Money and banking
EconomicsΒ· Unit 4: Basic Macroeconomic Concepts, Section 3.2Β· 12 min read
1. Functions and Characteristics of Moneyβ β ββββ± 3 min
Money eliminates the inefficiencies of a barter system by removing the requirement for a double coincidence of wants between trading parties. For any asset to be classified as money, it must fulfil four non-negotiable core functions, and meet key characteristics including divisibility, durability, portability, and limited supply.
Money
Any widely accepted asset that can be used to settle transactions and repay debt in an economy.
Medium of exchange: Accepted as payment for goods and services
Unit of account: Provides a consistent standard for pricing products
Store of value: Holds purchasing power over time to enable deferred spending
Standard of deferred payment: Allows future debt obligations to be defined
Identify which function of money is being used in each scenario: 1) A restaurant lists the price of a meal at $12, 2) A worker saves $200 from their monthly salary to pay for a holiday next year.
- 1
For scenario 1: The restaurant is using money to assign a comparable price to its product, so this demonstrates the unit of account function.
- 2
For scenario 2: The worker is holding money to retain purchasing power for future spending, so this demonstrates the store of value function.
Exam tip:
Always list all four functions of money for 6+ mark questions, do not omit any to avoid losing 1-2 marks.
2. Measures of Money Supplyβ β ββββ± 2 min
Money supply is split into narrow and broad measures based on liquidity. Narrow money only includes the most liquid assets that can be spent immediately, while broad money adds less liquid assets that cannot be used for instant transactions without prior conversion.
Measure | Components | Liquidity Level |
|---|---|---|
M0 (Narrow Money) | Cash outside banks + commercial bank reserves at central bank | 100% liquid |
M4 (Broad Money) | All M0 + sight deposits + time deposits at commercial banks | Partial liquidity for time deposits |
Test your understanding of money classification:
Which of the following would be counted in M0?
A 6-month fixed term deposit
A $50 bank note in your wallet
A 10-year government bond
Reveal answer
A \$50 bank note in your wallet βPhysical cash in circulation is part of narrow M0 money, while deposits and bonds are not.
3. Roles of Commercial Banksβ β β βββ± 3 min
Commercial banks are private, profit-seeking institutions that operate the payments system for households and firms. Their core revenue comes from the difference between the lower interest rate they pay on customer deposits and the higher interest rate they charge on issued loans.
Distinguish between two common types of commercial banking operations:
Retail Banking
Serves individual household customers with standard products including current accounts, personal loans, and mortgages
+ Pros: Low risk, stable revenue stream from mass market customers
β Cons: Lower profit margins per customer
Investment Banking
Serves large corporations and institutional clients with services including mergers and acquisitions advice, share issuance, and trading
+ Pros: Very high profit margins per deal
β Cons: Exposed to high market volatility risk
Classify each of the following services as a retail or investment banking activity: 1) A bank arranges the sale of new shares for a listed tech company, 2) A bank issues a $200,000 mortgage to a family buying a house.
- 1
Arranging share issuance for a corporation is an investment banking service targeted at institutional clients.
- 2
Issuing a home mortgage to a household is a standard retail banking product for individual customers.
4. Central Bank Functionsβ β β βββ± 2 min
Unlike commercial banks, central banks are non-profit public institutions owned by the national government, with a mandate to maintain monetary and financial stability across the whole economy.
Central bank
The national monetary authority that controls the national currency, sets base interest rates, and regulates the commercial banking system.
5. Credit Creation Processβ β β β ββ± 2 min
Derive the simple credit multiplier
Assume no cash drain, all deposits stay in the banking system, and commercial banks hold exactly the required reserve ratio r
- 1
Initial new deposit = D
- 2
Required reserves = D * r
- 3
Maximum new loans issued = D * (1 - r)
- 4
Total final money supply after full re-lending = D / r
Simple credit multiplier = where r is the required reserve ratio.
If the required reserve ratio is 10%, and a new initial deposit of $1000 is made, calculate the maximum total new money supply created across the banking system.
- 1
First calculate the credit multiplier: 1 / 0.1 = 10
- 2
Multiply the initial deposit by the multiplier: $1000 * 10 = $10,000 total new money supply
6. Common Pitfalls
Wrong move:
Classifying time deposits as part of narrow M0 money
Why:
M0 only includes 100% liquid cash and bank reserves, while time deposits cannot be spent immediately
Correct move:
Always check liquidity level before assigning an asset to a money supply measure
Wrong move:
Forgetting to subtract cash drain from the credit multiplier calculation
Why:
The simple multiplier assumes no public cash holdings, which is unrealistic in real economies
Correct move:
Adjust the formula to include both reserve ratio and cash drain ratio for full calculation marks
Wrong move:
Stating commercial banks set the central bank base interest rate
Why:
Base rate is exclusively determined by the central bank's monetary policy committee
Correct move:
Clarify that commercial banks only set retail rates relative to the central bank's published base rate
Wrong move:
Defining money as only physical notes and coins in circulation
Why:
Over 90% of broad money in developed economies is made up of bank deposits, not cash
Correct move:
Explicitly reference that any asset fulfilling all four core functions of money counts as money
Wrong move:
Claiming central banks have full direct control over total broad money supply
Why:
Commercial bank lending decisions and public demand for cash also change total money supply levels
Correct move:
Note that central banks only exert indirect influence over broad money via policy tools
7. Quick Reference Cheatsheet
Concept | Key Definition | Core Exam Point |
|---|---|---|
Functions of Money | Medium of exchange, unit of account, store of value, standard of deferred payment | All four must be present for an asset to qualify as money |
Narrow Money (M0) | Cash in circulation + commercial bank reserves | 100% liquid, used for immediate transactions |
Broad Money (M4) | All M0 + all customer deposits at commercial banks | Includes less liquid fixed term time deposits |
Credit Multiplier | Maximum new money generated from an initial deposit | Simple multiplier = 1 / Required Reserve Ratio |
Central Bank Roles | Banker to government, lender of last resort, set monetary policy, issue currency | Non-profit, no direct profit motive unlike commercial banks |
When this came up on past exams
AI-estimated based on syllabus patterns β cross-check with official past papers for accuracy. Use only as revision-focus signals.
- 2024 Β· Paper 2
Explain 3 functions of money
- 2023 Β· Paper 4
Evaluate central bank role in money supply
- 2022 Β· Paper 3
Calculate credit multiplier value
What's Next
Mastering money and banking is a critical foundation for upcoming macroeconomic topics including monetary policy, inflation, and exchange rate systems. You will be able to connect the credit creation process directly to shifts in aggregate demand, and explain how central bank interest rate decisions transmit through the wider economy to affect household spending, business investment, and net exports. This knowledge is also essential for 20-mark A2 essay questions that ask you to evaluate the effectiveness of monetary policy as a demand management tool, compared to fiscal or supply-side policies.