Money: Functions, Approaches and Types

Money is derived from a Latin word, Moneta, which was another name of Goddess Juno in Roman history.

The term money refers to an object that is accepted as a mode for the transaction of goods and services in general and repayment of debts in a particular country or socio-economic framework.

 

Traditionally, economists considered four main functions of money, which are a medium of exchange, a measure of value, a standard of deferred payment, and a store of value.

In simple words, money can be defined as a medium for transaction of goods and services.

Some of the popular definitions of money are as follows:

Robertson has defined money as “Anything which is widely accepted in payment for goods, or in discharge of other kinds of obligations.”

According to Hawtrey, “Money is one of those concepts which like a teaspoon or an umbrella, but unlike an earthquake or buttercup are definable primarily by the use or purpose which they serve.”

Money can be in various forms, such as notes, coins, credit and debit cards, and bank checks. Traditionally, economists considered four main functions of money, which are a medium of exchange, a measure of value, a standard of deferred payment, and a store of value.

However, in modern days, only three functions of money, such as a medium of exchange, measure of value, and a store of value are taken into consideration.

Functions of Money:

Economists considered four main functions of money, which are a medium of exchange, a measure of value, a standard of deferred payment, and a store of value.

These functions are broadly grouped into two categories, which are shown in Figure-1:

The different functions of money (as shown in Figure-1) are as explained as follows:

(a) Primary Functions:

Refer to the basic or original functions of money. The primary functions of money include:

(i) Medium of Exchange:

Refers to a function of money in which money is considered as a mode of exchanging goods. The medium of exchange function is considered as the main and unique function of money as it has solved the main problem of barter system of double coincidence of wants.

Double coincidence of wants refers to the condition when one person receives the commodity provided by the other person in exchange. For example, a butcher would not get the cloth unless the weaver does not require meat.

In such a case, it is essential that both the parties require goods that they are receiving from each other. Therefore, it was difficult to obtain required goods. However, with the introduction of money, goods are easily made available without dependence on any other good.

This is due to the fact that money is generally acceptable throughout an economy. Apart from this, money is also considered as medium of exchange as it is easily portable and divisible as well as authenticated by the government.

(ii) Measure of Value:

Refers to a function of money that helps in determining the value of goods and services. The value of all goods and services are expressed in terms of money. Money is taken as the common denominator while measuring the value of goods and services in monetary terms.

The measure of value function of money has the following advantages:

1. Helps in comparing and calculating the exchange rates between two goods

2. Provides more meaningful accounting systems

3. Helps in determining and comparing national income of different countries

4. Helps in comparing the cost incurred on production and distribution and the revenue generated from the consumption of goods and services

(b) Secondary Functions:

Refer to important functions of money that are obtained from primary functions.

The secondary functions of money are as follows:

(i) Store of Value:

Refers to a secondary function that has been derived from the medium of exchange function of money. Generally, individuals store their wealth in the form of money. Therefore, money acts as an asset that sustains value over a period of time.

In barter system, there used to be only one transaction, which was a simultaneous sale and purchase of goods and services. However, in money economy, the sale and purchase are considered as two separate functions. It can be possible when money not only serves as a medium of exchange, but also store of value. For example, salary drawn by an individual is not spent simultaneously rather it is consumed gradually for purchasing different goods and services.

(ii) Standard of Deferred Payments:

Refers to one of the most important functions of money. Deferred payments refer to payments made on loans, salaries, pensions, insurance premium, interests, and rents. The necessary condition for deferred payment is that the amount of repaid money should be the same as it was at the time of purchase.

In barter system, it was not possible to find out whether the amount returned in the form of commodity is same as it was at the time of purchase. For example, the price of one quintal rice purchased today would not be same after one year. However, the standard of deferred payment function of money is not free from limitations as the value of money has always remained a subject of fluctuations due to inflation.

Different economists have given different viewpoints on money. They treated money as a concept rather than a commodity. The definition of money has always been a controversial issue. Therefore, a universally accepted definition of money has not been provided.

Different Approaches of Money:

Economists have given a number of approaches to explain the concept of money. They have defined the concept of money off on the basis of different aspects of money. However, in recent time, there has been a controversy on which aspects of money should be included in the definition of money.

