The primary functions are the fundamental roles that money performs in any economic system. These functions solved the core inefficiencies of the barter system, specifically the lack of a common denominator for value.
Medium of Exchange
Money acts as an intermediary in the exchange of goods and services. It facilitates transactions by eliminating the need for the “double coincidence of wants.”
- Facilitation of Trade: It allows for the separation of the acts of buying and selling in time and space.
- Liquidity: Money is the most liquid asset because it can be instantaneously converted into any other commodity without loss of value.
Measure of Value (Unit of Account)
Money serves as a standard numerical unit for measuring the market value of goods, services, and other assets.
- Common Denominator: Just as centimeters measure length, money measures value, allowing for the calculation of relative prices (e.g., 1 kg of apples vs. 1 liter of milk).
- Accounting Framework: It enables the maintenance of business accounts, calculation of GDP, and determination of profit and loss in a standardized format.
Secondary Functions of Money
Also known as “Derivative Functions,” these emerged as economies evolved and required more complex financial arrangements, such as credit and investment.
Standard of Deferred Payments
Money acts as the unit in which future payments (debts) are expressed. This function is the cornerstone of the modern banking and credit system.
- Credit Transactions: Contracts for loans, mortgages, and salaries are settled in monetary terms to be paid at a later date.
- Stability Requirement: For this function to work effectively, the value of money must remain relatively stable over time; high inflation erodes this function.
Store of Value (Asset Function)
Money can be held and exchanged for goods or services in the future. It allows individuals to transfer purchasing power from the present to the future.
- Wealth Accumulation: While other assets (land, gold) also store value, money is preferred for its immediate purchasing power and lack of storage costs.
- Friedman’s View: Noted economist Milton Friedman emphasized money as a “temporary abode of purchasing power.”
Contingent and Other Functions
These functions are relevant in the context of a modern, organized macroeconomy like India’s, where money facilitates systemic stability.
Distribution of National Income
Money serves as the mechanism through which the National Income (GNP) is distributed among the factors of production (Land, Labor, Capital, and Entrepreneurship) in the form of Rent, Wages, Interest, and Profit.
Basis of the Credit System
The entire superstructure of the Indian banking system—including the creation of demand deposits by commercial banks—is built upon the cash reserves held by the central and commercial banks.
Equalization of Marginal Utilities
Money enables consumers to equalize the marginal utility of different goods by adjusting their expenditures. A rational consumer continues to buy a commodity until the marginal utility of the commodity equals its price in terms of money (MUx = Px).
Key Concepts for UPSC Prelims
| Concept | Definition/Significance |
| Gresham’s Law | “Bad money drives out good.” If two types of money exist with the same face value but different intrinsic values, the one with higher intrinsic value will be hoarded and disappear from circulation. |
| Legal Tender | Money that has legal backing by the government and cannot be refused for the settlement of any transaction (e.g., RBI banknotes). |
| Fiat Money | Money that does not have intrinsic value and is not backed by a physical commodity like gold, but by government order. |
| High Powered Money (H or M0) | The total liability of the RBI, consisting of currency in circulation and bankers’ deposits with the RBI. |
Functional Components of Indian Money Supply
The RBI classifies money into four functional aggregates based on their liquidity and functions:
- M1 (Narrow Money): Currency with the public + Deposit money of the public (Demand deposits with the banking system) + ‘Other’ deposits with the RBI. This serves primarily the Medium of Exchange function.
- M2: M1 + Savings deposits with Post Office savings banks.
- M3 (Broad Money): M1 + Time deposits with the banking system. This emphasizes the Store of Value function.
- M4: M3 + Total deposits with Post Office savings organisations (excluding NSC).
Trivia and Facts
- The Neutrality of Money: A classical economic theory suggesting that changes in the money supply only affect nominal variables (prices, wages) and not real variables (GDP, employment).
- Demonetization (2016): An administrative act where the “Legal Tender” status of specific currency denominations (₹500 and ₹1,000) was withdrawn, temporarily suspending their function as a medium of exchange.
- The “Double Coincidence of Wants”: The primary hurdle of the Barter system which necessitated the “Medium of Exchange” function.
- Digital Rupee (e₹): The e-Rupee fulfills all the functions of physical money but reduces the operational costs of the “Store of Value” and “Standard of Deferred Payment” functions by digitizing the ledger.