Money and banking
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context. Before money, economies used barter, which required a 'double coincidence of wants' (both parties must want what the other has). Money solves this by acting as an intermediary.
Money serves four primary functions:
- Medium of Exchange: It is used to facilitate transactions. You give money to buy goods; you do not need to trade goods for goods.
- Unit of Account (Measure of Value): It provides a common standard for measuring the value of different goods and services. This allows prices to be posted and compared easily.
- Store of Value: It allows purchasing power to be saved for future use. Money retains its value over time, unlike perishable goods.
- Standard of Deferred Payment: It is used to settle debts that are due in the future (e.g., loans, mortgages).
Characteristics of Good Money
To function effectively, money must possess specific characteristics:
- Generally Acceptable: Everyone must be willing to accept it.
- Portable: Easy to carry and transport.
- Divisible: Can be broken into smaller units for small transactions.
- Durable: Must not wear out or decay quickly.
- Limited in Supply (Scarce): If it is too abundant, it loses value (inflation).
- Uniformity: Each unit must be identical to another of the same denomination.
- Durable: It does not corrode or decay.
- Divisible: It can be melted and cast into coins of specific weights.
- Portable: High value-to-weight ratio.
- Limited Supply: Scarcity prevents rapid inflation.
However, gold is no longer used as money because it lacks portability for large transactions and its supply cannot be easily adjusted by a central bank to manage economic cycles.
Correction:
- Medium of Exchange is about spending now (buying a coffee).
- Store of Value is about saving for later (keeping cash in a wallet or bank account).
If a question asks why people hold cash during uncertain times, the answer relates to its function as a store of value (liquidity), not just a medium of exchange.
Why examiners accept this: Examiners look for the definition plus a contextual example. Simply listing 'Medium of Exchange' gets 1 mark. Explaining how it works gets full marks.
Correct Usage Example:
'Money acts as a medium of exchange because it is generally accepted in payment for goods and services, eliminating the need for a double coincidence of wants required in barter systems.'
Tip: Do not say 'Money is used to buy things.' Be precise: 'It facilitates transactions by serving as an intermediary.'
- Divisibility (can be broken into smaller units). [1]
- Durability (does not decay or wear out easily). [1]
A Central Bank is the primary monetary authority in a country. It is usually owned by the government (e.g., The Federal Reserve in the US, The Bank of England in the UK). Its main goal is to maintain macroeconomic stability, not to make a profit.
Key Roles:
- Monetary Policy: Controlling the money supply and interest rates to manage inflation and economic growth.
- Banker to the Government: Managing the government's bank accounts and issuing government bonds.
- Banker to Commercial Banks: Acting as the 'lender of last resort' for commercial banks in times of crisis.
- Regulator: Overseeing the stability of the financial system.
Monetary Policy Tools:
- Interest Rates: The central bank sets a base rate. Commercial banks use this to set their own lending rates.
- Raising rates: Reduces money supply, lowers inflation, but slows growth.
- Lowering rates: Increases money supply, stimulates growth, but may cause inflation.
- Quantitative Easing (QE): The central bank creates new electronic money to buy government bonds or other financial assets from commercial banks. This increases the reserves of commercial banks, encouraging them to lend more.
| Feature | Central Bank | Commercial Bank |
|---|---|---|
| Ownership | Government / Public Sector | Private Shareholders |
| Primary Objective | Macroeconomic Stability (Low Inflation, Growth) | Profit Maximization for Shareholders |
| Target Customers | Government and Commercial Banks | Individuals and Businesses |
| Money Creation Role | Issues high-powered money (currency/reserves) | Creates broad money via lending (credit creation) |
Correction: The Central Bank does not provide loan facilities to individuals or firms. It only lends to commercial banks (as lender of last resort) and manages government debt. Commercial banks are the ones that provide mortgages and personal loans to the public.
Why examiners accept this: Examiners want to see the transmission mechanism. Don't just say 'rates go down, growth goes up.' Explain the link.
Correct Usage Example:
'When the central bank lowers interest rates, the cost of borrowing for commercial banks falls. Commercial banks then lower their lending rates for businesses and households. This encourages investment (I) and consumption (C), leading to an increase in Aggregate Demand.'
Tip: Use the phrase 'cost of borrowing' and 'incentive to save/spend'.
- Sets interest rates / controls monetary policy. [1]
- Banker to the government / manages foreign exchange reserves. [1]
Commercial Banks are private financial institutions that accept deposits and make loans. Their primary objective is to make a profit.
Key Functions:
- Accepting Deposits: Providing safekeeping for money (savings accounts, current accounts).
- Lending: Providing loans to individuals (mortgages, personal loans) and businesses (overdrafts, business loans). This is how they make profit (interest income > interest paid on deposits).
- Payment Services: Facilitating transfers via checks, debit cards, and online banking.
- Credit Creation: Commercial banks create money through the lending process.
Commercial banks do not just lend out existing deposits; they create new money.
- A customer deposits \Delta D (change in deposits).
- The bank keeps a fraction as Reserve Ratio (RRR) and lends out the rest (Excess Reserves).
- The borrower spends the loan, which is deposited in another bank.
- That bank keeps a fraction and lends again.
This cycle repeats, creating a multiple expansion of the money supply.
Formula for Maximum Potential Money Creation:
\Delta M = \Delta D \times \frac{1}{RRR}
Where:
- \Delta M = Change in total money supply
- \Delta D = Initial deposit
- RRR = Reserve Ratio (e.g., 0.1 for 10%)
Note: This is the theoretical maximum assuming no cash leakages (people don't hold cash) and banks lend all excess reserves.
Scenario: A customer deposits 1,000 into Bank A. The Reserve Ratio (RRR) is 10% (0.1).</p> <p><strong>Step 1</strong>: Bank A keeps100 (10%) as reserves.
Step 2: Bank A lends out 900 (Excess Reserves).<br><strong>Step 3</strong>: The borrower spends the900, which is deposited in Bank B.
Step 4: Bank B keeps 90 and lends810, and so on.
Total Potential Increase in Money Supply:
\Delta M = 1,000 \times \frac{1}{0.1} = 1,000 \times 10 = 10,000
The total money supply increases by 10,000. Note that the <em>initial</em>1,000 is part of this total. The newly created money is 9,000.</p> <p><strong>Real World Caveat</strong>: In reality, the increase is less than10,000 because:
- People hold some cash (currency drain).
- Banks may hold excess reserves above the required minimum.
Correction: Banks must keep a fraction as reserves. They only lend out excess reserves. Also, students often confuse the initial deposit with the newly created money. The initial deposit already existed; the multiplier effect creates additional money through lending.
Why examiners accept this: Examiners look for the concept of Net Interest Margin (spread).
Correct Usage Example:
'Commercial banks make a profit by charging a higher interest rate on loans than they pay in interest on deposits. This difference is known as the net interest margin.'
Tip: Do not say 'they charge fees.' While true, the primary source of profit is the interest spread.
- Banks accept deposits and keep a fraction as reserves. [1]
- They lend out the remaining excess reserves to borrowers. [1]
- These loans are spent and re-deposited in other banks, repeating the process and multiplying the initial deposit into a larger money supply (credit creation). [1]
- Accepting deposits from customers. [1]
- Providing loans/credit to individuals and businesses. [1]