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Functions Of Money

Updated on April 15, 2024
Article byJyotsna Suthar
Edited bySusmita Pathak
Reviewed byDheeraj Vaidya, CFA, FRM

Functions Of Money Definition

The Functions of Money in economics refer to the set of essential features and benefits that money offers to individuals, bankers, government, and other entities. The primary role of money is to act as a source of value for transacting deals with parties.

Functions Of Money

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The concept of money traces back to the beginning of trade when the barter system still existed. It acts as a medium of exchange, enabling individuals to use them to purchase goods and services. However, while money enhances economic efficiency significantly, there are various limitations to the trading instrument as well. 

Key Takeaways

  • Functions of money refer to the necessary features that money possesses to keep an economy financially active. It helps in determining the value of goods and services. 
  • It emerged as the best way to deal with the restrictions that the barter system came with.
  • The primary functions include acting as a store of value, medium of exchange, store of wealth, facilitating transfer, serving as a measure of value, and functioning as a standard of deferred payment. 
  • Various factors, such as inflation, can affect the functioning of money. This becomes a challenge to its effectiveness within the economy.

Functions Of Money Explained

The functions of money in the economy include the crucial roles and responsibilities it fulfills in the market that revolves around exchanging everything for money. Although it exists in a physical paper form, it influences transactions in a significant way and is globally accepted. 

Before money was invented, the barter system prevailed, where goods and services were exchanged directly. This mechanism observed one party exchanging its goods and services with the goods and services of another party with no currency forms involved. However, there were certain limitations to this system of exchanging goods and services. 

Firstly, one party needed to require the goods and services that the other party had to offer. In case the requirements differed from what the parties had to offer to each other, the deal was canceled. Secondly, the government always attempted to introduce regulations to limit the barter system, given the negative effect it had on the tax revenues generated.

Fiat money or paper currency emerged as an answer to all the restrictions that the barter system imposed. Since its emergence, the concept and significance of money have evolved. Over time, economists have explained money’s role in the economy, including economist John Keynes, who discussed the importance of money in the book “The General Theory of Employment, Interest, and Money,” published in 1936. 

Types

Money serves various functions in the economy. Broadly, these functions are classified into two categories – primary and secondary functions of money. 

Let us discuss them in detail below: 

#1 – Medium Of Exchange

One of the five functions of money is to serve as a medium of exchange, which is crucial among all other functions it offers. It allows individuals to buy goods and services from the retailer. However, getting overall acceptance on a significant level is essential to act as a medium of exchange. This ensures that people can easily use it to exchange commodities for paper money. For instance, in earlier times, metal coins were used as a medium of exchange. But over time, evolution has replaced metal with paper money. 

#2 – Standard Of Deferred Payment 

Money serves as an ideal medium for deferred payment. This applies in cases where people purchase things on credit but have a provision to pay it later in cash. For example, when one takes a loan, they can use the borrowed money to buy something, which they can repay in the future. As a prime function, it has durability and stability compared to others. Thus, it has general acceptability in most nations. 

#3 – Measure Of Value 

An essential role of money is that it can help identify the true value of products and services. Money makes transactions transparent and efficient by giving buyers and sellers a standard unit of measurement. This allows them to determine the actual value of the products and services being traded.

#4 – Store Of Value 

During the barter system, accumulating wealth was challenging as each item had a different value. This made it difficult for individuals to store commodities or items. Moreover, the shelf life of these commodities was also low. Money, on the contrary, evaluates everything that it can purchase. From commodities to metals to luxury items, money can be used to buy anything, and it allows those assets to be stored to be retrieved in the future when required. As a result, the store of value or wealth, therefore, serves as one of the primary functions of money. 

#5 – Transfer Of Value

Money holds the critical feature of transferability. Individuals can effortlessly transfer funds to other parties after deducting their respective shares. Moreover, the smooth transferability of funds makes a range of financial operations easier, including investments, payments, and remittances, all of which boost the growth of economic exchanges.

Examples

Let us look at the examples to understand the concept better:

Example #1

Let’s say Stella is a homemaker who has been preserving her gold jewelry from time to time to ensure she can retrieve its value when required in an emergency. Unfortunately, her husband dies in an accident without any insurance policies to cover her materialistic needs any further. In such a scenario, she hears about a gold loan scheme, keeps the gold jewelry with the service provider, and gets the money in exchange for it. She takes up the loan on her gold ornaments and starts a bakery business. 

In two years, her business grew, and she managed to pay back the gold loan provider and get all her jewelry pieces back immediately. This example shows how money can serve as a store of value/wealth and a standard of deferred payment both at once.

Example #2

At the Crypto and Digital Assets Summit held on May 2023 in London, England, Tom Mutton, the head of the Bank of England, stated that cryptocurrency does not fulfill any of the functions that money does. He stated that cryptocurrencies do not possess the fundamental qualities required to function as a store of value, a unit of account, or a medium of exchange. He discussed the concern that cryptocurrencies could be used secretly for illegal activities, unlike traditional money, which is more transparent and regularly monitored by the government.

How Does Inflation Affect It?

Inflation significantly affects the functions of money in the economy. Let us explore how:

  • Raises interest rates – As inflation strikes the nation, the government takes a prudent step by raising interest rates. This encourages individuals to reduce expenses and save more money in banks. As a result, it can affect consumer spending habits. 
  • Affects the medium of exchange – With rising inflation, the value of the country’s currency and its role as a medium of exchange will decrease. Individuals may lose their trust in the money, resulting in fewer people using it as a currency to transact. 
  • Leads to currency depreciation – Inflation also causes a severe impact on the nation’s currency. The country’s economic condition brings a downfall for the currency. As a result, its exchange value in the global market also fluctuates. 
  • Impacts store of value – As inflation rises, individuals may choose to invest their money in buying assets like land or gold instead of hoarding money. This change indicates a decline in trust in the currency’s long-term stability.

Frequently Asked Questions (FAQs)

What are the contingent functions of money?

The contingent functions observed in economics include:
a. Distribution of national income
b. Increased productivity of assets
c. Increased customer satisfaction
d. Improved credit creation and capital productivity

How do functions of money as a unit of account influence economic decision-making?

Money’s function as a measure of value gives organizations and individuals a consistent way to analyze the value of investments, products, and services. This helps them make well-informed financial decisions. Moreover, this feature makes budgeting, resource allocation, and pricing comparisons easier.

On which forms of money are the functions of money applicable?

The various forms of currency available in the market are commercial, fiduciary, commodity, fiat, metallic, and paper.

How do the functions of money affect consumer behavior?

Money gives people the ability to buy things and services that satisfy their needs and desires, which in turn affects consumer behavior and satisfaction. Money facilitates transactions as a medium of exchange, promoting customer choice and overall satisfaction with the accessibility and availability of goods and services.

This article has been a guide to Functions Of Money and its definition. Here, we explain its types, examples, and how inflation affects it. You may also find some useful articles here –

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