MONEY

CH-5
HANDOUT ON FUNCTIONS OF MONEY
The functions of money can be broadly categorised under two heads:
A. Primary Functions (Main or Basic Functions)
B. Secondary Functions (Subsidiary or Derivative Functions)
C. Contingent Functions of Money
D. Static and Dynamic Functions of Money

A. Primary Functions
Primary functions include the most important functions of money, which it must perform in every
country. These are:
(1) Medium of Exchange
Money, as a medium of exchange, means that it can be used to make payments for all
transactions of goods and services. It is the most essential function of money. Money has the quality
of general acceptability. So, all exchanges take place in terms of money.
(i) This function has removed the major difficulty of lack of double coincidence of wants and
inconveniences associated with the barter system.
(ii) Use of money allows purchase and sale to be conducted independently of one another.
(iii) This function of money facilitates trade and helps in conducting transactions in an economy.
(iv) Money has no power to satisfy human wants, but it commands power to purchase those things,
which have utility to satisfy human wants.
(2) Measure of Value (Unit of Value)
Money as a measure of value means that money works as a common denomination, in which
values of all goods and services are expressed.
(i) By reducing the value of all goods and services to a single unit (i.e. price), it becomes very easy to
find out the exchange ratios between them and comparing their prices.
(ii) This function facilitates maintenance of business accounts, which would be otherwise impossible.
(iii) Money helps in calculating relative prices of goods and services. Due to this reason, it is regarded
as a ‘Unit of Account'. For instance, 'Rupee' is the unit of account in India, 'Pound' in England and so
on.
B. Secondary Functions
These refer to those functions of money which are supplementary to the primary functions. These
functions are derived from primary functions and, therefore, they are also known as 'Derivative
Functions'.
The major secondary functions are:
(1) Standard of Deferred Payments
Money as a standard of deferred payments means that money acts as a 'standard' for payments,
which are to be made in future. Every day, millions of transactions take place in which payments are
not made immediately. Money encourages such transactions and helps in capital formation and
economic development of the economy.
This function of money is significant because:
(i) Money as a standard of deferred payments has simplified the borrowing and lending operations.
(ii) It has led to the creation of financial institutions.
(2) Store of Value (Asset Function of Money)
Money as a store of value means that money can be used to transfer purchasing power from
present to future. Money is a way to store wealth. Although wealth can be stored in other forms also,
but money is the most economical and convenient way. It provides security to individuals to meet
contingencies, unpredictable emergencies and to pay future debts. Under barter system, it was difficult
to use goods as a store of wealth due to perishable nature of some goods and high cost of storage.
Money as store of value has the following advantages:
(i) Money is available in fractional denomination, ranging from Rs.1 to Rs. 1,000.
(ii) Money is easily portable. So, it is easy and economical to store money as its storage does not require
much space.
(iii) Money has the merit of general acceptability. So, it can be easily exchanged for goods at all times.
(iv) Savings in terms of money are much more secured than in terms of goods.
(3) Transfer of Value
It means transferring the value of durable and immovable goods from one place to another.
Through money, anybody can sell his immovable property at any particular place and buy a property at
some other place. This function provides mobility to machinery, land and goods.
C. CONTINGENT FUNCTIONS OF MONEY
The functions performed by money in assisting various economic agents such as consumers,
producers, etc., in making economic decisions are called contingent functions of money. The
money income of the consumer and the money-prices of the commodities influence the consumption
decisions of different individuals.
(i) Distribution of National Income: Money helps in optimum distribution of national income
among different factors of production (land, labour, capital and enterprise). Total output of the
country is jointly produced by these factors. So, the output should be distributed among them. Money
helps in distribution of the national product in the form of rent, wage, interest and profit, which are
expressed in money terms.
(ii) Maximisation of Satisfaction: Money helps the consumers and producers in maximizing their
satisfaction. A consumer derives maximum satisfaction by equating the price (expressed in terms of
money) of each commodity with its marginal utility (satisfaction). Similarly, a producer maximises his
satisfaction (profit) by equating the marginal productivity of a factor with price of such factor.
(iii) Basis of Credit Creation: Credit creation by commercial banks was not possible until money
was introduced. Money as a store of value has encouraged savings by people in the form of demand
deposits in banks. Such demand deposits are used by the commercial banks to create credit.
(iv) Productivity of Capital: Money increases the productivity of capital as it is the most liquid
asset and can be put to any use. Due to liquidity of money, capital can be easily transferred from less
productive uses to more productive uses.
(v) Bearer of options: Money provides purchasing power in the hands of the person (bearer)
holding it and he has numerous options for its use. The bearer can change his decision regarding
use of money from time-to-time and place-to-place depending upon urgency, intensity and his priority.
(vi) Guarantee of Solvency: Money serves as a guarantee of solvency for an individual or institution.
If an individual has enough money (more than his liabilities), then he cannot be declared insolvent or
bankrupt. Due to this reason, individuals and firms keep large amount of money to meet unexpected
needs.
D. STATIC AND DYNAMIC FUNCTIONS OF MONEY
According to Paul Einzig, functions of money can be classified under two heads:
(i) Static Functions: They refer to those functions which facilitate the working of the economy
of a country. For example, the functions of money, as a medium of exchange, a measure of value, a
store of value and a standard of deferred payments, are all static functions because without these
functions, the economy of a country cannot work.
(ii) Dynamic Functions: They refer to those functions which cause movement in the level of
economic activity in a country. So, dynamic functions determine the economic trends. For
example, function of money as the basis of credit and liquidity actually brings about changes in the level
of economic activity in a country. Expansion of credit not only leads to a rise in the price level, but also
increases the levels of income, output and employment in the economy.
Note: Both, Static and Dynamic functions are needed for healthy functioning of an economy

