A baker who wants shoes must find a shoemaker who wants bread, and must find them today, before the bread goes stale. That problem, the double coincidence of wants, is why every society that has traded seriously has invented money. Money is not wealth and it is not valuable in itself. It is a technology for making exchange possible, and understanding what it has to do explains why some things work as money and others do not.
Money performs four functions and questions expect all four. As a medium of exchange it is accepted in payment, which removes the need for barter and the double coincidence of wants. As a unit of account it provides a common measure, so the value of everything can be expressed in the same terms and compared. As a store of value it allows purchasing power to be held over time, so income earned today can be spent next year. And as a standard of deferred payment it allows contracts to be written for future settlement, which is what makes borrowing and lending possible.
The store of value function is the one inflation attacks, and linking the two earns marks in both topics. High inflation erodes purchasing power, so money becomes a poor store of value, and in extreme cases people abandon the currency for foreign money or goods. That connection explains why price stability is a macroeconomic objective rather than an accounting preference.
For something to serve as money it needs certain characteristics, and each follows from a function. It must be generally acceptable, or it cannot be a medium of exchange. Durable, or it cannot store value. Portable, so it can be used where trade happens. Divisible, so transactions of different sizes are possible. Homogeneous, meaning each unit is identical to every other, so it can be a unit of account. Limited in supply, since something available in unlimited quantity would be worth nothing. And recognisable, so people can accept it with confidence.
Central bank
The institution responsible for a country's monetary policy, for issuing currency, for acting as banker to the government and to commercial banks, and for supervising the banking system.
The banking system has two distinct layers and confusing them is a common error. Commercial banks deal with the public: they accept deposits, make loans to households and firms, provide payment services, and profit from the difference between the interest they charge borrowers and the interest they pay savers. The central bank deals with the government and with the commercial banks rather than with the public. It sets the policy interest rate, issues notes and coin, holds foreign currency reserves, regulates the banks, and acts as lender of last resort when a solvent bank runs short of cash.
The lender of last resort function is worth understanding rather than merely naming. Banks hold only a fraction of deposits as cash, because most of the money deposited has been lent out. That is how banking makes money available for investment, but it means no bank could repay every depositor at once. If enough depositors demand their money simultaneously, a bank run, even a perfectly sound bank fails. The central bank standing ready to lend removes the reason to run, which is why the guarantee mostly prevents the crisis rather than merely responding to it.
Working out whether saving is worthwhile
A household deposits $4,000 in a savings account paying 3% interest a year. Inflation over the year is 5%. Calculate the money value of the account after one year, the real interest rate, and the change in what the savings can actually buy.
Households: spending, saving and borrowing
A household divides its disposable income, meaning income after direct tax and benefits, between spending, saving and repaying debt. Which way it leans depends on several influences. Income is the largest: as income rises, both spending and saving rise in total, but the proportion saved tends to rise while the proportion spent falls, which is why poorer households save less. Interest rates matter, since a higher rate rewards saving and makes borrowing dearer. Confidence about future income and job security matters greatly, because uncertainty encourages precautionary saving. Age matters, as younger households typically borrow to buy homes and equipment while middle-aged households save for retirement and the retired draw down. And the availability of credit determines whether borrowing is even possible.
Households borrow for reasons that differ in kind. Mortgages purchase an asset that is expected to hold or increase in value, and the loan is secured against it, which is why mortgage rates are low. Consumer credit funds current spending on cars, furniture or holidays, is usually unsecured and carries higher rates. Student loans fund investment in human capital, with returns arriving over a working life. The economic distinction is between borrowing to acquire an asset or a skill, which raises future income or wealth, and borrowing to bring forward consumption, which does not. Both can be rational, but only the first improves the household's long-term position.
Which function of money is most directly undermined by very high inflation?
Which activity is carried out by a central bank rather than a commercial bank?
