Money: meaning, definitions, functions, evils and the supply of money (M1 to M4)

1. Meaning of money

Before money, goods were exchanged directly for goods: this is barter. Barter breaks down as an economy grows, for four reasons that every answer should state, because the functions of money are simply the cures for them:

• Lack of double coincidence of wants. A weaver who wants rice must find a farmer who has rice and at the same time wants cloth.
• No common measure of value. Each good has to be priced in terms of every other good; with 100 goods there are 4,950 exchange ratios.
• Indivisibility. A cow cannot be divided to buy a pair of sandals.
• No store of value and no basis for future payments. Grain rots and cattle die; a loan in kind cannot be repaid fairly.

Money is whatever a community generally accepts in exchange for goods and services and in settlement of debts. The essential quality is general acceptability, not the material it is made of.

2. Definitions

• D.H. Robertson: money is “anything which is widely accepted in payment for goods, or in discharge of other kinds of business obligations.”
• Geoffrey Crowther: “anything that is generally acceptable as a means of exchange and at the same time acts as a measure and a store of value.”
• Seligman: money is “one thing that possesses general acceptability.”
• F.A. Walker gave the functional definition: “Money is what money does.”
• Keynes (A Treatise on Money, 1930) distinguished money of account, in which debts and prices are expressed, from money proper, the thing that answers to that description and is delivered in discharge.

Definitions fall into three groups: those based on general acceptability (Robertson, Seligman), functional definitions (Walker, Crowther), and legal definitions (G.F. Knapp: money is what the State declares to be legal tender). A good answer names all three groups.

3. Functions of money

The old couplet sums up the classical view: “Money is a matter of functions four, a medium, a measure, a standard, a store.” Modern textbooks (following Kinley) group the functions as follows.

(a) Primary functions

1. Medium of exchange. Money splits barter into two separate acts, sale and purchase, and so removes the need for a double coincidence of wants. This is the function that makes specialisation and division of labour possible.
2. Measure of value (unit of account). All goods are priced in one common unit, the rupee. Prices make comparison, accounting and economic calculation possible.

(b) Secondary functions

1. Standard of deferred payments. Loans and future obligations (salaries, rent, interest) are expressed in money. This made the growth of credit and capital markets possible.
2. Store of value. Money is the most liquid asset; purchasing power can be saved for future use without the waste of storing goods.
3. Transfer of value. Purchasing power can be moved from one person or place to another through cheques, drafts and electronic transfers.

(c) Contingent functions

• Distribution of national income among the factors of production as wages, rent, interest and profit.
• Equalisation of marginal utilities for the consumer and of marginal productivities for the producer, because all goods and factors are priced in one unit.
• Basis of credit. Cheques, bills and bank deposits all rest on money.
• Liquidity. Keynes stressed that people hold money because it is the most liquid of all assets (the liquidity preference).
• Guarantee of solvency. A firm must keep money to meet its obligations.

4. Role (significance) of money

Money is significant in consumption (the consumer spreads income to maximise satisfaction), in production (the firm compares costs and revenues and pays factors), in exchange (markets and the price mechanism work through money), in distribution (factor rewards), and in public finance (taxes, public expenditure and borrowing are all in money). In a planned economy too, plan targets, budgets and costs are calculated in money. Money is also the vehicle of monetary policy: by changing its supply and cost, the central bank influences output, employment and prices.

5. Evils of money

• Instability of value. Inflation erodes savings and fixed incomes; deflation ruins producers and debtors.
• Inequality. Money can be accumulated without limit and passed on, widening the gap between rich and poor.
• Over-capitalisation and over-production. Easy credit leads to excess investment and then to depression; the trade cycle is in part a monetary phenomenon.
• Exploitation and moral evils. Money makes possible bribery, black money, hoarding and speculation.
• Debt. Easy borrowing tempts governments and households into debt they cannot service.

Robertson put the balanced view: money, which is a source of so many blessings, becomes, unless it is controlled, a source of peril and confusion. The evils come from mismanagement of money, not from money itself.

6. Kinds of money

• Commodity and metallic money: cattle, grain, then full-bodied coins whose metal value equals face value; token coins have face value above metal value.
• Paper money: convertible (into gold or silver on demand) or inconvertible (fiat money, resting on the authority of the State). The rupee note is fiat money.
• Legal tender: money a creditor must accept. RBI bank notes are unlimited legal tender (section 26, RBI Act, 1934); coins of one rupee and above are legal tender for sums up to Rs. 1,000 (section 6, Coinage Act, 2011). Cheques are optional money.
• Bank (credit) money: demand deposits transferable by cheque or electronic transfer.
• Near money: highly liquid assets that are not themselves a means of payment, such as time deposits, treasury bills and post office deposits.
• Digital currency: the RBI began pilots of the e-rupee, a central bank digital currency, in November 2022 (wholesale) and December 2022 (retail).

7. Supply of money

The supply of money is the total stock of money held by the public at a point of time. “Public” excludes the money-creating sector, that is, the Government, the RBI and the banks; inter-bank deposits are not counted. Supply of money is a stock; when multiplied by velocity it gives the flow of money spending.

The RBI’s four measures (Second Working Group, 1977)

Liquidity falls from M1 to M4. M1 is the most liquid; M3, called aggregate monetary resources, is the measure most used for policy. “Other deposits with the RBI” are demand deposits of quasi-government bodies, foreign central banks and international institutions such as the IMF and World Bank.

The new monetary aggregates (Working Group under Y.V. Reddy, 1998)

• M0 (reserve money): currency in circulation + bankers’ deposits with the RBI + other deposits with the RBI.
• NM1: currency with the public + demand deposits with banks + other deposits with the RBI.
• NM2: NM1 + short-term time deposits of residents (contractual maturity up to one year).
• NM3: NM2 + long-term time deposits of residents + call and term borrowings from non-depository financial corporations.
• Liquidity aggregates L1, L2, L3: add post office deposits, then term deposits and certificates of deposit of financial institutions, then public deposits of non-banking financial companies.

Determinants: high-powered money and the money multiplier

Money supply M = m × H, where H is high-powered (reserve) money and m is the money multiplier, m = (1 + c) / (c + r), c being the public’s currency to deposit ratio and r the banks’ reserve to deposit ratio.

Worked example. c = 0.2, r = 0.1, H = Rs. 100 crore. m = 1.2 / 0.3 = 4, so M = 4 × 100 = Rs. 400 crore. If the RBI raises the cash reserve ratio so that r becomes 0.2, m = 1.2 / 0.4 = 3 and M falls to Rs. 300 crore. The supply of money therefore depends on the RBI (through H and r), the banks (excess reserves) and the public (c).

The legal side of the RBI’s note issue and reserve requirements is in RBI: monetary regulation, credit control, currency and exchange.

How this is examined

Essay: “Define money. Explain the various functions of money” (January 2026, 16 and 10 marks; June 2025, 10 marks). Open with barter and its difficulties, give three definitions, then the functions under primary, secondary and contingent heads, and close with Robertson’s remark. Short notes: “Evils of money” (January 2026), “Role of money” (June 2025), “Supply of money” (January 2026, 100-mark paper). For supply of money, draw the M1–M4 table and add one line on the money multiplier.