Functions of money can be classified into four heads:
1. Primary or main functions of money,
2. Secondary functions of money,
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3. Contingent functions of money,
4. Other functions of money.
Let us discuss them in brief for clarity of concept.
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1. Primary Functions of Money:
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Functions that money has essentially to perform are known as its primary functions. They are two—the medium of exchange and the measure of value.
(a) Medium of Exchange:
One of the primary functions of money is to serve as a medium of exchange for day to day transactions. The property of general acceptability of money is must for the purpose. If all goods and services were exchanged for money, lack of double coincidence of wants would no longer obstruct transactions.
(b) Measure of Value:
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The other primary function of money is to serve as a measuring rod for value of goods and services. As a measure of value, money must facilitate pricing of products so crucial for exchange. The number of money units that represent the value of a good or service is called its price. Money must serve as a common denominator so that value of all goods and services may be expressed in terms of its units.
2. Secondary Functions of Money:
The following are the secondary functions of money:
(a) Standard of Deferred Payments:
Lending and borrowing, so common and so essential in trade, could not be possible under barter system due to lack of standard of deferred payments. In business, payments for goods received now are often put off to a point of time in future.
Such payments are known as deferred payments. Use of a commodity with highly flexible value lends an element of uncertainty to the value of repayment. This discourages credit and loans. Evolution of money must eliminate this uncertainty and must provide a standard of deferred payments.
(b) Store of Value:
Storing surpluses or savings involves the risk of loss of value with the passage of time under the barter system. Savings and surpluses if stored in terms of goods either perishable or susceptible to loss of value due to deterioration, infliction and such other time and age related damages, the very purpose of saving is defeated. Evolution of money must eliminate the value-loss in the process of storing surpluses.
(c) Transfer of Purchasing Power:
Transfer of purchasing power from one place to another or from one individual to another in terms of assets under barter involves transfer-costs and transit-damages. Evolution of money must do away with such wastages. Transfer of money must transfer purchasing power.
3. Contingent Functions:
In addition to the above, money performs certain additional functions in developed countries. These functions, described as the contingent functions by Prof. Kinley, are as given below:
(а) As the Basis of Credit:
In developed and developing countries, credit plays a very important role in all economic activities. Instruments of credit, such as the bills of exchange, etc. are in extensive use in developed countries. Money forms the basis of such credit instruments.
(b) As the Basis of Distribution of Income:
Share of each factor of production in the total output is measured in terms of money. This was exceedingly difficult under barter. Each factor is now duly compensated for its services in terms of money. Money thus helps distribution of income.
(c) As the Basis of Maximization of Total Utility by Consumer and Total Productivity by Producer:
Money plays an important role in utility maximization of the consumer. Value of goods and services is expressed in terms of money. A consumer can compare the marginal utility of a product with that of money he is to forego.
A simple mathematical treatment can show that the utility maximizing level of consumption requires equating the marginal utility of money to the marginal utility of the product. In the same way, equating marginal productivity of a factor of production to the marginal utility of money paid in compensation to the factor helps the cause of cost minimization and productivity maximization by the producers.
4. Other Functions of Money:
Through its mere existence, money plays the following important roles:
(a) As Guarantor of Solvency.
(b) As Bearer of the Last Option.
(c) As an Instrument that Renders Liquidity to Capital.
(d) As Basis of the Price-mechanism.
Money, due to its general acceptability, serves as a guarantor of solvency. Possession of liquidity (cash) serves as a safeguard against insolvency.
Holding wealth in terms of money renders the last option to the individual who holds it. For instance, if wealth is stored in the form of real estate, one needs to sell off a large chunk of it (due to its indivisibility) in case one needs funds for a child’s education or for his/her marriage.
Moreover, disposal of fixed assets in such emergencies often causes loss due to distress sale. But if wealth is stocked in liquid (cash) form, money can serve as a bearer of the last option by helping the holder to choose the best among its available alternative uses.
Money is the most liquid form of capital. It helps a variety of motives of the individuals. For instance, money provides for certain anticipated or non- anticipated transactions in day-to-day functioning of business or in day-to-day needs of domestic life.
Such motives money helps to fulfil are called the transaction motives. In like manner, people store cash as a safeguard against unforeseen contingencies. Such motives are called the precautionary motives.
People hold cash so that they may not miss the opportunity of acquiring shares and such other liquid assets when their market prices crash. Prof. Keynes calls such motives as speculative motives.
Price mechanism fails to function without the institution of money. Product prices are expressed in terms of money. This is crucial for functioning of the price mechanism.
In sum, money, initially invented to serve as a medium of exchange and a measure of value, turned out to be doing much more for modern societies. Its contribution to the modern industrial world is so crucial that it is impossible even to think of money-less society, leave alone the question of running it. The role of money is of an identical importance in all economic systems—be they capitalistic, socialistic or mixed in nature.