Money and banking
Why money is needed
- Barter - the direct exchange of one good or service for another, without using money. What was used in more traditional times.
- Double coincidence of wants - the problem with barter—in which each person must possess exactly what the other person wants at the same time.
Barter makes exchange slow and difficult. A baker who wants shoes must find a shoemaker who wants bread, then both must agree on a fair exchange rate. Money removes this problem because it is universally accepted in payment.
- Money - anything that is accepted as payment for goods and services.
Forms of money
| Form | Meaning and use |
|---|---|
| Notes and coins | Physical cash issued or authorised by the central bank; useful for immediate face-to-face payments. |
| Bank deposits | Money held in bank accounts and transferred by card, cheque, bank transfer or mobile payment. |
| Digital money | Value stored and transferred electronically. It functions as money when it is widely accepted and can reliably make payments. |
Important: A debit card or payment app is usually a method of accessing bank deposits; the plastic card or app itself is not the money.
Functions of money
| Function | Plain meaning | Why it matters |
|---|---|---|
| Medium of exchange | Money is accepted to buy and sell products. | It removes the need for barter and makes specialisation easier. |
| Measure of value / unit of account | Prices are stated in a common unit. | Consumers and firms can compare values and keep financial records. |
| Store of value | Purchasing power can be kept for future use. | People can save income now and spend it later, although rising prices can reduce its value. |
| Standard of deferred payment | Future debts are stated and repaid in money. | Borrowing and lending become easier because repayment is measurable. |
Characteristics of good money
- Acceptable: Most people and firms must be willing to receive it.
- Durable: It must survive repeated use without quickly wearing out.
- Portable: It should be easy to carry or transfer.
- Divisible: It must be available in different values so small and large payments can be made.
- Recognisable and difficult to copy: Users must identify genuine money and trust it.
- Scarce and reasonably stable in supply: If it can be created without limit, confidence and purchasing power may fall.
Central banks
- Central bank - the national institution responsible for the country's currency and for overseeing the monetary and banking system. It normally does not provide everyday accounts to the public.
- Interest rate - the percentage charged for borrowing or paid as a reward for saving.
- Money supply - the total amount of money available in an economy at a particular time.
A central bank supports trust in money and stability in the financial system. Its exact powers differ between countries, but its main roles usually include:
- Issuing currency: It issues or authorises notes and coins and protects confidence in the currency.
- Banker to the government: It holds government accounts, helps manage government borrowing and advises on financial matters.
- Banker to commercial banks: Commercial banks hold accounts at the central bank and use it to settle payments between themselves.
- Lender of last resort: It may lend to a solvent bank facing a temporary shortage of cash, reducing the risk of wider panic.
- Supervision: It may regulate or supervise banks so they hold enough funds, manage risks and treat customers lawfully.
- Influencing interest rates and money supply: It may change financial conditions to support stable prices and wider economic stability; the policy is studied formally in Unit 4.
Why it matters: If confidence in banks collapses, households may rush to withdraw money and firms may lose access to payments and credit. Central-bank oversight helps the financial system continue operating.
Commercial banks
- Commercial bank - a profit-seeking financial institution that provides banking services to households and firms.
- Accepting deposits: Banks keep money secure and provide accounts from which payments can be made.
- Providing loans: Banks lend to households and firms for spending and investment, charging interest.
- Processing payments: They transfer money through cards, bank transfers, cheques and digital systems.
- Encouraging saving: Savings accounts may pay interest and help households store money for future use.
- Other financial services: Banks may exchange currencies, provide financial advice and offer insurance or safe custody services.
Commercial banks connect savers with borrowers. Deposits provide part of the funds that banks can lend, while loans allow firms to buy machinery and households to make large purchases. Banks must judge risk carefully because some borrowers may not repay.
| Central bank | Commercial bank |
|---|---|
| Works for the national financial system | Works mainly to provide services and earn profit |
| Issues or authorises currency | Distributes cash but does not issue national currency |
| Banker to government and banks | Banker to households and firms |
| May set or influence the policy interest rate | Sets its own saving and lending rates in response to costs, risk and central-bank policy |
| Oversees stability and may regulate banks | Accepts deposits, makes loans and processes payments |