Functions of Money – B.A. (General) Economics
Prepared for IIT‑JEE / Competitive Exams
1. Introduction
| Question | Answer |
|---|---|
| What is money? | A medium that is accepted in exchange for goods & services, monetary unit for accounting, store of value, standard for deferred payment, and unit of account. |
| Why study functions of money? | They are the operational pillars of a monetary system; understanding them helps analyze inflation, exchange rates, policy choices, and economic behaviour. |
Key Idea – Money is not a thing but a set of functions that a currency performs in an economy.
2. Features of Money (Quick Review)
| Feature | Explanation |
|---|---|
| Medium of Exchange | Eliminates the double‑coinage problem (barter). |
| Unit of Account | Standard measure of value (prices, wages). |
| Store of Value | Preserves purchasing power over time. |
| Standard of Deferred Payment | Used to settle future obligations. |
Note: The store of value function is the most fragile—inflation erodes it.
3. Functions of Money – In‑Depth
3.1 Medium of Exchange
- Definition: A medium that facilitates transactions.
- Characteristics:
- Acceptability – Universally accepted.
- Portability – Easy to carry.
- Durability – Withstands wear & tear.
- Divisibility – Can be split into smaller units.
- Homogeneity – Same unit is identical (e.g., 1 rupee = 1 rupee).
- Limited Supply – Prevents devaluation.
Tricky Point – In credit economies, credit can be the medium of exchange if it is accepted (e.g., credit cards), but it is not money proper because it is not a stored medium.
3.2 Unit of Account
- Definition: A standard numeric measure for valuing goods & services.
- Implication: Prices, wages, profits, interest rates are all expressed using the monetary unit.
- Derivation:
[ \text{Price of Good } A = \frac{\text{Value of Goods in Money}}{\text{Quantity of Good A}} ] The unit of account is implicitly the denominator of the price ratio.
Tricky Point – A non‑money asset (e.g., land) can be priced in money but does not serve as a unit of account for all economic transactions.
3.3 Store of Value
- Definition: The ability to maintain purchasing power over time.
- Condition:
[ \text{Value of Money}{t+1} \ge \text{Value of Money}{t} ] For inflation ( \pi > 0 ), the real value decreases:
[ \text{Real Value}{t+1} = \frac{\text{Nominal Value}{t+1}}{1+\pi} ] - Measurement: Velocity and inflation are inversely related to the store of value quality.
Tricky Point – Savings in a bank account (interest‑bearing money) can increase the store of value, whereas cash in hand tends to lose value at the inflation rate.
3.4 Standard of Deferred Payment
- Definition: Money is used to settle future obligations.
- Illustration:
[ \text{Debt of } 5,\text{₹} \text{ at } 5% \text{ interest for one year} \Rightarrow \text{Payment after 1 year} = 5 \times (1+0.05) = 5.25,\text{₹} ] - Why it matters: Enables credit and financial contracts.
Tricky Point – Non‑monetary securities (e.g., gold) can serve as deferred payment standards in informal markets but are not accepted in formal monetary systems.
4. Money Supply & Demand – A Quick Derivation
4.1 Money Supply (M)
- M1 = Currency in circulation + Demand deposits
- M2 = M1 + Savings deposits + Time deposits (≤ ₹20,000)
- M3 = M2 + Other larger deposits (institutional)
Derivation: The monetary base (B) (currency + reserves) is expanded by the money multiplier (m):
[ M = m \times B, \quad m = \frac{1}{\text{Reserve Ratio}} ]
4.2 Velocity of Money (V)
- Definition: Number of times each unit