A household's disposable income rises. Economic theory predicts that:
Draw a simple flow diagram showing a household's disposable income dividing into spending, saving and debt repayment. Add arrows showing where the saved funds go, through a commercial bank, to firms as loans for investment. Then mark where a rise in the interest rate would change the size of each flow.
The point of drawing it is to see that saving is not money withdrawn from the economy but money redirected: it leaves the household, passes through the banking system and returns as investment. That link is why banks matter to growth and not merely to convenience, and it is the same relationship formalised as the circular flow at A Level.
Applied context
Mobile money services across parts of sub-Saharan Africa, of which Kenya's M-Pesa is the best known, allowed millions of people without bank accounts to store value, send payments and eventually save and borrow using a basic mobile phone. The service worked because it satisfied the requirements of money: it was generally accepted, divisible, portable and recognisable, and it solved the specific problem that transferring cash over distance was slow and dangerous. Studies have associated its spread with increased saving and with households being better able to cope with unexpected costs.
Use this to argue that what functions as money is determined by whether it performs the functions, not by whether a government issued it. It also links banking to development, since access to financial services is a constraint on saving and investment in poor economies.
This note is the foundation for several later topics rather than an end in itself. The store of value function connects directly to inflation, which is analysed in the inflation and price stability note along with the quantity theory of money at A Level. The central bank's control of interest rates is the subject of the monetary policy note, which also explains how commercial banks create credit and multiply an initial deposit. Household saving and borrowing decisions become the consumption function and the marginal propensity to save in the circular flow, and the paradox of thrift shows what happens when every household saves more at once.
9708-4.6 · 9708-5.3 · 9708-9.1 · 9708-9.4
Questions asking whether households should save more attract one-sided answers. Give both: saving provides security against unexpected costs, funds future spending and supplies the banking system with funds to lend for investment; but saving too much reduces present living standards, and if all households save more at once, spending falls and firms sell less, which can cost jobs. Naming that second effect is what lifts the answer, and it is the intuitive version of the paradox of thrift.
The money supply, banks and interest rates
At A Level money is defined by what it does: anything generally accepted as payment for goods and services and in settlement of debts. The money supply is the total quantity of money in the economy at a point in time, and how much of it you count depends on the definition. Narrow money covers notes and coins and the reserves banks hold at the central bank, the money that can be spent immediately. Broad money adds bank deposits, including savings and time deposits that can be turned into spending money quickly. Most of the broad money supply is not notes and coins at all but bank deposits, which is why the behaviour of commercial banks matters so much.
Commercial banks accept deposits and lend. Demand deposits, or current accounts, can be withdrawn at any time and pay little or no interest; savings and time deposits pay more interest but require notice or a fixed term. Banks lend through overdrafts, which let a customer spend beyond their balance up to a limit, and through loans and mortgages for fixed amounts and terms. On the other side of the balance sheet they hold assets: cash, reserves at the central bank, short-term securities such as government bills, longer-term bonds and, above all, loans to customers. Regulators set a reserve ratio, the share of deposits that must be held as cash or central bank reserves, and a capital ratio, the amount of the bank's own capital relative to its risky assets, which is what absorbs losses if loans go bad.
A bank balances three objectives that pull against each other. Liquidity is the ability to meet depositors' demands for cash, which argues for holding cash and short-term assets. Security is avoiding losses, which argues for safe borrowers and government securities. Profitability comes from lending at higher interest rates, which usually means longer and riskier loans that are neither liquid nor secure. Cash is perfectly liquid and secure but earns nothing; a long-term loan to a small business earns the most but is the hardest to get back quickly and the most likely to go unpaid. Bank failures are almost always a story of profitability pursued at the expense of the other two.
How banks create money when they lend
- A customer deposits $1,000 in a bank, and the bank must keep 10% as reserves.
- The bank keeps $100 and lends $900 to a borrower, who spends it.
- The $900 is paid into another bank account, creating a new deposit of $900.
- That bank keeps $90 and lends $810, which is spent and deposited again.
- Each round creates a smaller new deposit, but deposits keep growing.
