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.