Functions and Significance of Money

Meaning of Money, Definition of Money, Approaches to the Definition of Money, Need for Empirical Definition, Transactions Approach vs Liquidity Approach, and the Best Definition of Money.

Money is one of the most important inventions in the history of human civilization. Modern economic life would be impossible without money. Every day, individuals, businesses, and governments use money to buy goods and services, pay wages, settle debts, and accumulate wealth. Although money is so familiar in daily life, defining it precisely has always been a complex task for economists.

From primitive barter systems to digital currencies, money has evolved continuously. Economists have debated its nature, functions, and scope for centuries. As economies became more complex, the need to understand what constitutes money and what does not became more critical for economic analysis, policy formulation, and monetary control.

This article provides a comprehensive and SEO-friendly discussion on the functions and significance of money, the meaning and definition of money, different approaches to defining money, the need for an empirical definition, a comparison between the transactions approach and liquidity approach, and finally, the best definition of money.

Meaning of Money

What Is Money?

In ordinary language, money refers to anything that is generally accepted as a means of payment for goods and services and for the settlement of debts. It acts as a common medium that facilitates exchange in an economy.

In economics, money is not limited to coins and currency notes. It includes demand deposits, bank balances, and other highly liquid financial assets that can be easily used to make payments.

Evolution of Money

1. Barter System
   In early societies, goods were exchanged directly for other goods. This system suffered from several problems such as:

   • Lack of double coincidence of wants

   • Difficulty in valuation

   • Indivisibility of goods

   • Lack of store of value

2. Commodity Money
   Commodities like cattle, grains, salt, shells, and metals were used as money.

3. Metallic Money
   Gold and silver coins became popular due to durability and uniformity.

4. Paper Money
   Paper notes issued by governments replaced metallic money due to convenience.

5. Credit and Digital Money
   Bank deposits, debit cards, mobile payments, and digital wallets represent modern forms of money.

Definition of Money

Defining money is not easy because money performs multiple functions and exists in different forms. Economists have given various definitions based on the functions and characteristics of money.

Traditional Definitions of Money

1. Crowther’s Definition

   “Money is anything that is generally acceptable as a means of exchange and at the same time acts as a measure and a store of value.”

2. Walker’s Definition

   “Money is what money does.”

3. Robertson’s Definition

   “Money is anything which is widely accepted in payment for goods or in discharge of other kinds of business obligations.”

4. Keynes’ Definition

   “Money is that by delivery of which debt contracts and price contracts are discharged, and in the shape of which a store of general purchasing power is held.”

Key Elements in Definitions of Money

• General acceptability

• Medium of exchange

• Measure of value

• Store of value

• Standard of deferred payments

Functions of Money

Money performs several important functions in an economy. These functions can be classified into primary functions, secondary functions, and contingent functions.

Primary Functions of Money

1. Medium of Exchange

Money acts as an intermediary in the exchange process. Instead of exchanging goods directly, people sell goods for money and then use money to buy other goods.

Significance:

• Eliminates the barter system

• Solves the problem of double coincidence of wants

• Facilitates specialization and division of labor

2. Measure of Value (Unit of Account)

Money provides a common unit for measuring the value of goods and services.

Significance:

• Prices of goods are expressed in monetary terms

• Makes comparison of values easy

• Facilitates accounting and record keeping

Secondary Functions of Money

3. Store of Value

Money allows people to store purchasing power for future use.

Significance:

• Encourages saving

• Provides security against uncertainty

• More convenient than storing commodities

4. Standard of Deferred Payments

Money acts as a standard for settling future payments.

Significance:

• Essential for credit transactions

• Enables long-term contracts

• Promotes economic growth

Contingent Functions of Money

5. Basis of Credit

Money serves as the basis of the credit system. Banks create credit on the basis of deposits.

6. Transfer of Value

Money facilitates transfer of value from one place to another.

7. Distribution of National Income

Wages, rent, interest, and profit are all paid in monetary terms.

8. Maximization of Satisfaction

Money helps consumers and producers maximize satisfaction and profits.