The different approaches of money can broadly be grouped into two categories, which are shown in Figure-2:

The different approaches of money (as shown in Figure-2) are explained below:

Conventional Approach:

The conventional approach is considered as one of the oldest approach for defining the concept of money. It takes into consideration only two functions of money, namely, medium of exchange and measure of value. Therefore, as per this approach, any good or service that fulfills these two functions is termed as money, regardless of the fact that money is always a subject of authentication by the government.

According to this approach, commodities that serve the purpose of money are cattle (cow, sheep, horse, and bull), grains (wheat, jowar, and rice), stones and metals (copper, brass, silver, and gold). These commodities considered as money as long as they fulfilled the two conditions of money.

Some of the definitions of money given by economists who support conventional approach are as follows:

According to R.P. Kent, “Money is anything that is commonly used and generally accepted as a medium of exchange, or as a standard of value.”

According to Marshall, “All those things which are (at any time and place) generally accepted without doubt or special enquiry as a means of purchasing commodities and services and defraying expenses are included in the definition of money.”

According to Geoffry Crowther, “Money can be defined as anything that is generally accepted as a means of exchange and at the same time acts as a measure and as a store of value.”

Modern Approach:

Over a passage of time, it was realized that conventional approach provides a restrictive definition of money. In addition, the functions of money are not only confined to medium of exchange and measure of value rather it performs a large number of functions.

The modern approach of money is broadly classified into three categories, which are as follows:

(a) Chicago Approach:

Lays emphasis on extending the definition of money given in conventional approach. This approach was given by Milton Friedman and his associates in Chicago University. They have extended the definition of money given in conventional approach by including three more concepts, namely, currency, checkable demand deposits, and time deposits.

However, economists having conventional viewpoint of money were against the addition of the concept time deposit in the definition of money. According to conventional approach, time deposits are not available easily in liquid form or spent directly; therefore, do not serve the purpose of money. However, the Chicago school of thought has given two points emphasizing the importance of time deposits in the definition of money.

These two points are as follows:

i. Advocated that national income and money are interrelated to each other and this interlink can be more strengthen if time deposits are included in money

ii. Propounded that definition of money should include the close substitutes of money and time deposit is one of those substitutes

However, both of the explanations are not strong enough to include time deposits in the definition of money.

(b) Gurley-Shaw Approach:

Includes the liabilities of non-banking financial intermediaries in the definition of money. The main contributors of this approach were John G. Gurley and Edward S. Shaw. Gurley and Shaw, while explaining the concept of money, highlighted the substitution relationship among various factors, such as currency, demand deposits, time deposits, and saving bank deposits.

These factors act as the sources for storing value. Therefore, according to Gurley-Shaw, money can be defined as the weighted sum of currency, demand deposits, and other deposits and claims against the financial intermediaries. The weights should be allotted on the basis of substitutability of currency.

However, the practical implication of this approach is not possible as it is difficult to determine the degree of substitutability of deposits and claims against the financial intermediaries. Moreover, assigning weights to measure the money supply is a challenging task.

(c) Central Bank Approach:

Constitutes the broader view of the whole concept of money. The function of the central bank is to control and regulate the flow of money in an economy. Therefore, the central bank formulates and implements a monetary policy to achieve its goals and objectives.

For this purpose, it needs to determine all the sources and modes of payment and flow of credit in the economy, which are treated as money. According to the central bank view, currency and all other assets that can be converted into money (realizable assets) are included in the money supply.

Radcliffe Committee of United States endorsed the central bank approach. According to this committee, “the similarity between currency and other realisable assets or means of purchasing to the point of rejecting money in favor of some broader concept, measurable or immeasurable.”

In other words, money can be any form through which the borrowers receive credit. On the basis of monetary policy and policy targets, the central bank implements different measures to control money supply.

Types of Money:

We have discussed above the types of commodities that are considered as money.

However, the different forms of money are classified into the following:

(a) Commodity Money:

Refers to a form of money as per the classical approach. The commodity form of money involves commodities, such as cattle, grains, leather, skins, utensils, and weapons. However, in the present time, commodity money is not preferable as it lack certain important characteristics of money, such as uniformity, homogeneity, standard size and weight, portability, and divisibility.

(b) Metallic Money:

Includes money made up of metals, such as copper, brass, silver, gold, alloys, and aluminium. The need for metallic money was realized due to the limitations of commodity money. However, the exact period when metallic money was invented is unknown.