- The process can continue until total deposits reach the original deposit multiplied by 1 / reserve ratio, here $10,000.
- Broad money has grown by far more than the cash originally deposited, because the new deposits are money created by lending.
The worked calculation, and the reasons the actual expansion is smaller than this maximum, are in the monetary policy note. The point here is that most money is created by commercial banks lending, not printed by the central bank.
Practise this chain →In an open economy the money supply changes for five main reasons. Commercial banks expand or contract lending, creating or destroying deposits. The central bank changes the reserves available to banks and the rules they must follow. The government finances a budget deficit by borrowing, and if it borrows from the central bank or the banking system rather than from the non-bank public, new money is created. Quantitative easing, in which the central bank creates reserves to buy bonds, adds directly to money held in the economy. And the balance of payments matters: a surplus brings in foreign currency that is converted into domestic money, especially where the central bank holds the exchange rate fixed, while a deficit drains money out.
Liquidity preference
Keynes's theory of the demand for money: people's desire to hold wealth in the form of money rather than less liquid assets such as bonds.
Keynes identified three motives for holding money. The transactions motive is money held to pay for everyday purchases between paydays, and it rises with income. The precautionary motive is money held for unexpected expenses, which also rises with income. The speculative motive is money held instead of bonds, and it depends on the interest rate. When interest rates are high, holding money means giving up a large return, and bond prices are low and expected to rise, so people hold little speculative money. When interest rates are low, the return given up is small and bond prices are high and expected to fall, so people prefer money. The demand for money therefore slopes downwards against the interest rate. With the money supply set by the central bank, drawn as a vertical line, the interest rate settles where the demand for money equals its supply.
Draw a liquidity preference diagram with the interest rate on the vertical axis and the quantity of money on the horizontal axis. Draw a downward-sloping demand for money curve and a vertical money supply curve, and mark the equilibrium interest rate. Show the effect of an increase in the money supply. Then flatten the demand curve at a very low interest rate and show that a further increase in the money supply no longer lowers the rate.
The flat section is the liquidity trap. At a very low rate everyone expects rates to rise and bond prices to fall, so extra money is simply held, and monetary policy loses its power to reduce interest rates.
The loanable funds theory explains interest rates differently. It treats the interest rate as the price of borrowing, set in the market for loanable funds. The supply comes mainly from saving, which rises as the interest rate rises because saving becomes more rewarding. The demand comes from firms borrowing to invest, and from households and government borrowing, which falls as the interest rate rises because fewer projects are worth the higher cost. The equilibrium interest rate is where the two meet. The theories differ in what they emphasise: loanable funds sees the rate as the reward for saving and the cost of investment, a flow of funds, while liquidity preference sees it as the reward for giving up liquidity, determined by the stock of money. Loanable funds underpins the crowding out argument, since government borrowing adds to demand for funds and raises the rate; liquidity preference underpins the liquidity trap.
According to liquidity preference theory, why does the speculative demand for money rise when interest rates fall?
Which theory explains interest rates?
- In practice central banks set short-term interest rates directly and supply whatever money is demanded at that rate, so neither theory describes how the policy rate itself is chosen.
- Liquidity preference explains well why rates can get stuck near zero and why extra money may simply be held, which matched the experience after 2008 when rates were near zero for years.
- Loanable funds explains well why heavy government borrowing can push up long-term rates when saving is limited, and why countries with high savings tend to have lower real interest rates.
- The two are better treated as complements: loanable funds for long-term real rates set by saving and investment, liquidity preference for short-run movements driven by money and expectations.
- The strongest answers say which rate they are explaining and over what time period, since that decides which theory fits better.
Questions on the demand for money are lost by candidates who describe the three motives without linking them to the interest rate. Only the speculative motive depends on the rate, and it is the one that gives the demand curve its slope. Say that explicitly, draw the diagram, and state what moves the curve (income, for the other two motives) and what moves along it (the interest rate).