Meaning and Functions of Money

This chapter of the Andhra Pradesh Intermediate first-year Economics syllabus moves from the theory of markets and prices to the institutions that make a modern exchange economy work at all — money, the banks that create and move it, and the price-level problem, inflation, that arises when its supply and the economy's real output drift out of step.

Money is anything that is generally accepted, by law or by custom, as a medium of exchange, a measure of value, and a means of discharging debts within an economy. Before money existed, exchange took the form of barter — goods traded directly for other goods. Barter suffered from serious limitations: the double coincidence of wants (each party had to want exactly what the other offered), the indivisibility of many goods (a cow cannot be split to buy a sack of rice), the absence of a common unit to compare the value of unlike goods, and no reliable way to store value for later use. Money removed each of these frictions.

Economists group the functions of money into three categories.

Primary functions — the functions money must perform to be called money at all:

• Medium of exchange — money is accepted by everyone in a transaction, so a seller no longer needs a buyer who happens to want exactly what is on offer; goods can be sold for money and money used to buy anything else.
• Measure of value — money supplies a common unit (rupees and paise, in India) in which the value of every good and service can be expressed, added, and compared.

Secondary functions — functions that support exchange over time and distance:

• Store of value — money can be saved and its purchasing power carried forward to a later date, unlike a perishable commodity.
• Standard of deferred payments — loan instalments, wages, rents, and other future obligations are fixed and settled in money, because its value is assumed to stay reasonably stable over the contract period.
• Transfer of value — money lets value move easily from one person or place to another, something direct barter could never do efficiently.

Contingent (other) functions — money is the base on which the entire credit system rests (banks lend against and create money); it enables the equitable distribution of national income, since rent, wages, interest, and profit are all paid and compared in money terms; and it helps a consumer maximise satisfaction and a producer maximise profit, by acting as the common denominator against which marginal utilities and marginal costs are compared.