 • Income level
• Interest rates
• Economic uncertainty
✔ If k decreases, people hold less cash → spend more → higher V → prices rise.
Criticism

✖ Does not fully explain changes in velocity (V).

✖ Focuses on individual behavior but ignores macroeconomic factors.

3. Comparison: Fisher vs. Cambridge

Fisher’s Transactions
Aspect Cambridge Cash Balance Approach
Approach
Focus Money’s role in transactions Money demand (cash holdings)

Formula
MV=PT M=kPY
Assumptions Constant V and T k is variable (depends on behavior)
Cause of
Increase in M directly raises P Demand for money in uences P
In ation
Does not fully explain velocity
Limitations Ignores money demand
changes

4. Which Theory is Superior?

The Cambridge approach is superior because:
✔ It recognizes money demand, unlike Fisher’s rigid supply-focused model.
✔ More realistic assumptions – People’s cash-holding preferences change, affecting
money circulation.
✔ Provides a better link between money supply, income, and in ation.
✔ Forms the basis for Keynesian liquidity preference theory, which improved monetary
policy analysis.

However, Fisher’s equation is useful for simple monetary analysis and explaining long-run
in ation trends. But for modern economics, the Cambridge approach is more practical
and exible.

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