Significance of Money in Modern Economy

Money plays a central role in the functioning of a modern economy.

Economic Significance

• Facilitates large-scale production

• Promotes trade and commerce

• Helps in price determination

• Encourages capital formation

Social Significance

• Improves standard of living

• Provides freedom of choice

• Reduces social inequalities through redistribution

Political Significance

• Enables government expenditure

• Facilitates taxation

• Supports economic planning and development

Approaches to the Definition of Money

Economists have adopted different approaches to define money. These approaches determine what assets should be included in the money supply.

The two most important approaches are:

1. Transactions Approach

2. Liquidity Approach

Need for an Empirical Definition of Money

Meaning of Empirical Definition

An empirical definition of money identifies specific assets that function as money in practice rather than relying on abstract concepts.

Why Is an Empirical Definition Necessary?

1. Monetary Policy Formulation
   Central banks need a clear definition to control money supply.

2. Measurement of Money Supply
   To calculate M1, M2, M3, etc.

3. Economic Analysis
   Helps in studying inflation, growth, and employment.

4. Avoids Ambiguity
   Different assets have varying degrees of liquidity.

5. Policy Effectiveness
   Ensures better regulation of credit and inflation.

Transactions Approach to the Definition of Money

Meaning of Transactions Approach

The transactions approach defines money as anything that is commonly used as a medium of exchange.

Main Proponents

• Irving Fisher

• Classical economists

Components of Money Under Transactions Approach

• Currency notes and coins

• Demand deposits

• Chequeable deposits

Strengths of Transactions Approach

• Simple and clear

• Focuses on actual use of money

• Useful for analyzing spending and income

Limitations of Transactions Approach

• Ignores near-money assets

• Too narrow in modern economies

• Fails to account for liquidity preference

Liquidity Approach to the Definition of Money

Meaning of Liquidity Approach

The liquidity approach defines money as an asset that can be easily converted into purchasing power without loss of value.

Main Proponent

• John Maynard Keynes

Components of Money Under Liquidity Approach

• Currency

• Demand deposits

• Time deposits

• Savings deposits

• Near-money assets

Strengths of Liquidity Approach

• Broad and realistic

• Suitable for modern financial systems

• Explains demand for money

Limitations of Liquidity Approach

• Difficult to draw boundaries

• Too broad and complex

• Measurement problems

Transactions Approach vs Liquidity Approach

Basis	Transactions Approach	Liquidity Approach
Focus	Medium of exchange	Store of value
Scope	Narrow	Broad
Main Proponent	Irving Fisher	J.M. Keynes
Assets Included	Currency & demand deposits	Currency + near-money
Suitability	Traditional economies	Modern economies

Best Definition of Money

Criteria for the Best Definition

A good definition of money should:

• Be clear and precise

• Reflect actual economic practice

• Be useful for policy and analysis

• Cover modern financial instruments

Most Accepted Definition

The most practical and widely accepted definition is:

“Money is anything that is generally acceptable as a medium of exchange and at the same time serves as a measure of value, a store of value, and a standard of deferred payments.”

Why This Is the Best Definition

• Combines functional and practical aspects

• Applicable to both traditional and modern economies

• Balances transactions and liquidity perspectives

With the development of financial markets and digital technology, the concept of money has expanded significantly. Traditional definitions based only on currency and coins are no longer sufficient to explain modern economic realities.

Electronic and Digital Money

Electronic money includes:

• Debit cards

• Credit cards

• Internet banking

• Mobile wallets (UPI, PayPal, etc.)

Characteristics:

• No physical existence

• Highly liquid

• Easily transferable

• Accepted widely in modern economies

Digital money has strengthened the liquidity approach because it emphasizes ease of convertibility and purchasing power rather than physical exchange.

Money Supply and Its Relation to the Definition of Money

The definition of money directly affects how money supply is measured.

