Economics (0455) | Money and banking

💰 Study Notes: Money and Banking (Microeconomic Decision Makers)

Hello future economists! Welcome to one of the most practical and essential topics in IGCSE Economics: Money and Banking.
Why is this chapter important? Because money is the central tool we use for virtually every transaction, and banks are the institutions that manage the flow of this money. Understanding their roles helps you understand the decisions made daily by households, businesses, and governments.
Don't worry if financial concepts seem complex; we will break them down into simple, manageable steps!

1. Money: Forms, Functions, and Characteristics (Syllabus 3.1.1)

1.1 What is Money?

In simple terms, money is anything generally accepted as payment for goods and services or repayment of debts.

Did you know? Before money, people relied on barter, which is trading goods or services directly for other goods or services. Imagine trying to trade a bicycle for a haircut! This system was inefficient because you needed a 'double coincidence of wants' – both parties had to want exactly what the other was offering.

1.2 The Forms of Money

Money comes in different forms today:

• Coins and Notes (Currency): Physical money used for smaller transactions.
• Bank Deposits: Money held electronically in bank accounts (like savings and current accounts). This is the most common form of money in modern economies.

1.3 The Four Essential Functions of Money

Money is only useful if it performs four key roles. These roles solve the problems of the old barter system.

1. Medium of Exchange:
• Definition: Money allows goods and services to be traded without direct bartering.
• Analogy: Instead of trading your Economics textbook for a slice of pizza, you sell the textbook for $20 (money), and then use the $20 to buy pizza. Money acts as the middle step.
2. Measure of Value (or Unit of Account):
• Definition: Money provides a common standard for placing a value on goods and services.
• Analogy: Everything has a price tag ($5, $50, $5,000). Money allows you to easily compare the value of a chocolate bar versus a laptop.
3. Store of Value:
• Definition: Money holds its value over time, allowing people to save their wealth.
• Analogy: You can earn money today and save it (put it in a 'piggy bank') to spend next week or next year. (Note: High inflation can reduce this function, but it still serves the purpose better than perishable goods.)
4. Standard of Deferred Payment:
• Definition: Money is used to settle debts and specify the value of future payments (like loans).
• Analogy: When you take out a loan for university, you agree to pay back a fixed amount of money over several years.

💡 Memory Aid for Functions: M M S S
Medium of Exchange, Measure of Value, Store of Value, Standard of Deferred Payment.

1.4 Characteristics of a Good Money System

For money to successfully perform its functions, it must possess certain characteristics:

• Acceptability: Everyone must agree that it can be used for payment. (This is the most important characteristic.)
• Durability: It must last a long time without falling apart (bank notes and coins are built to be strong).
• Portability: It must be easy to carry around and move (a small coin is better than a huge stone).
• Divisibility: It must be easily divided into smaller units for making change (e.g., $1 can be broken into 100 cents).
• Uniformity (Homogeneity): All units must be the same (one $10 bill must be exactly the same as any other $10 bill).
• Limited Supply (Scarcity): If there is too much money, it loses its value (causes inflation).

2. The Banking System (Syllabus 3.1.2)

The banking system provides the vital link between households who save and producers who need funds for investment. There are two main types of banks you need to know:

2.1 Commercial Banks

Definition: Commercial Banks (like HSBC, Barclays, or Chase) are private sector institutions that operate to make a profit. They deal directly with the public (consumers and firms).

Roles and Importance of Commercial Banks

Commercial banks are crucial decision makers in the microeconomy because they facilitate day-to-day transactions and help finance growth.

A. Importance for Consumers (Households):

1. Holding Deposits: They provide a safe place for households to keep their savings and current account money.
2. Lending: They lend money for personal use, such as mortgages (loans to buy houses) and personal loans.
3. Facilitating Payments: They manage methods of payment like credit cards, debit cards, and online transfers, making transactions simple and fast.

B. Importance for Producers (Firms):

1. Providing Business Loans: They lend money to firms for investment (e.g., buying new machinery or expanding a factory). This supports economic growth.
2. Offering Specialist Services: Managing payroll, offering foreign exchange services (essential for international trade), and providing insurance.

2.2 Central Banks

Definition: The Central Bank (e.g., the Bank of England, the European Central Bank) is a non-profit, government-owned institution at the top of the financial system. Its main goal is macroeconomic stability, not profit.

Roles and Importance of Central Banks

The Central Bank has two primary relationships: one with the government and one with the commercial banks.

A. Importance for Government:

1. Banker to the Government: It manages the government’s accounts (collecting taxes, making payments) and helps manage national debt.
2. Managing Monetary Policy: The Central Bank sets the interest rate (the price of borrowing money). By changing interest rates, they influence spending, saving, and inflation in the economy.

B. Importance for Commercial Banks and the Economy:

1. Banker to the Banks: Commercial banks hold deposits at the Central Bank, just like you hold deposits at a commercial bank.
2. Lender of Last Resort: If a commercial bank faces a sudden, temporary shortage of cash, the Central Bank can lend it money. This prevents banks from collapsing and protects the entire financial system.
3. Supervising the Banking System: It regulates commercial banks to ensure they operate safely and don't take excessive risks, protecting consumers' deposits.
4. Issuing Currency: The Central Bank is the only body authorised to print bank notes and mint coins.

Analogy: Think of the Central Bank as the coach or referee of the financial sports league, while Commercial Banks are the teams playing the game. The coach (Central Bank) doesn't play with the ball (deal with the public) but sets the rules and controls the overall pace of the game (interest rates).