EconomicsCBSE Class 12 · Money and Banking

Money: Meaning, Functions and Money Supply (Class 12)

Updated 15 October 2026 · Fact-checked

Money is an intermediate good acceptable to all that removes the need for a double coincidence of wants in barter. Its functions are medium of exchange, unit of account and store of value. Money supply (M1) = currency held by the public + net demand deposits with banks.

Understand Money: Meaning, Functions and Supply

Why money? In a barter economy goods are exchanged for goods. This needs a double coincidence of wants: a person with surplus rice who wants cloth must find someone with surplus cloth who wants rice. As the number of people grows, search costs become prohibitive. An intermediate good acceptable to both, money, smooths exchange: sell produce for money, then buy what you need.

Three functions (NCERT).

1. Medium of exchange (the first and foremost): it removes the double-coincidence problem and cuts search costs.
2. Unit of account: values of all goods and services are expressed in money units. If a pencil costs ₹2 and a pen ₹10, a pen is worth 10 ÷ 2 = 5 pencils; a rupee is worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen. When the general price level rises, a unit of money buys less: purchasing power of money falls.
3. Store of value: wealth can be stored as money for future use. Unlike rice, money is not perishable, has low storage cost and is acceptable at any time. Its value must be stable; inflation erodes it. Other assets (gold, land, houses, bonds) also store value but are less easily convertible and not universally acceptable.

Fiat money and legal tender. Currency notes and coins are fiat money: they have no intrinsic value like a gold coin, and are issued on the authority of the government. They are legal tender: they cannot be refused by any citizen for settling a transaction. Cheques (demand deposits) can be refused, so demand deposits are not legal tender.

Money supply. The total stock of money in circulation among the public at a point of time (a stock variable).

M1 = CU + DD: currency (notes and coins) held by the public + net demand deposits of commercial banks ('net' excludes inter-bank deposits).
M2 = M1 + savings deposits with post office savings banks.
M3 = M1 + net time deposits of commercial banks (most commonly used; also called aggregate monetary resources).
M4 = M3 + total deposits with post office savings organisations (excluding National Savings Certificates).
M1 and M2 are narrow money; M3 and M4 are broad money; liquidity decreases from M1 to M4.

Towards less cash. NCERT notes India's push for digital payments and financial inclusion through Jan Dhan accounts, Aadhaar-enabled payment systems and e-wallets.

Money: Meaning, Functions and Supply: key facts

Three functions: Medium of exchange; unit of account; store of value; Mnemonic: 'MUSt' (Medium, Unit, Store).
Relative price: Price of A in terms of B = Price of A ÷ Price of B; Unit-of-account use.
Value of money: Value of ₹1 in terms of a good = 1 ÷ price of the good; Falls when prices rise.
M1: M1 = CU + DD (currency with public + net demand deposits); Syllabus measure of money supply.
M2, M3, M4: M2 = M1 + PO savings deposits; M3 = M1 + net time deposits; M4 = M3 + total PO deposits (excl. NSC); Narrow: M1, M2; broad: M3, M4.

How to answer Money: Meaning, Functions and Supply questions

Functions of money give 1-mark identifications and 3- or 4-mark explanations, often with barter's problems; money supply gives 1-mark items on M1 and legal tender.

1Match the use: buying and selling (medium of exchange), measuring and comparing values (unit of account), saving for later (store of value).
2For barter questions, explain the double coincidence of wants and search costs.
3For value of money, use 1 ÷ price; show how a price rise cuts purchasing power.
4For money supply, remember 'net' demand deposits and that money supply is a stock.
5Legal tender: currency yes, cheques/demand deposits no.

Money: Meaning, Functions and Supply in real life

The idea, met in an everyday situation. Answer the question in your own words, then compare with the model answer. The one-line hook is what to remember.

Double coincidence of wants

Suppose a potter in a village wants a pair of sandals. The cobbler has sandals but wants rice, not pots. The rice farmer wants pots.

Why does barter fail here, and how does money solve it?

Try it first, then show the solutionSolution

Potter and cobbler do not want each other's goods: no double coincidence.
A chain of swaps would be needed, which is costly to arrange.
With money, the potter sells pots to the farmer for money and pays the cobbler.

Answer: Barter fails because there is no double coincidence of wants between the potter and the cobbler. Money, acceptable to all, acts as a medium of exchange: the potter sells pots for money and uses it to buy sandals.

Memory hook: Money is the friend everyone agrees to trust.

Purchasing power

Imagine notebooks cost ₹40 last year and ₹80 this year. You still have ₹400 saved in a piggy bank.

What happened to the value of your money?

Try it first, then show the solutionSolution

Last year: ₹400 buys 10 notebooks.
This year: ₹400 buys 5 notebooks.
The value of a rupee in notebooks halved.

Answer: Your money's purchasing power halved: it now buys 5 notebooks instead of 10. Rising prices weaken money's role as a store of value.

