Following are the functions of money:
1. Medium of Exchange
The most important function of money is that it serves as a medium of exchange. In the barter economy a great difficulty was experienced in the exchange of goods as the exchange in the barter system required double coincidence of wants. Money has removed this difficulty. Now a person A can sell his goods to B for money and then he can use that money to buy the goods he wants from others who have these goods. As long as money is generally acceptable, there will be no difficulty in the process of exchange. The function of medium of exchange that money performs has become possible because money has enabled us to separate the act of buying from the act of selling and thus avoids double coincidence of wants. We saw above that under the barter system because of this double coincidence of wants exchange of goods and services was difficult and inconvenient to occur. The use of money which is generally accepted as a medium of exchange has made it possible to sell anything to anyone who wants to buy it and accept in return some amount of money as a price. He then uses the money to buy the good he wants from someone who has it. In this way separation of the acts of selling and buying through the use of money helps us to avoid double coincidence of wants. By serving as a very convenient medium of exchange money has made possible the complex division of labour or specialisation in the modern economic organisation.
2. Measure of Value or a Unit of Account
Another important function of money is that it serves as a common measure of value or a unit of account. Under barter economy there was no common measure of value in which the values of different goods could be measured and compared with each other. Money has also solved this difficulty. Money serves as a yardstick for measuring the value of goods and services. As the value of all goods and services is measured in a standard unit of money, their relative values can be easily compared.
Money has also solved this difficulty. Under barter, values of different goods were expressed and measured in terms of quantities of each other such as so many bushels of wheat, so many litres of milk, so many number of cigarettes and this makes the comparison of values of different goods difficult. For example, rupee is the basic unit of account in India for measuring economic values. Almost all prices of goods, rent of land, wages of labour, interest on capital, prices of gold and silver and real estate are expressed and measured in rupees. Measuring values of all goods and services in a single uniform account simplifies the comparison of values of different goods and services. Money serves as a yardstick for measuring the value of goods and services. When the value of all goods and services is measured in a standard unit of money, say rupee, their relative values can be easily compared to achieve optimum of one’s budget expenditure among different goods for consumption.
3. Standard of Deferred Payment
Another function of money it that it serves as a standard for deferred payments. Deferred payments mean those payments which are to be made in the future. If a loan is taken today, it would be paid back after a period of time. The amount of loan is measured in terms of money and it is paid back in money. A large number of credit transactions involving huge future payments are made daily. Money performs this function of standard for deferred payments because its value remains more or less stable.
If the prices are falling, i.e., the value of money is rising, the creditors will gain in real terms and the debtors will lose. Conversely, if the prices are rising (or value of money is falling) creditors will be the losers. Thus, if the money is to serve as a fair and correct standard for deferred payments, its value must remain stable. In case the value of money is changing very much, the creditors or debtors will be put to much loss and sufferings. Thus when there is severe inflation or deflation, money ceases to serve as a standard for deferred payments.
4. Store of Value
Lastly, money acts as store of value. Money being the most liquid of all assets is a convenient form in which to store wealth, that is, money can be held as an asset. Thus, store of value function is also called asset function of money. It is, therefore, essential that the good chosen as money should be such as can be easily stored without deterioration or wastage. That is why gold was popular in the past as money material. Gold could be kept safely without deterioration. But in the modern times even paper money can be kept as deposits in banks to serve as asset. Of course, there are other assets like houses, factories, bonds, shares etc., in which wealth can be stored. But money performs the store of value function with a difference. Money being the most liquid of all assets has the advantage that an individual or a firm can buy with it anything at any time. But this is not the case with other assets. Other assets like houses and shares have to be sold first and converted into money and only then they can be used to buy other things.
Money would perform the store of value function properly if it remains stable in value. For example, if there is a high rate of inflation in the economy, real value or purchasing power of money goes on falling. This adversely affects the store of value function of money. Since a high rate of inflation erodes the real value of money, it discourages people to save. Besides, a high rate of inflation induces people to invest whatever savings they do in unproductive assets such as gold and jewellery, real estate etc. rather than storing their savings in cash money or deposits in banks with a fixed rate of interest or in bonds and shares of corporates companies and mutual funds from which real return is uncertain.
It may however be noted that while only money performs function of medium of exchange or a unit of account but any other asset such as bonds, shares, gold or real estate can serve as a store of value. These other assets generally provide the holder of these assets a higher return compared to that of money. The question arises as to why people usually use money as a store of value though return from it is relatively low. Cash money yields no return at all and money in the form of savings bank deposits yields a very low return of 4% per annum in India.
5. Transfer of value
Since money is a generally acceptable means of payment and acts as a store of value, it keeps on transferring values from person to person and place to place. A person who holds money in cash or assets can transfer that to any other person. Moreover, he can sell his assets at Delhi and purchase fresh assets at Bangalore. Thus, money facilitates transfer of value between persons and places.
6. Most Liquid of all Liquid Assets
Money is the most liquid assets in which wealth is held. Individuals and firms may hold wealth in infinity varied forms. They may, for example, choose between holding wealth in currency, demand deposits, time deposits, savings, bonds, treasury bills, short-term government securities, long-term government securities, debentures, preference shares, ordinary shares, stocks of consumer goods, and productive equipment. All these are liquid forms of wealth which can be converted into money, and vice-versa.
7. Basis of Credit System
Money is the basis of the credit system. Business transaction is either in cash or on credit. Credit economises the use of money. But money is at the back of all credit. A commercial bank cannot create credit without having sufficient money in reserve. The credit instruments drawn by businessmen have always a cash guarantee supported by their bankers.
8. Equaliser of Marginal Utilities and Productivities
Money acts as an equaliser of marginal utilities for the consumer. The main aim of a consumer is to maximise his satisfaction by spending a given sum of money on various goods which he wants to purchase. Since price of goods indicate their marginal utilities and are expressed in money, money helps in equalising the marginal utilities of various goods. This happens when the ratios of the marginal utilities and price of the various goods are equal.
9. Equaliser of Marginal Productivities
Money also helps in equalising the marginal productivities of the various factors. The main aim of the producer is to maximise his profits. For this, he equalises the marginal productivity of each factor with its price. The price of each factor is nothing but the money he receives for his work.
10. Measurement of National Income
It was not possible to measure national income under the barter system. Money helps in measuring national income. This is done when various goods and services produced in a country are assessed in money terms.
11. Distribution of National Income
Money also helps in the distribution of national income. Rewards of factors of production in the form of wages, rent, interest and profit are determined and paid in terms of money.
From above it is clear that money has removed the difficulties of barter system. It has facilitated trade and has made possible the complex division of labour and specialisation of the modern economic system. Without the use of money, modern economy will not run smoothly and the production will get a serious setback. For these reasons, monetary economy is preferred to barter economy.