It is supposed that metallic coins were traded in India around 2500 years ago. Initially, the pieces of metals, such as gold, silver, copper, and aluminum, served the purpose of money. However, in later years, these pieces took the form of coins.

(c) Paper Money:

Refers to the form of money printed, authenticated, and issued by the government of a country. Paper money is regarded as the most common form of money and constitutes a large part in the money supply of a country. Some of the countries adopted the dual system of currency notes.

For example, in India, both, five rupees notes and coins are issued by Reserve Bank of India (RBI). The currency notes issued by RBI are promissory notes, but they get a status of legal money. For example, on every currency note, it is written, “I promise to pay the bearer a sum of…. Rupees.”

Paper money was invented as the supply of metallic coins, such as silver and gold, was very less as compared to its demand. In addition, a large amount of metallic money is not easily portable and the value of metallic coins depreciates with time.

(d) Bank Deposits:

Refers to money that is in the form of current account deposits, saving account deposits, and time deposits. This form of money was invented with the evolution of the banking system. Unlike metallic money and paper money, this form of money cannot be passed hand to hand for purchasing goods and services.

Deposit money is considered as entries in the ledger of the bank to the credit of the holder. These deposits can only be transferred through checks.

Since time immemorial, money has retained some value; therefore has demand.

Demand for Money:

The demand for money is different from demand for a commodity. Demand for money refers to the amount of money to be held by individuals and businesses. On the other hand, demand for a commodity is the demand for the continuous flow of goods and services. Therefore, the difference between the demand for money and demand for commodity is that the former focuses on the holding, while later focuses on the flow. Earlier, the demand for money was defined as the amount of money required for making business transactions.

In simple terms, the demand for money was dependent on the number of transactions done in an economy. As a result, there was a rapid rise in the demand for money in the boom period, whereas the demand for money fell at the time of depression. On the other hand, modern view on demand of money given by Keynes, demand for money is the demand for money to hold.

There are three broad motives on the basis of which money is required by people, which are as follows:

(a) Transaction Motive:

Refers to the demand for money to fulfill the present needs of individuals and businesses. Individuals require money to fulfill their current requirements, which is termed as income motive. On the other hand, businesses need money for carrying out their business activities, which is known as business motive.

These two motives of money are discussed as follows:

(i) Income Motive:

Refers to the motive of individuals who demand money for fulfilling the needs of themselves as well as their family. Generally, individuals hold cash for bridging the gap between the receipt of income and its expenditure.

The income is received once in a month but the expenditure takes place every day. Therefore, it is required to hold some part of income to make current payments. The holding amount depends on the amount of an individual’s income and interval of receiving income.

(ii) Business Motive:

Refers to the requirement of money by businesses in liquid form to meet the current requirements. Businesses require money for procuring raw material and paying transport charges, wages, salaries, and other expenses. The money demanded by businesses depends on their turnover. The higher turnover indicates the requirement of higher amount of money to cover up expenses.

(b) Precautionary Motive:

Refers to the longing of individuals to hold money for various contingencies that may take place in future. These contingencies can include unemployment, sickness, and accidents. The amount of money need to be held for the precautionary motive depends on the nature of a person and his/her living conditions.

(c) Speculative Motive:

Refers to the motive of individuals for holding cash to make out benefit from the movements of market regarding the change in interest rate in future. The precautionary and speculative motive acts as the store of value with different purposes.

Supply of Money:

As discussed above, the demand for money is demand for money to hold. Similarly, supply of money refers to the supply of money to hold. Money needs to be held by individuals, else it does not exist. Supply of money refers to the total amount of money (in any form) that is held by a community in a given period of time.

In earlier times, the metallic money was the most common form of money that constituted the major part of money in an economy. In modern times, metallic money has been replaced by currency notes and checkable bank deposits.

The money supply is categorized as M₁, M₂, M₃ and M₄. M₁ refers to the money stock that includes coins, currency notes, and demand deposits. M₂ refers to the money stock that includes coins, currency notes, demand deposits, and time deposits. M₃ refers to the money stock includes coins, currency notes, demand deposits, time deposits, and post office deposits.

M₄ refers to the money stock includes coins, currency notes, demand deposits, lime deposits, post office deposits, savings bank, and term deposits. The credit control policies imposed by the banking system of a country- help in determining the total supply of money.