Measures of Money Supply

1. M1 (Narrow Money)

   • Currency with the public

   • Demand deposits

   • Other deposits with central bank

2. M2

   • M1 + savings deposits

3. M3 (Broad Money)

   • M1 + time deposits

4. M4 (Very Broad Money)

   • M3 + post office savings

👉 These classifications reflect the liquidity approach, as assets are arranged according to their degree of liquidity.

Role of Money in Economic Stability

Money is not only a facilitator of exchange but also a powerful tool for maintaining economic stability.

Money and Inflation

• Excess supply of money leads to inflation

• Shortage of money leads to deflation

• Stable money supply ensures price stability

Money and Economic Growth

• Encourages investment

• Facilitates capital formation

• Promotes industrialization

Money and Employment

• Adequate money supply increases demand

• Higher demand leads to higher production

• Increased production generates employment

Criticism of Traditional Views on Money

Despite their importance, traditional definitions and approaches have certain limitations.

Criticism of “Money Is What Money Does”

• Too vague

• Lacks precision

• Not suitable for empirical analysis

Criticism of Functional Definitions

• Ignore institutional aspects

• Overlook changing financial instruments

Criticism of Broad Definitions

• Difficult to control monetarily

• Measurement problems

Reconciliation of Transactions and Liquidity Approaches

Modern economists argue that the two approaches should not be viewed as contradictory.

Complementary Nature

• Transactions approach explains use of money

• Liquidity approach explains demand for money

Integrated View

A comprehensive definition of money should:

• Include assets used directly in transactions

• Include assets that can easily become means of payment

This integrated view is widely accepted by central banks and monetary authorities.

Importance of Money in Developing Economies

In developing countries, money plays a critical role in economic transformation.

Key Contributions

• Monetization of the economy

• Expansion of markets

• Mobilization of savings

• Financial inclusion

Challenges

• Inflationary pressures

• Black money

• Unequal distribution of income

Money and Government Policy

Money is a powerful instrument of public policy.

Fiscal Policy

• Government spending and taxation operate through money

• Budget deficits are financed through money creation

Monetary Policy

• Control of money supply

• Regulation of credit

• Interest rate policy

Central banks rely heavily on a clear definition of money to implement effective policy.

Summary: Key Points at a Glance

• Money is anything generally accepted as a medium of exchange

• It performs primary, secondary, and contingent functions

• Money is vital for economic growth and stability

• Definitions of money vary due to its evolving nature

• Transactions and liquidity approaches offer different perspectives

• An empirical definition is essential for policy and measurement

• The best definition of money combines all major functions

Frequently Asked Questions (FAQs)

1. Why is money important in an economy?

Money facilitates exchange, encourages specialization, supports savings, and enables economic development.

2. What is the main function of money?

The primary function of money is to act as a medium of exchange.

3. Who introduced the liquidity approach?

John Maynard Keynes introduced the liquidity approach.

4. Why is an empirical definition of money needed?

To measure money supply accurately and formulate effective monetary policy.

5. Which approach is better: transactions or liquidity?

Both are important and complementary in modern economies.

Examination-Oriented Questions

Short Answer Questions

1. Define money.

2. What are the primary functions of money?

3. Explain the transactions approach.

4. What is meant by liquidity?

Long Answer Questions

1. Discuss the functions and significance of money.

2. Explain the need for an empirical definition of money.

3. Compare transactions and liquidity approaches.

4. Critically examine the best definition of money.

Conclusion

Money is the lifeblood of a modern economy. From facilitating simple exchanges to supporting complex financial systems, its role is indispensable. Although economists differ in their definitions and approaches, there is consensus that money must be understood in both functional and practical terms.

The transactions approach highlights money’s role in exchange, while the liquidity approach explains its demand and flexibility. A balanced and empirical definition that incorporates both perspectives provides the most effective understanding of money in today’s dynamic economic environment.

Money is the backbone of a modern economy. It facilitates exchange, promotes specialization, enables savings, and supports economic development. While defining money has always been a challenge due to its evolving nature, economists have developed various approaches to understand it better.

The transactions approach emphasizes money’s role as a medium of exchange, whereas the liquidity approach highlights its role as a store of value. Both approaches are important and complementary.