Money and Banking: Forms, Functions and Characteristics of Money

This section explores the different forms money takes, the roles it plays in an economy, and the key characteristics that make it a valuable medium of exchange.

What is Money?

Money is any commodity or token that is generally accepted as a medium of exchange, a store of value, and a measure of value.

Forms of Money

Money exists in three main forms:

• Commodity Money: Money that has intrinsic value in itself (e.g., gold, silver).
• Representative Money: Money that represents a claim on a commodity (e.g., paper money backed by gold).
• Fiat Money: Money that is declared legal tender by the government and is not backed by a commodity (e.g., most modern currencies like the pound sterling or the US dollar).

Functions of Money

Money performs three key functions in an economy:

1. Medium of Exchange: Money is widely accepted for buying and selling goods and services, avoiding the need for barter.
2. Store of Value: Money can be held and used at a later time, preserving purchasing power (although inflation can erode this).
3. Unit of Account: Money provides a common measure of value for goods, services, and assets, making it easy to compare prices.

Characteristics of Money

For money to be effective, it needs to possess certain characteristics:

Characteristic	Description
Liquidity	How easily money can be converted into purchasing power. Money should be highly liquid.
Durability	Money should be able to withstand wear and tear.
Portability	Money should be easy to carry and transfer.
Divisibility	Money should be easily divided into smaller units to facilitate transactions of all sizes.
Uniformity	Each unit of money should be the same as every other unit.
Limited Supply	The supply of money should be controlled to maintain its value.
Acceptability	Money must be widely accepted as a medium of exchange.

The Role of Banks

Banks play a crucial role in the modern economy, particularly in managing money supply and facilitating transactions. They perform several key functions:

• Accepting Deposits: Banks accept deposits from individuals and businesses.
• Making Loans: Banks lend out a portion of these deposits to borrowers.
• Payment Systems: Banks facilitate payments between individuals and businesses (e.g., through cheques, debit cards, online transfers).
• Creating Money: Through the process of lending, banks can effectively create new money in the economy. This is known as the money multiplier effect.

The Money Supply

The money supply refers to the total amount of money in circulation in an economy. Different measures of the money supply exist:

• M0 (Monetary Base): Includes currency in circulation and commercial banks' reserves held at the central bank.
• M1: Includes M0 plus demand deposits (chequing accounts) and other checkable deposits.
• M2: Includes M1 plus savings deposits, money market deposits, and other less liquid assets.

The Role of the Central Bank

The central bank (e.g., the Bank of England or the Federal Reserve) is responsible for managing the money supply and maintaining economic stability. Its key functions include:

• Controlling Interest Rates: Influencing the cost of borrowing money.
• Setting Reserve Requirements: The amount of money banks must hold in reserve.
• Open Market Operations: Buying and selling government securities to influence the money supply.
• Lender of Last Resort: Providing loans to commercial banks during times of financial difficulty.