Money, Banking and Households
EconomicsΒ· 3.1, 3.2Β· 25 min read
1. Functions and Characteristics of Moneyβ β ββββ± 6 min
Money
Any generally accepted medium of exchange used to pay for goods, services and settle debts.
Barter, the exchange of goods for other goods without money, requires a 'double coincidence of wants' which makes trade highly inefficient. Money solves this problem through four core, examinable functions:
Medium of exchange: Accepted as payment for all goods and services, removing the need for barter
Unit of account: Provides a common measure of the value of goods and services to allow easy price comparison
Store of value: Holds its purchasing power over time, so it can be saved and used for future purchases
Standard of deferred payment: Allows for borrowing and lending, so goods can be bought now and paid for later
A small island economy uses a barter system. A fisherman wants to buy bread from a baker, but the baker does not want fish. Explain how the introduction of money would solve this problem.
- 1
Step 1: Identify the barter barrier: The double coincidence of wants is not met, as the baker does not want the fisherman's fish, so no trade can occur.
- 2
Step 2: Apply the medium of exchange function: The fisherman can sell his fish to another consumer for money, then use that money to buy bread from the baker.
- 3
Step 3: Confirm the outcome: Money removes the requirement for both parties to want what the other offers, enabling efficient trade between the fisherman and baker.
Exam tip:
When asked to explain a function of money, always include a real-world example to secure full marks for 3+ mark questions.
2. Roles of Banks in the Economyβ β β βββ± 7 min
There are two key types of banks you need to distinguish for your exam: central banks and commercial banks, each with distinct roles in the economy.
Central Bank
The government-owned authority responsible for managing the country's currency, financial system, and monetary policy.
Issuing national currency
Regulating and supervising commercial bank activities
Setting the base interest rate for the whole economy
Holding the country's foreign currency reserves
Acting as the banker to the government and commercial banks
Commercial Bank
A for-profit financial institution that provides services to households, firms and other retail customers.
Accepting deposits from customers
Lending money to borrowers via loans, mortgages and overdrafts
Enabling payments via debit cards, credit cards, bank transfers and cheques
Offering savings accounts with interest returns to customers
State two ways a central bank differs from a commercial bank.
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Step 1: State first difference: A central bank is owned by the government, while commercial banks are owned by private shareholders seeking profit.
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Step 2: State second difference: A central bank sets interest rates for the whole economy, while commercial banks only set interest rates for their own products, aligned to the central bank base rate.
Exam tip:
Questions often ask you to compare or contrast the roles of the two bank types, so revise using a side-by-side comparison table to avoid confusion.
3. Types of Bank Accounts for Householdsβ β ββββ± 5 min
Commercial banks offer three main types of accounts for households, each with different features suited to different use cases:
Account Type | Key Features | Common Use Case |
|---|---|---|
Current Account | Low/no interest, unlimited withdrawals, debit card/cheque book included | Everyday spending, paying bills, receiving salary |
Savings (Deposit) Account | Higher interest rate, limited withdrawals per year, no cheque book | Short/medium term saving for goals like holidays, earning interest on surplus income |
Fixed Term (Time) Deposit Account | Highest interest rate, money locked in for 6 months to 5 years, penalty for early withdrawal | Long-term saving for large purchases e.g. house deposit, university fees |
A 19-year-old worker earns a monthly salary of \1200 per month on living costs, and want to save the remaining \$600 per month for a holiday in 12 months' time. Recommend the most suitable bank account for their monthly savings, justifying your choice.
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Step 1: Identify the saver's needs: They need access to their full savings in 12 months, no early withdrawal required, and want to earn interest on their savings.
- 2
Step 2: Eliminate unsuitable options: A fixed term deposit is unsuitable because money is locked away, and a current account pays very little or no interest.
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Step 3: Recommend and justify: A savings (deposit) account is the most suitable. It pays a higher interest rate than a current account, and allows full withdrawal after 12 months with no penalty to pay for the holiday.