Memory hook: Same notes, fewer notebooks.

Tricks to remember Money: Meaning, Functions and Supply

Short memory aids. Say each one aloud once, then use it on a question the same day.

MUSt
Money MUSt be: Medium of exchange, Unit of account, Store of value.
Use it when: Three functions.
M1 = cash + cheque money
Currency with the public + net demand deposits.
Use it when: Money supply.
Legal tender test
Can a shopkeeper refuse it? Notes and coins, no; a cheque, yes.
Use it when: Legal tender vs demand deposits.

Money: Meaning, Functions and Supply: solved examples

Ordered from board level to HOTS. Try each one before you open the solution.

Example 1: Unit of account · 1 mark · MCQBoard level

When we say a wristwatch is worth ₹500, money is performing the function of:
(a) Medium of exchange
(b) Unit of account
(c) Store of value
(d) Legal tender

Try it first, then show the solutionSolution

Expressing value in money units = unit of account.

Answer: (b) Unit of account

Example 2: Functions of money · 3 marks · Short answerBoard level

Explain the three functions of money. (3 marks)

Try it first, then show the solutionSolution

One mark each.

Answer: (1) Medium of exchange: money is accepted in exchange for goods and services, removing the need for a double coincidence of wants. (2) Unit of account: values of all goods and services are measured in money, making comparison easy. (3) Store of value: wealth can be kept as money for future use, since money is non-perishable, cheap to store and universally acceptable (provided its value is stable).

Example 3: Relative prices · 3 marks · Short answerHarder board level

A pencil costs ₹5 and a pen ₹20. Find (i) the price of a pen in pencils, (ii) the value of one rupee in pencils and in pens. Which function of money does this show? (3 marks)

Try it first, then show the solutionSolution

(i) 20 ÷ 5 = 4 pencils.
(ii) 1 ÷ 5 = 0.2 pencil; 1 ÷ 20 = 0.05 pen.
Unit of account.

Answer: (i) A pen = 4 pencils. (ii) ₹1 = 0.2 pencil = 0.05 pen. Money is acting as a unit of account.

Example 4: Barter's problems · 2 marks · Short answerHarder board level

Explain any two difficulties of the barter system that money removes. (2 marks)

Try it first, then show the solutionSolution

Double coincidence of wants; difficulty storing value.

Answer: (1) Lack of double coincidence of wants: finding someone who has what you want and wants what you have involves high search costs; money as a medium of exchange removes this. (2) Difficulty of storing wealth: goods like rice perish and need space; money stores value cheaply and is acceptable at any time.

Example 5: Money supply measures · 3 marks · Short answerHOTS / competency

Distinguish between narrow money and broad money, naming the measures in each. (3 marks)

Try it first, then show the solutionSolution

Narrow: M1, M2; broad: M3, M4.
Liquidity decreases from M1 to M4.

Answer: Narrow money: M1 (CU + DD) and M2 (M1 + post office savings deposits); most liquid and easiest for transactions. Broad money: M3 (M1 + net time deposits of banks) and M4 (M3 + total post office deposits excluding NSCs); less liquid. M3 is the most commonly used measure.

Example 6: Legal tender · 1 mark · Assertion-reasonHOTS / competency

Assertion (A): Demand deposits are not legal tender.
Reason (R): A cheque drawn on a demand deposit can be refused as a mode of payment.
(a) Both A and R are true and R is the correct explanation of A.
(b) Both A and R are true but R is not the correct explanation of A.
(c) A is true but R is false.
(d) A is false but R is true.

Try it first, then show the solutionSolution

Legal tender cannot be refused; cheques can.

Answer: (a) Both A and R are true and R is the correct explanation of A.

Where students lose marks in Money: Meaning, Functions and Supply

The slips examiners see most often, and what to write instead.

Mistake: Writing gross demand deposits in M1
Inter-bank deposits must be excluded.
Wrong working
M1 = currency + all demand deposits in banks.
Right working
M1 = currency held by the public + net demand deposits (excluding inter-bank deposits).
Do this: Remember 'net'.
Usually costs: ½ to 1 mark.
Mistake: Calling money supply a flow
Confusing with income.
Wrong working
Money supply is measured over a year.
Right working
Money supply is a stock at a point of time.
Do this: Stock, like a photograph.
Usually costs: 1 mark.
Mistake: Mixing medium of exchange and unit of account
Both involve prices.
Wrong working
Price tag of ₹500: medium of exchange.
Right working
Expressing value: unit of account; paying ₹500: medium of exchange.
Do this: Measuring vs paying.
Usually costs: 1 mark.

Exam tips

Functions and forms of money appeared in about five tagged items (10 marks) in the PYQ bank, mainly 1-mark MCQs and 3-mark explanations.
Use NCERT's three functions; link 'store of value' to stable prices.
Learn M1 = CU + DD exactly as the syllabus states it.