DEMAND FOR MONEY

People demand commodities such as rice, wheat, clothes, etc. because these goods assess utility.
However, money does not possess any utility to directly satisfy the consumers. Then, why do people
demand money?
Broadly stating, there are three main motives, for which money is wanted by the people:
(1) Transaction Motive;
(2) Precautionary Motive;
(3) Speculative Motive.
(1) Transaction Motive: It refers to demand for money for conducting day-to-day transactions.
This motive can be looked at from the perspective of consumers, who want income to meet their
household expenditure (income motive) and from the perspective of businessmen, who require money
to carry on their business activities (business motive). The transaction motive relates to demand for
money to meet the current transactions of individuals and business units.
The income, which a person gets, is not continuous whereas, expenditure is continuous. So, to bridge
the gap between receipt of income and its expenditure, people hold cash.
According to Keynes, transaction demand for money is positively associated with the level of income,
i.e. higher the level of income, larger would be the size of money holdings for transactions.
(2) Precautionary Motive: It refers to the desire of people to hold cash balances for unforeseen
contingencies. People wish to hold some money to provide for the risk of unforeseen events like
sickness, accident, etc. The amount of money held under this motive, depends on the nature of
individual and on the conditions in which he lives. The demand of money for precautionary balances is
also closely related to the level of income. Higher the level of income, more will be the cash balances
for contingencies.
Transaction Motive Vs Precautionary Motive
1. In case of transaction motive, money is held for ordinary transactions, while under precautionary
motive, cash is kept to meet unforeseen transactions.
2. Under transaction motive, holding of money is very convenient and value of money, in terms of other
goods, is relatively certain. However, under precautionary motive, holding of money depends on the
degree of uncertainty, i.e. more money is kept in the events of war or financial crisis and less money
during normal conditions.
In general, the cash balances held for transaction and precautionary motives are directly dependent on
the level of income.
(3) Speculative Motive: It refers to desire of the holder to keep cash balance as an alternative to
financial assets like bonds. Under speculative motive, it is presumed that people can hold their wealth
either in the form of bonds or in the form of cash balances. The decisions regarding holding of bonds
or cash balances depend upon the expectations about changes in the rate of interest or capital value
of assets (bonds) in future.
The interest rate varies inversely with the market value of securities (bonds), i.e. when interest
rate rises, market value of bonds falls. Hence, demand for money for speculative motive becomes less
at high interest rates and becomes large at low interest rates.
HOTS HIGHER ORDER THINKING SKILLS QUESTIONS

Q. 1. Identify the function of money highlighted in the given statement.

(i) This function has led to capital formation and economic development of the economy.
(ii) This function has separated the acts of sale and purchase.
(iii) This function of money facilitates transfer of purchasing power from present to future.
(iv) It works as a common denomination, in which values of all goods and services are expressed.
(v) This function of money is also termed as 'Asset Function' of money.
(vi) This function has simplified the borrowing and lending operations.
(vii) This function helps to find out exchange ratios between various goods and services.
(viii) This function has removed the difficulty of lack of double coincidence of wants.
(ix) This function helps to make payments for all transactions of goods and services.
Ans. (i) Standard of deferred payments; (ii) Medium of exchange; (iii) Store of value; (iv) Measure
of value; (v) Store of value; (vi) Standard of deferred payments; (vii) Measure of value; (viii)
Medium of exchange; (ix) Medium of exchange.
Q. 2. How does money separate the acts of sale and purchase?
Ans. Under the barter exchange, there should be double coincidence of wants, i.e. barter system can
work only when both buyer and seller are ready to exchange each other's goods at the same point of
time. However, such double coincidence is very rare. With money as a medium of exchange, money
can be used to make payments for all purchases and receive money for all sales of goods and services.
As a result, a person can buy or sell at different points of time with the help of money. Hence, money
has separated the acts of sale and purchase.
Q. 3. "Like money, goods also perform the function of store of value with same merits." Defend
or refute.
Ans. The given statement is refuted. Although, goods can be stored for future, but money is the most
economical and convenient way. Money as a store of value helps people to transfer their purchasing
power from present to future. Goods do not perform the function of store of value because of following
problems:
(i) Storage of goods requires time, money and efforts.
(ii) Goods do not possess durability and their quality deteriorates with passage of time.
(iii) They may not be as liquid as money, i.e. they might not be quickly converted into cash without loss
of value
Q4. “Money has overcome the drawbacks of Barter System” Explain.
Ans. Barter system makes the exchange process very difficult and highly inefficient as Barter Exchange
refers to exchange of goods for goods. An economy, where there is a direct barter of goods and
services, is called a 'Barter Economy' or 'C-C Economy' (where C stands for commodity).
Barter System can work when there exists 'Double Coincidence of Wants'.
Double Coincidence of Wants refers to the simultaneous fulfilment of mutual wants of buyers and
sellers.
Money has overcome the drawbacks of barter system in the following manner:
(i) Medium of Exchange
(ii) Measure of value
(iii) Store of Value
(iv) Standard of deferred payments (explain these)