Definition and Functions of Money

In order to understand the fundamentals of economics, it is imperative to have a good understanding of money. In this article, we will look at the definition of money from an economics perspective and also the various functions of money.

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Definition of Money

Money, in simple terms, is a medium of exchange. It is instrumental in the exchange of goods and/or services.

Further, money is the most liquid assets among all our assets. It also has general acceptability as a means of payment along with its liquid nature.

Usually, the Central Bank or Government of a country creates and issues money. Also called cash money, this is a legal tender and hence there is a legal compulsion on citizens to accept it.

Browse more Topics under Money

Credit money is another form of money which the banks create through loan transactions.

functions of money

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Functions of Money

There are many static and dynamic functions of money as follows:

Static Functions of Money

These functions are:

  • A medium of Exchange – In an exchange economy, money plays an intermediary role. It makes the exchange system smooth and convenient.
  • A measure of Value – The value of a product or service is determined on the basis of the money needed for its possession. This helps in making the exchange a mutually profitable activity.
  • The Standard of Deferred Payments – Money plays an important role in lending and borrowing. Money is taken as a loan and repaid after a time-gap.
  • Store of Value – You can store the purchasing power of money and keep a part of it for future use – monetary savings. You can use your current income for current consumption as well as future consumption through savings.

Learn more about Quantity Theory of Money here in detail.

Dynamic Functions of Money:

These functions are:

  • Money can activate idle resources and put them into productive channels.
  • Therefore, it helps in increasing output, employment, and also income levels.
  • Further, it helps in converting savings into investments.
  • The creation of new money governments of modern economies can spend more than what they earn.

Value of Money

The value of money simply implies its exchange value. It means the number/amount of goods and/or services that you can obtain in exchange for a single unit of money.

Further, the value of money is inversely proportional to the price of goods/services. Therefore, if the price level increases, the value of money decreases and vice-versa.

Forms of Money

We can classify the total money supply of an economy into two broad groups – Cash Money and Credit Money, including all other financial assets. The degree of money-ness of different assets is different.

The Components of Money Supply

The components of the money supply are as follows:

  • Paper Money and Coins – The Central Bank or Government issues these as Currency. Further, they have a 100% acceptance as a means of payment. The acceptance is based on a ‘promise to pay the bearer’ gold and/or foreign exchange in return.
  • Demand Deposit – A bank has a legal obligation to pay money on demand. The money-ness is highest in currency and demand deposits.
  • Near Money or Money Substitute – A commonly used Near Money is a bank cheque. many people accept it as a means of payment. However, there is no legal compulsion behind their acceptance.
  • Term deposit – This is less liquid than a demand deposit as the individual cannot use it before a fixed period of time.
  • Other Financial Assets – Many non-banking financial intermediaries issue these assets.

Solved Question on Functions of Money

Q1. What are the static functions of money?

Answer: The static functions of money are:

  1. Money works as a medium of exchange
  2. It helps to measure the value of a good or service
  3. Money plays an important role in lending and borrowing
  4. A person can store the purchasing power of money
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