4. Household Financial Decisions: Spending, Saving, Borrowingβ β β β ββ± 7 min
Households make choices about how much of their income to spend, how much to save, and when to borrow, based on five key examinable factors:
Interest rates: Higher rates increase the return on saving and the cost of borrowing, so most households save more and borrow/spend less
Disposable income: Higher post-tax income leads to higher total spending and higher total saving
Age: Younger households tend to borrow more for education/property and save less, while older households near retirement save more and spend less
Income confidence: If households expect job security and rising future income, they spend more and save less
Wealth: Households with higher assets (property, savings) feel more financially secure, so they tend to spend more
Explain how a rise in the central bank base interest rate is likely to affect household spending and saving decisions.
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Step 1: Link base rate to commercial bank products: When the central bank raises the base rate, commercial banks increase the interest rate they pay on savings and charge on loans.
- 2
Step 2: Impact on saving: The return on each dollar saved increases, so households have an incentive to save a larger share of their income, raising total saving.
- 3
Step 3: Impact on spending and borrowing: The cost of borrowing (for mortgages, car loans, credit cards) increases, so households borrow less and reduce spending on expensive items bought on credit, lowering total spending for most households.
Exam tip:
For 6 mark analysis questions, always include a logical chain of reasoning linking a change in a factor (e.g. interest rate rise) to its outcome, rather than just stating the outcome.
5. Common Pitfalls
Wrong move:
Listing only 3 functions of money in a question asking for all four.
Why:
The syllabus explicitly requires all four functions, so missing one will cost you marks.
Correct move:
Use the MUSS mnemonic to recall all four functions every time you are asked about this topic.
Wrong move:
Stating that commercial banks issue national currency.
Why:
Only central banks have the authority to issue national currency; commercial banks do not have this power.
Correct move:
Revise a comparison table of central vs commercial bank roles to clearly distinguish their functions.
Wrong move:
Recommending a fixed term deposit for short-term savings that need to be accessed quickly.
Why:
Fixed term deposits charge large penalties for early withdrawal, so they are only suitable for long-term savings goals.
Correct move:
Match the account type to the saver's time horizon: savings accounts for short/medium term goals, fixed deposits for long-term goals.
Wrong move:
Claiming higher interest rates always reduce all household spending.
Why:
Households with large savings earn more interest income when rates rise, so their spending may increase.
Correct move:
Note that higher rates reduce spending for most households, but savers may see a partial offset from higher interest income.
Wrong move:
Defining disposable income as total income before tax.
Why:
Disposable income is the income households have available to spend or save after tax and mandatory deductions are subtracted.
Correct move:
Remember the formula: Disposable income = Total income - Taxes - Mandatory contributions.
6. Quick Reference Cheatsheet
Concept | Key Exam Facts |
|---|---|
Functions of Money | Medium of exchange, unit of account, store of value, standard of deferred payment |
Central Bank Roles | Issue currency, set interest rates, regulate commercial banks, hold foreign reserves |
Commercial Bank Roles | Accept deposits, lend money, facilitate payments, offer savings products |
Bank Account Types | Current (everyday), Savings (short/medium term), Fixed Deposit (long term) |
Household Decision Factors | Interest rates, disposable income, age, income confidence, wealth |
7. Frequently Asked
Do I need to learn all four functions of money for the exam?
Yes, all four (medium of exchange, unit of account, store of value, standard of deferred payment) are examinable. You may be asked to explain 1-2 of them with examples for 2-4 mark questions.
What is the difference between a central bank and a commercial bank?
A central bank is a government-owned institution that regulates the financial system, issues currency, and sets interest rates. Commercial banks are for-profit businesses that offer accounts, loans, and other services to households and firms.
Going deeper
What's Next
Now that you have mastered money, banking and household financial decisions, you are ready to move on to the next set of microeconomic decision makers: firms and their production decisions. You will learn about the costs of production, types of business organisation, and how firms make choices about output and pricing to maximise profits, all aligned to the CIE IGCSE Economics 0455 syllabus. You can also practice exam-style structured questions on this topic to test your understanding and identify any gaps in your knowledge before your exam.