Money and Banking

Money and its functions

Money is anything widely accepted as payment for goods and services.

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Before money, people used barter, swapping goods directly. Barter needs a double coincidence of wants: I must have what you want and want what you have. That is rare, which is why barter is slow and limits trade. Money solves this problem, and saying so is often worth a mark.

The four functions of money:

Inflation damages two of these. If prices rise quickly, money loses value, so it works badly as a store of value and as a standard of deferred payment. In extreme inflation people stop accepting the currency altogether and return to barter, which shows why controlling inflation matters (4.8).

Characteristics of money

For something to work as money it must be:

• Acceptable: everyone must be willing to take it.
• Durable: it must not wear out quickly.
• Portable: easy to carry.
• Divisible: it can be split into smaller units for small purchases.
• Limited in supply: if anyone could make it; it would lose value.
• Recognisable: easy to identify and hard to forge.
• Uniform: each unit of the same denomination is identical.

A useful test: gold is durable and limited but not very portable or divisible; a banknote is portable, divisible and recognisable, which is why notes replaced coins for larger amounts.

Commercial banks

A commercial bank is a bank that serves the general public and businesses.

Its main functions:

• Accepting deposits: current accounts for spending, savings accounts for saving.
• Lending: loans, mortgages and overdrafts, charging interest.
• Enabling payments: debit cards, transfers, cheques.
• Providing other services, foreign exchange, insurance, financial advice.

Banks make their profit mainly from the difference between the interest they charge borrowers and the interest they pay savers. That single sentence answers most questions about how banks earn money.

Central banks

A central bank is the government's bank and the bank to the commercial banks. There is one per country (or currency area).

Its main functions:

• Issuing notes and coins.
• Setting the interest rate and operating monetary policy (4.4).
• Acting as banker to the government, holding its accounts and managing borrowing.
• Acting as banker to commercial banks, and as lender of last resort if a bank runs short of funds.
• Regulating and supervising the banking system.
• Holding the country's foreign exchange reserves and managing the exchange rate.

Do not confuse the two. A commercial bank deals with the public and aims to make a profit. A central bank deals with government and banks, and aims to keep the economy stable; it is not trying to make a profit.

Worked example

A country experiences very high inflation, with prices doubling every few months.

1. Money loses value quickly
2. people no longer want to store their wealth as money, so they spend it immediately or buy goods and foreign currency instead
3. lending collapses, because nobody wants to be repaid later in money worth much less
4. money begins to fail as a store of value and as a standard of deferred payment.

What the central bank might do: raise the interest rate, which makes borrowing more expensive and saving more attractive, reducing spending and slowing the rise in prices.

The cost: higher interest rates also discourage firms from investing and may raise unemployment, so there is a trade-off, which is exactly the kind of point that earns evaluation marks.

Common exam mistakes

• Giving only two or three functions of money when four are expected.
• Confusing the characteristics of money (durable, portable) with its functions (medium of exchange).
• Confusing central banks with commercial banks.
• Saying banks make money "from fees", the main source is the interest difference.
• Forgetting that inflation undermines money's role as a store of value.

Exam technique

Learn the four functions and the characteristics as two separate lists, questions ask for one or the other, and mixing them loses marks.

When explaining a function, add a short example: "a unit of account, a shirt priced at $20 can be compared with a meal priced at $10."

For central bank questions, be clear that it is about stability, not profit, and link its interest-rate role forward to monetary policy in Unit 4.

Building an answer

4 marks, "Explain two functions of money."

Money acts as a medium of exchange: it is accepted in payment, which removes the need for a double coincidence of wants and makes specialisation and trade possible.
Money is also a store of value: it can be held and spent later, so people can save. This function fails when inflation is high, because the money loses purchasing power while held.

6 marks, "Analyse the role of commercial banks in an economy."

Banks accept deposits, providing households and firms with a safe place to hold money and earn interest.
They lend those deposits to borrowers, channelling funds from savers to those who want to invest, which is how saving becomes investment.
They provide the payments system: cards, transfers and cheques through which almost all transactions now settle.
Through lending they also create money: a loan credited to an account is new deposit money, so the banking system expands the money supply, which is why banks are regulated so closely.

The four functions, and what breaks each

The characteristics money must have

Acceptability, durability, portability, divisibility, scarcity (limited supply) and uniformity. Note that these are characteristics, not functions, a distinction 0455 tests directly, and one where students routinely give a function when asked for a characteristic.

A real case to quote

M-Pesa in Kenya. Mobile phone credit became a widely accepted medium of exchange and store of value for people without bank accounts, and is now used by most Kenyan adults. It is a strong example because it shows money is defined by what it does, not by what it is made of, a balance on a SIM card performs every function that notes and coins do.

Quick revision

• Money solves the double coincidence of wants problem of barter.
• Four functions: medium of exchange, store of value, unit of account, standard of deferred payment.
• Characteristics: acceptable, durable, portable, divisible, limited, recognisable, uniform.
• Commercial banks: deposits, loans, payments, profit from the interest difference.
• Central bank: issues currency, sets interest rates, banker to government and banks, lender of last resort, regulator.
• Inflation damages money as a store of value and standard of deferred payment.

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