Money and banking | IGCSE Class 10 Economics Notes

This note covers the forms of money, its functions and characteristics, and the role and importance of central banks and commercial banks for governments, producers and consumers.

What is money, and why do economies need it?

Before money existed, people exchanged goods and services directly through barter. Barter only works where there is a double coincidence of wants: each trader must want exactly what the other is offering, at the same time.

A farmer with surplus rice who wants cloth must find a weaver who happens to want rice. As an economy grows and more goods are traded, finding such a match becomes slow and costly.

Money solves this problem. It is any commonly accepted item that people will take in exchange for goods, services or in settlement of debts.

Once money exists, a seller does not need to find a buyer who wants to swap goods directly; the seller accepts money for the goods and then uses that money to buy whatever is needed from someone else.

Money therefore removes the need for a double coincidence of wants and allows trade to become far more specialised and efficient.

Definition: Money. Money is anything that is widely and readily accepted as payment for goods and services, and in the settlement of debts, without needing a further exchange.

What forms does money take?

Money has taken many physical forms over time. Early societies used commodities that had their own value, such as grain, cattle or precious metal coins.

Modern economies instead use currency, meaning banknotes and coins issued by a monetary authority, together with bank deposits that can be transferred by cheque, card or electronic instruction.

A demand deposit is a deposit held with a bank that the account holder can withdraw or transfer at any time, without notice.

Because cheques, debit cards and electronic transfers drawn against demand deposits are widely accepted as payment, demand deposits function as money alongside notes and coins, even though no cash physically changes hands in most transactions.

Many countries are also moving towards a more cashless economy, where digital transfers of information between bank accounts replace physical notes and coins for most everyday payments.

Modern currency is called fiat money because the paper or metal it is made from has very little value in itself; a banknote is accepted only because the issuing authority guarantees its value and the law makes it acceptable in settling debts.

Such currency is described as legal tender: no one can lawfully refuse it as payment for a debt within the country that issues it.

Demand deposits, by contrast, are not legal tender, since a seller is free to refuse a cheque or decline to accept a bank transfer.

Definition: Legal tender. Currency that the law requires must be accepted when offered in payment of a debt; it cannot be lawfully refused.

What are the functions of money?

Money performs several distinct roles in an economy, and each overcomes a specific weakness of barter.

1. As a medium of exchange, money is accepted by anyone in payment for goods or services, so a seller no longer needs to find a buyer offering exactly what is wanted in return.
2. As a unit of account, money allows the value of very different goods to be expressed and compared in the same units, for example by stating the price of a pen and a pencil in the same currency, so that their relative value can be worked out easily.
3. As a store of value, money lets people hold their wealth over time, because unlike a perishable good such as rice, money does not spoil and is cheap to store, so it can be kept for future spending.
4. As a standard of deferred payment, money is used to settle debts and contracts that are agreed now but paid later, such as a loan repaid in instalments.

Money performs the store of value function well only if its own value stays reasonably stable.

If prices rise generally, the purchasing power of a unit of money falls, since the same amount of money buys fewer goods than before; this is one reason that keeping the price level stable matters to a monetary authority.

Definition: Medium of exchange. The function of money by which it is accepted by all parties to a transaction, removing the need for a direct swap of goods for goods.

What characteristics must good money have?

For an item to work well as money, it needs several practical characteristics. It must be generally acceptable to everyone in the economy, so that it can always be exchanged for goods and services.

It should be reasonably durable, so it does not decay or wear out quickly, unlike a perishable commodity such as rice or fruit.

It needs to be easy to divide into smaller units so that purchases of different sizes and values can be made exactly, and easy to carry from place to place without excessive cost, unlike a bulky commodity such as cattle or grain.

Money must also be limited in supply, or scarce. If anyone could create more of it at will, as with leaves or pebbles, it would quickly lose its value and people would stop accepting it.

Good money should also be difficult to copy or forge, so that its supply can be trusted and controlled, and its value should stay reasonably stable, otherwise people lose confidence in holding it or accepting it in exchange.