Practice questions on Money: Meaning, Functions and Supply

Write each answer on paper first. Open the hint only if you are stuck, and the answer only when you have finished.

Q1 · 1 mark · MCQBoard level
Which of the following can be refused as a mode of payment, because it is not legal tender?
(a) A ₹500 currency note
(b) A ₹10 coin
(c) A cheque drawn on a savings account
(d) A ₹2 coin
Hint
Notes and coins cannot be refused.
Answer
(c) A cheque drawn on a savings account
Q2 · 1 mark · Short answerBoard level
State the components of money supply (M1) as per the syllabus. (1 mark)
Hint
CU + DD.
Answer
Currency held by the public and net demand deposits held by commercial banks.
Q3 · 2 marks · Short answerBoard level
What is meant by 'double coincidence of wants'? (2 marks)
Hint
Both want what the other has.
Answer
In barter, an exchange happens only if each party wants what the other has to offer at the same time; e.g. a person with surplus rice who wants cloth must find someone with surplus cloth who wants rice. This rarely happens and search costs are high.
Q4 · 2 marks · Short answerHarder board level
Why must the value of money be stable for it to work as a store of value? (2 marks)
Hint
Inflation erodes purchasing power.
Answer
Money stored today is spent later. If the price level rises, each unit of money buys less, so the wealth stored in money loses value. Only with stable prices does money preserve purchasing power over time.
Q5 · 2 marks · Short answerHarder board level
A school bag costs ₹500 one year and ₹600 the next. How many bags can ₹6,000 buy in each year? What happens to the value of money? (2 marks)
Hint
6,000 ÷ price.
Answer
Year 1: 12 bags; year 2: 10 bags. The purchasing power of money in terms of bags falls by one-sixth (about 16.7%) because the price rose.
Q6 · 2 marks · Short answerHarder board level
Distinguish between fiat money and full-bodied gold coins as described in NCERT. (2 marks)
Hint
Intrinsic value.
Answer
Fiat money (currency notes and coins today) has no intrinsic value and is money because of government authority; it is legal tender. A gold or silver coin has intrinsic value equal to the metal it contains.
Q7 · 1 mark · Assertion-reasonHarder board level
Assertion (A): Gold can act as a store of value.
Reason (R): Gold is as universally acceptable and easily convertible into other goods as money.
(a) Both A and R are true and R is the correct explanation of A.
(b) Both A and R are true but R is not the correct explanation of A.
(c) A is true but R is false.
(d) A is false but R is true.
Hint
NCERT on other assets.
Answer
(c) A is true but R is false: gold stores value but is not as easily convertible or universally acceptable as money.
Q8 · 3 marks · Short answerHarder board level
Identify the function of money: (i) a family saves ₹5,000 a month for a future trip; (ii) a shop compares the prices of two phones in rupees; (iii) a farmer sells wheat for cash and buys fertiliser. (3 marks)
Hint
Store, measure, exchange.
Answer
(i) Store of value; (ii) unit of account; (iii) medium of exchange.
Q9 · 3 marks · Short answerHOTS / competency
Suppose a country moves to mostly digital payments. Does money still perform its three functions? Explain. (3 marks)
Hint
Form changes, functions remain.
Answer
Yes. Digital money (bank deposits, e-wallets) still serves as a medium of exchange (payments), a unit of account (prices in rupees) and a store of value (balances held for future use). Only the form changes: transfers of digital information replace notes and coins. Its value as a store still depends on stable prices.
Q10 · 3 marks · Short answerHOTS / competency
Explain why a larger economy finds barter harder than a small village. (3 marks)
Hint
Search costs rise with numbers.
Answer
In a large economy there are many goods and many people, so finding a partner with exactly the opposite wants (double coincidence) involves much higher search costs; relative prices between every pair of goods would also have to be remembered. Money as a medium of exchange and unit of account solves both problems.

Test your recall

Answer in your head or on paper first, then open the card. Pulling an answer out of memory makes it stick far better than re-reading.

1.Name the three functions of money.Show answer
Medium of exchange, unit of account, store of value.
2.What is M1?Show answer
Currency held by the public + net demand deposits.
3.Are cheques legal tender?Show answer
No.
4.Which measures are broad money?Show answer
M3 and M4.
5.Is money supply a stock or a flow?Show answer
A stock.

Money: Meaning, Functions and Supply: frequently asked questions

What are the functions of money in Class 12 Economics?

Medium of exchange, unit of account and store of value.

What is the double coincidence of wants?

In barter, both parties must want what the other has at the same time; money removes this requirement.

What is legal tender?

Money that cannot be refused in settlement of a transaction; currency notes and coins are legal tender, cheques are not.

What does money supply include?

Currency held by the public and net demand deposits with commercial banks (M1); broader measures add time and post-office deposits.