Functions and Forms of Money

Why Money Matters in the CDS Paper

The CDS General Studies paper and the OTA economics portion regularly carry a question on the functions or forms of money. These are scoring marks because the ideas are concrete and the definitions are short — you simply have to be precise. Money also links to almost every other economics topic the exam tests, from inflation and banking to monetary policy, so a clear grip here pays off across the whole paper.

Money is anything that is generally accepted as a medium of exchange and as a means of settling debts. Notice the phrase ‘generally accepted’ — acceptability, not the material, is what makes something money.

The Barter System and Why It Failed

Before money, people exchanged goods directly for goods — this is the barter system (the C–C economy, commodity for commodity). It worked in tiny village settings where wants were few and neighbours knew one another, but it broke down completely as trade grew larger and reached across regions. The drawbacks were serious and each one slowed the growth of trade:

• Double coincidence of wants: a person with rice wanting cloth had to find someone with cloth who also wanted rice — rarely possible.
• No common measure of value: there was no single yardstick to say how much cloth equalled how much rice.
• Indivisibility: a cow cannot be split to buy a small quantity of salt.
• No store of value: perishable goods like milk or vegetables could not store wealth over time.
• Difficulty of deferred payments: lending and repaying in goods was disputed because quality and value changed.

Primary Functions of Money

The primary (or main) functions are the two jobs that every money must perform, in every economy and at every stage of history:

• Medium of exchange: money is accepted in all transactions, so goods are sold for money and money buys other goods (C–M–C). This single feature ends the need for a double coincidence of wants and lets a person sell what they have and, separately, buy what they need, whenever and from whomever they choose.
• Measure of value (unit of account): money provides a common unit — the rupee — in which the price of every good is expressed, so values can be compared and added. Without a common measure you could not say a shirt is ‘worth’ three kilograms of rice; with money, both simply carry a price tag and the comparison is instant.

Secondary and Contingent Functions

The secondary (derived) functions developed as economies grew more complex:

• Store of value: money lets people save purchasing power for the future; it is durable, compact and easily stored, unlike perishable goods such as milk, fish or vegetables that lose value within days. Wealth held in money can be spent at a time of the holder’s choosing.
• Standard of deferred payments: loans, salaries, rents and instalments are fixed and repaid in money over time. Because the rupee is a stable, agreed unit, lenders and borrowers can sign contracts today that will be settled months or years later without disputes over quality.
• Transfer of value: wealth can be shifted from one person or place to another — you can sell property in Delhi and use the proceeds to buy a house in Pune. Money makes value mobile across both people and geography.

Economists also list contingent functions: money helps distribute national income (as rent, wages, interest, profit), forms the basis of credit, and gives liquidity to assets.

Forms of Money

Money has evolved through several forms, and CDS often asks you to match a form with its definition:

• Commodity money: goods accepted as money — cowrie shells, cattle, grain, salt. Its value as a commodity equals its value as money. The English word ‘salary’ itself comes from salt once paid to soldiers, a reminder of how old commodity money is.
• Metallic money: coins of gold, silver or copper. Full-bodied coins have a face value equal to the value of the metal in them; token coins (today’s coins) have a face value greater than their metal value, so their worth rests on government authority rather than the metal.
• Paper money: currency notes issued by the central bank — in India the RBI issues all notes except the one-rupee note, which the Government of India issues.
• Bank (deposit) money: demand deposits in banks operated through cheques, drafts and electronic transfer.
• Digital / plastic money: debit and credit cards, UPI, mobile wallets and the RBI’s digital rupee (CBDC).

Legal Tender and Acceptability

Legal tender is money that a creditor is legally bound to accept in settlement of a debt; refusing it cancels the debt. The authority of the state, not the material, is what gives legal-tender money its force. It is of two kinds:

• Limited legal tender: accepted only up to a certain amount — coins are limited legal tender in India.
• Unlimited legal tender: accepted for any amount — currency notes are unlimited legal tender.

Money that people accept by custom but which carries no legal compulsion (such as a cheque) is called optional or fiduciary money — you may refuse it.

Near Money and Liquidity

Near money refers to assets that are not money themselves but can be quickly and cheaply converted into cash. Examples include time deposits, treasury bills, bills of exchange, bonds and savings certificates.

Near money is highly liquid but is not a medium of exchange — you cannot directly buy bread with a fixed-deposit receipt; you must convert it to cash first. Because such assets are close to cash in liquidity yet earn interest, people hold a part of their wealth in near money rather than idle currency. The growth of near money also matters to policymakers, since it can quickly turn into spending and affect demand in the economy.

Measures of Money Supply: M1 to M4

Money supply is the total stock of money held by the public at a point in time. Note that money held by the government and by the banking system itself is excluded — only money in the hands of the public counts, because that is what is available for spending. The Reserve Bank of India publishes four measures, moving from the most liquid (narrow money) to the least liquid (broad money):

• M₁ = Currency with the public + Demand deposits with banks + Other deposits with the RBI. This is narrow money.
• M₂ = M₁ + Savings deposits with post-office savings banks.
• M₃ = M₁ + Time (term) deposits with banks. This is broad money and the most watched aggregate.
• M₄ = M₃ + Total deposits with post-office savings organisations (excluding NSCs).

Worked Example: Calculating Narrow Money

Let us apply the M₁ formula to a simple data set, exactly the kind of numerical CDS sometimes frames.

Common Mistakes to Avoid

These slips cost easy marks in the exam — train yourself to dodge them:

• Confusing the medium of exchange (primary) with store of value (secondary). Keep the four-function memory line ready.
• Thinking a cheque is legal tender — it is fiduciary/optional money and can be refused.
• Including time deposits in M₁. They belong to M₃, not narrow money.
• Forgetting that the one-rupee note and all coins are issued by the Government of India, while other notes are issued by the RBI.
• Calling near money a ‘medium of exchange’ — it is liquid but must first be converted to cash.

Previous-Year Style Question

Attempt this the way it would appear in the paper, then check the reasoning.

Quick Recap and Revision