Modern currency and demand deposits meet these characteristics far better than commodities such as cattle, grain or precious metal did, which is one reason economies have moved progressively towards paper and digital money.

What is a central bank, and why is it important?

A central bank is the institution responsible for managing a country's currency and money supply. Almost every country has one central bank, which sits above the ordinary commercial banking system and regulates it.

A central bank is distinct from commercial banks because it does not deal directly with the general public in the same way that a commercial bank does; instead, it oversees and supports the banking system as a whole.

A central bank has several core functions. It is usually the sole institution permitted to issue currency in the country. It controls the money supply through tools such as the bank rate, open market operations and reserve requirements.

It acts as banker to the government, managing the government's accounts and borrowing. It is the custodian of foreign exchange reserves held by the country.

It also acts as a bank to the commercial banking system, which is why it is often described as the lender of last resort: it stands ready to lend to commercial banks when they need funds, so that the banking system does not collapse for lack of cash.

Definition: Central bank. The institution, usually owned or controlled by the state, that issues a country's currency, manages its money supply and oversees the commercial banking system.

How does a central bank serve the government, producers and consumers?

A central bank's functions matter to each group in the economy in a different way.

For the government, the central bank manages its bank accounts, helps it borrow money by issuing and managing government bonds, and holds and manages the country's foreign exchange reserves, which the government relies on for international payments and for defending the value of its currency.

For producers, meaning firms and businesses, the central bank's control of money supply and interest rates affects the cost of borrowing for investment, and its role as lender of last resort gives confidence that the banking system producers depend on for loans and payments will remain stable, even in a crisis.

For consumers, the central bank's management of the money supply affects the overall price level in the economy; if a central bank allows the money supply to grow too quickly, this can raise prices and erode the purchasing power of the money consumers hold and earn.

By aiming to keep the currency's value reasonably stable, a central bank protects the usefulness of money as a store of value for savers and consumers alike.

What is a commercial bank, and what does it do?

A commercial bank is a financial institution that accepts deposits from the public and lends out part of these funds to borrowers.

Commercial banks mediate between individuals or firms that have surplus funds and wish to save, and individuals or firms that need funds and wish to borrow, for example for a home loan or a loan to buy equipment for a business.

Banks pay depositors a lower rate of interest than they charge borrowers; this difference between the two rates, called the spread, is the bank's main source of profit.

Because not every depositor asks for their money back on the same day, a bank does not need to keep the whole of every deposit as cash; it keeps only a portion in reserve to meet day-to-day withdrawals and lends out the rest.

This process, by which new loans add new deposits to the banking system, is called credit creation: when a bank grants a loan, it typically opens a new deposit in the borrower's name, so that the total of deposits in the banking system rises above the original cash paid in.

Definition: Commercial bank. A bank that accepts deposits from, and makes loans to, the general public and businesses, earning profit from the difference between the interest it charges borrowers and the interest it pays depositors.

How does a commercial bank serve the government, producers and consumers?

Commercial banks are useful to the government because they channel the public's savings into the formal financial system, where they can be taxed, tracked and used productively, and because banks hold reserves with, and are supervised by, the central bank, which helps the government and the central bank monitor the health of the financial system as a whole.

For producers, commercial banks provide the loans needed to buy equipment, raw materials or working capital, and offer safe places to deposit business revenue, with cheques and cards making payments between firms far more convenient and secure than carrying large sums of cash.

For consumers, commercial banks provide a safe place to hold savings that also earns interest, loans for large purchases such as housing, and the demand deposits, cheques and cards that make everyday payments convenient without the risks of holding large amounts of cash.

Advantages of a credit-creating banking system

A banking system that creates credit allows savings that would otherwise sit idle to be lent out to borrowers who can put the funds to productive use, such as a producer investing in new equipment.

It allows people to hold their wealth safely and conveniently as deposits rather than as cash, while still earning interest.

It supports the spread of cashless, electronic payments, through cheques and cards drawn on demand deposits, which are generally safer and more convenient than carrying cash for large transactions.

