Business Economics · Role of money and interest rates in the economy

Functions and Types of Money: M0 to M3 Money Supply Explained

Updated 11 October 2026 · Fact-checked

Money is anything generally accepted as payment for goods, services and debts. It has three core functions: medium of exchange, store of value and unit of account. Types include commodity, fiat and bank money. Money supply is measured in layers, M0 (narrowest) to M3 (broadest). To solve questions, name the function or measure and justify it.

Understand Functions and Types of Money

Money is any asset that people generally accept in payment for goods, services and the settlement of debts. The key word is generally accepted. A house is valuable, but you cannot pay a shop with it. Money works because everyone trusts that others will take it.

Without money, trade needs barter. Barter requires a double coincidence of wants: you must find someone who has what you want and wants what you have. That is slow and costly. Money removes this problem.

Money has three main functions:

Medium of exchange: you use it to buy and sell. It breaks barter into two simple steps, sell for money, then buy with money.
Store of value: you can hold it now and spend it later. It does this imperfectly, because inflation reduces what a unit of money can buy.
Unit of account: prices, wages and debts are stated in it. This lets you compare the cost of very different goods.

Some texts add a fourth function, standard of deferred payment: contracts for future payment, such as loans, are written in money terms. Check how your study material lists the functions and be ready to explain both versions.

Types of money differ by what gives them value. Commodity money has value of its own, such as gold or silver coins. Fiat money has value because the government declares it legal tender and people trust it, such as rupee notes. Bank money (deposits) is a claim on a bank and moves by cheque, card or electronic transfer. Most money in a modern economy is bank money.

Money supply is measured in layers by liquidity. M0 (reserve money or base money) is currency in circulation plus bankers' deposits with the central bank plus other deposits with the central bank. M1 (narrow money) is currency with the public plus demand deposits with banks plus other deposits with the central bank. M3 (broad money) is M1 plus time deposits with banks. Higher numbers include less liquid assets. Exact RBI definitions can change, so use the definition given in your study material.

Key rules to remember

Functions of money: Medium of exchange + Store of value + Unit of account (+ Standard of deferred payment); Name the function and link it to the example in the question. Deferred payment is listed separately in some texts.
Narrow money (M1), India: M1 = Currency with the public + Demand deposits with banks + Other deposits with RBI; Most liquid measure of money held by the public. Check the current RBI definition in your material.
Broad money (M3), India: M3 = M1 + Time deposits with banks; Broader and less liquid than M1, so M3 ≥ M1.
Ordering of measures: M1 ≤ M3; M0 is a different concept (the base that supports the money supply), not a subset of M1. Do not claim M0 ≤ M1 as a rule.
Money multiplier: Money multiplier = Money supply ÷ Reserve money; Shows how much money supply the banking system creates from each unit of base money.

How to solve Functions and Types of Money questions

Use this method for definition, application and calculation questions on money.

1Read the question and decide if it asks about a function, a type of money or a measure of money supply.
2For a function question, identify what the money is being used for: buying (exchange), saving (store), pricing or comparing (unit of account), or future contracts (deferred payment).
3For a type question, ask what gives the money its value: its own material (commodity), government order and trust (fiat), or a claim on a bank (bank money).
4For a money supply question, write the definition of each measure before calculating. Check which components belong in M1 and which are added for M3.
5Add the components carefully. Use the same units throughout, such as ₹ crore.
6State the result and add one line of meaning, for example that M3 is broader and less liquid than M1.
7If asked to evaluate, give one limitation, such as inflation weakening money as a store of value.

Quickest way: Match the use to the function

When to use it: Use for multiple-choice questions that describe a situation and ask which function of money is shown.

Find the verb: pay or accept means medium of exchange.
Saving or keeping for later means store of value.
Quoting a price, valuing assets or comparing costs means unit of account.
Loan or contract repayable in future means standard of deferred payment.
For M-measures, start from M1 and add time deposits to get M3. Check the answer is larger.

Common mistakes in Functions and Types of Money

Saying money has value only because it is made of a valuable material.
Students think of gold coins and forget fiat money.
Fix: State that fiat money has value because of legal tender status and public trust, not its material.
Mixing up store of value and unit of account.
Both involve value, so they sound alike.
Fix: Store of value is about holding purchasing power over time. Unit of account is about measuring and quoting prices.
Treating M0 as part of M1 by adding it in.
Students assume the numbers are nested like M1 and M3.
Fix: M0 is reserve money, the base. M1 and M3 are measures of money held by the public. Learn each definition separately.
Leaving time deposits out of M3 or including them in M1.
Poor recall of what separates narrow from broad money.
Fix: Remember: M1 has demand deposits only. M3 adds time deposits.
Claiming money is a perfect store of value.
Students ignore inflation.
Fix: Say money is a store of value but loses purchasing power when prices rise.

Worked examples

Example 1

A farmer sells wheat for ₹40,000, keeps ₹10,000 in a cupboard for next season's seeds, and quotes the price of his tractor repair as ₹6,000. Identify the function of money in each case.

Show the solution

Selling wheat for ₹40,000: money is accepted in payment, so it acts as a medium of exchange.
Keeping ₹10,000 for next season: money holds purchasing power over time, so it acts as a store of value.
Quoting the repair as ₹6,000: money expresses the price, so it acts as a unit of account.

Answer: Medium of exchange, store of value and unit of account respectively.

Example 2

In a year, currency with the public is ₹30 lakh crore, demand deposits with banks are ₹20 lakh crore, other deposits with the RBI are ₹0.5 lakh crore, and time deposits with banks are ₹150 lakh crore. Calculate M1 and M3.

Show the solution

M1 = currency with the public + demand deposits + other deposits with RBI.
M1 = 30 + 20 + 0.5 = ₹50.5 lakh crore.
M3 = M1 + time deposits.
M3 = 50.5 + 150 = ₹200.5 lakh crore.
Check: M3 is larger than M1, as expected.

Answer: M1 = ₹50.5 lakh crore; M3 = ₹200.5 lakh crore.

Exam tips

Learn the three functions with a one-line example each. Multiple-choice questions often describe a scenario and ask you to pick the function.
In written answers, define the term first, then apply it. Marks usually go for definition and application.
Write out the components of M1 and M3 from memory. Calculation questions are easy if you know them.
Mention a limitation, such as inflation hurting store of value, to earn evaluation marks.
Use the definitions in your IAI study material if they differ slightly from other sources.

Practice questions from Role of money and interest rates in the economy

Functions and Types of Money in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Functions and Types of Money: frequently asked questions

What are the main functions of money?

The main functions are medium of exchange, store of value and unit of account. Some texts add standard of deferred payment. Learn all four so you can match any textbook.

What is the difference between M1 and M3 in India?

M1 is narrow money: currency with the public, demand deposits and other deposits with the RBI. M3 is broad money: M1 plus time deposits with banks. M3 is larger and less liquid.

What is the difference between commodity, fiat and bank money?

Commodity money has value from the material itself, such as gold. Fiat money has value because the government declares it legal tender and people trust it. Bank money is a deposit claim on a bank that can be transferred electronically.

What is M0 or reserve money?

M0 is the monetary base created by the central bank. It includes currency in circulation and bank deposits with the central bank. It supports the wider money supply through the banking system.