Limitations of a credit-creating banking system

Because a bank keeps only a portion of deposits as reserves, the system depends on the assumption that not all depositors will ask for their money back at the same time; if confidence in a bank is lost and many depositors try to withdraw funds together, a bank may struggle to repay them promptly.

Because banks need a central bank willing to act as lender of last resort to remain stable in a crisis, a banking system without strong central bank oversight and reserve requirements can allow banks to over-lend, which increases the risk of a bank running short of funds.

Glossary

• Money — anything widely and readily accepted as payment for goods, services and debts.
• Barter — the direct exchange of goods or services for other goods or services, without using money.
• Double coincidence of wants — the requirement, under barter, that each trader wants exactly what the other is offering.
• Medium of exchange — the function of money by which it is accepted in payment, removing the need to swap goods directly.
• Unit of account — the function of money that allows the values of different goods to be expressed and compared in the same units.
• Store of value — the function of money that allows wealth to be held over time for future use.
• Standard of deferred payment — the function of money used to settle debts and contracts agreed now but paid later.
• Legal tender — currency that cannot be lawfully refused when offered in payment of a debt.
• Fiat money — currency with little value in the material it is made from, accepted because the issuing authority guarantees its value.
• Central bank — the institution that issues a country's currency, manages its money supply and oversees commercial banks.
• Commercial bank — a bank that accepts deposits from, and makes loans to, the public and businesses.
• Demand deposit — a bank deposit that the holder can withdraw or transfer at any time without notice.
• Credit creation — the process by which bank lending adds new deposits to the banking system.
• Lender of last resort — the central bank's role of standing ready to lend to commercial banks when they need funds.
• Money supply — the total stock of currency and bank deposits held by the public at a point in time.

Common errors and misconceptions

• Misconception: Money must always be made of a valuable material, such as gold. Correct: Modern fiat money has little value in the paper or metal itself; it is accepted because the law and the issuing authority guarantee its value.
• Misconception: Barter is simply trading without money, with no real drawback. Correct: Barter requires a double coincidence of wants, which makes finding a trading partner slow and costly as an economy grows.
• Misconception: A cheque itself is money. Correct: A cheque is only an instruction to transfer money from a demand deposit; the demand deposit, not the piece of paper, is the money.
• Misconception: Central banks and commercial banks do the same job. Correct: A central bank issues currency and regulates the banking system; commercial banks accept deposits from, and lend to, the public.
• Misconception: Demand deposits are legal tender, just like cash. Correct: Only currency issued by the monetary authority is legal tender; a seller may lawfully refuse a cheque or bank transfer.
• Misconception: A bank keeps every deposit as cash in its vault. Correct: A bank keeps only a portion of deposits as reserves and lends out the rest, which is how credit creation occurs.
• Misconception: The functions of money and the characteristics of money are the same thing. Correct: Functions describe what money does, such as acting as a medium of exchange; characteristics describe the qualities, such as durability, that make something suitable to perform those functions.

Exam-style questions with model answers

Q1. Define 'legal tender'. [2 marks]

1. Legal tender is currency that the law requires must be accepted when offered in payment of a debt, so it cannot be lawfully refused within the country that issues it.

Q2. State two functions of money. [2 marks]

1. Money acts as a medium of exchange, since it is accepted by anyone in payment for goods and services.
2. Money acts as a store of value, since it can be held over time without losing its usefulness, unlike a perishable good.

Q3. A pen costs $10 and a pencil costs $2. Using these prices, explain how money acts as (i) a unit of account and (ii) a medium of exchange. [4 marks]

1. Money acts as a unit of account because both prices can be expressed in the same currency units, so a pen can be shown to be worth five pencils ($10 ÷ $2 = 5), without needing to compare the two goods directly against each other.
2. Money acts as a medium of exchange because a seller of pencils can accept $2 in payment and then use that money to buy a pen from someone else, without needing to find a buyer who wants to swap pencils directly for a pen.

Q4. Distinguish between a central bank and a commercial bank. [4 marks]

1. A central bank is the single institution in a country responsible for issuing currency, managing the money supply and overseeing the whole banking system, whereas a commercial bank is one of many ordinary banks that deal directly with the public and firms.
2. A central bank acts as banker to the government and as lender of last resort to commercial banks, while a commercial bank earns its profit from the spread between the interest it charges borrowers and the interest it pays depositors.

Q5. Explain two characteristics that money needs in order to perform its functions well. [4 marks]

1. Money must be durable, so that it does not decay or wear out quickly, unlike a perishable commodity such as rice, which would make a poor store of value.
2. Money must be easily divisible into smaller units, so that purchases of different values can be made exactly, and easy to carry, unlike a bulky commodity such as cattle.

Q6. Analyse the importance of a central bank for a government and for producers in an economy. [6 marks]

1. For the government, the central bank acts as its banker, managing its accounts and helping it borrow funds through government bonds, which allows the government to finance its spending.
2. The central bank also holds and manages the country's foreign exchange reserves, which the government relies on for international payments and to help stabilise the value of its currency.
3. For producers, the central bank's control over interest rates and the money supply affects how expensive it is for firms to borrow to invest in equipment or expansion.
4. As lender of last resort, the central bank stands ready to lend to commercial banks in difficulty, which keeps the banking system that producers depend on for loans and payments stable.
5. A stable banking system supported by the central bank gives producers confidence to plan long-term investment, since they can trust that their deposits and credit lines will remain secure.

Q7. Discuss whether commercial banks are more important to consumers than to producers in an economy. [6 marks]

1. Commercial banks are important to consumers because they offer safe, interest-earning deposits, loans for large purchases such as housing, and convenient payment methods such as cheques and cards instead of carrying cash.
2. Commercial banks are equally important to producers, since they provide the loans needed for working capital and investment in equipment, and offer safe, efficient ways to receive and make business payments.
3. Without commercial bank credit, many producers would struggle to fund the gap between paying for inputs and receiving revenue from sales, which could limit output and employment.
4. Without commercial bank deposits and payment facilities, consumers would have to rely on cash for all transactions, which is less safe and less convenient.
5. Overall, it is difficult to argue that banks matter more to one group than the other, since both producers and consumers depend on the same deposit-taking and lending functions, though in different ways.

Key takeaways

• Money removes the need for a double coincidence of wants that makes barter slow and inefficient.
• Money's functions are medium of exchange, unit of account, store of value and standard of deferred payment.
• Good money needs to be acceptable, durable, divisible, portable, hard to forge and reasonably stable in value.
• Modern currency is fiat money and legal tender; demand deposits function as money but are not legal tender.
• A central bank issues currency, controls the money supply, banks for the government, holds foreign reserves and acts as lender of last resort.
• Commercial banks accept deposits and make loans, earning profit from the spread between deposit and loan interest rates.
• Commercial bank lending can create credit, since new loans typically add new deposits to the banking system.
• A credit-creating banking system channels savings into productive use but depends on confidence that not all depositors withdraw funds at once.

Test yourself

What problem of barter does money solve?

Money removes the need for a double coincidence of wants, so a seller does not need to find a buyer who happens to want to trade exactly what is on offer.

Name the four functions of money.

Medium of exchange, unit of account, store of value and standard of deferred payment.

Why is modern currency called fiat money?

Because the paper or metal it is made from has little value in itself; it is accepted only because the issuing authority guarantees its value.

What makes a demand deposit different from legal tender?

A demand deposit can be withdrawn or transferred on demand and functions as money, but it is not legal tender, since a cheque or transfer can be lawfully refused.

What is the "spread" earned by a commercial bank?

The difference between the interest rate a bank charges borrowers and the lower interest rate it pays depositors.

Why is a central bank called the "lender of last resort"?

Because it stands ready to lend to commercial banks when they need funds, preventing the banking system from collapsing for lack of cash.

Give one way a central bank serves a consumer.

By managing the money supply to keep the price level reasonably stable, protecting the purchasing power of consumers' wages and savings.