Role and importance of central banks

Money and Banking – Cambridge IGCSE Economics (0455)

1. Money – definition, functions and characteristics

Definition: Money is any item that is widely accepted as a means of payment for goods and services.

• Functions of money
  • Medium of exchange – used to buy and sell.
  • Unit of account – provides a common measure for prices.
  • Store of value – can be saved and used in the future.
• Characteristics of good money (each linked to the three functions)
  • Divisible – can be broken into smaller units, making it easy to use as a medium of exchange for low‑value items.
  • Durable – does not wear out quickly, so it can retain value over time as a store of value.
  • Portable – easy to carry and transfer, facilitating its use as a medium of exchange.
  • Uniform – each unit is identical to every other unit, allowing it to serve as a reliable unit of account.
  • Limited supply – enough to be valuable (supporting the store of value) but not so scarce that it hinders transactions (the medium of exchange).
• Forms of money (with real‑world examples)
  • Commodity money – e.g., gold or silver coins.
  • Fiduciary (representative) money – e.g., banknotes that represent a claim on a commodity such as the gold standard notes of the 19th century.
  • Fiat money – e.g., the British pound sterling or US dollar, which have value because the government declares them legal tender.
  • Electronic money – e.g., balances held in bank accounts, debit cards, mobile‑payment apps, or a Bitcoin wallet (digital currency).

2. Commercial banks – role and importance

• Accept deposits from households and firms (savings, current accounts).
• Provide loans and overdrafts – the main source of credit for the economy.
• Credit creation: when a bank grants a loan it creates a new deposit, expanding the money supply.
• Facilitate payments through cheques, debit cards, electronic transfers and mobile‑payment systems.
• Hold a portion of deposits as reserves (required & excess) – the basis for the money multiplier.
• Act as an intermediary, channeling funds from savers to borrowers, which promotes investment and consumption.

3. Central bank – definition and core functions

A central bank is the chief monetary authority of a country. Its actions affect the whole economy.

• Issue of legal tender – sole right to print notes and mint coins.
• Monetary‑policy implementation – uses tools to influence interest rates, the money supply and credit conditions.
• Banker’s bank – holds the reserves of commercial banks and provides them with short‑term liquidity.
• Lender of last resort (LLR) – supplies emergency funding to banks that are otherwise solvent but illiquid, preventing bank runs.
• Regulation and supervision – sets prudential rules, monitors banks and maintains confidence in the financial system.
• Management of foreign reserves – buys or sells foreign currency to stabilise the exchange rate, supporting the exchange‑rate objective in the macro‑economy and helping to maintain external balance.

4. Tools of monetary policy (AO2/3)

Central banks use a mix of quantitative (directly change the amount of money) and qualitative (influence behaviour) tools.

5. Money multiplier and credit creation

The money multiplier shows how an initial change in reserves can generate a larger change in the total money supply.

Money multiplier (m) = 1 ÷ reserve ratio (r)

Example: If the reserve ratio is 10 % (r = 0.10), then m = 1 ÷ 0.10 = 10. An extra £1 of reserves can ultimately create up to £10 of deposits in the banking system.

6. Why central banks are important

1. Price stability – controlling inflation protects the purchasing power of money.
2. Economic growth – appropriate monetary policy stimulates investment and consumption.
3. Financial stability – LLR facilities and supervision help avoid banking crises.
4. Confidence in the currency – managing foreign reserves and exchange rates maintains trust in the national money.
5. Policy coordination – works with the government’s fiscal policy to achieve balanced macro‑economic outcomes.

7. Illustrative example – impact of an interest‑rate cut

Assume the central bank lowers the policy rate from 5 % to 3 %.

• Commercial banks can borrow cheaper from the central bank.
• They pass on lower rates to households and firms (mortgages, business loans).
• Borrowing becomes more attractive → investment (I) and consumption (C) rise.
• Aggregate demand (AD) shifts right, potentially increasing real GDP.
• If the economy is near full capacity, the right‑ward shift may also put upward pressure on the price level (inflation).

8. Key take‑aways

• Money performs three essential functions; each characteristic of good money supports one or more of these functions.
• Commercial banks are the engine of credit creation; the reserve ratio determines the size of the money multiplier.
• The central bank is the cornerstone of a country’s monetary system, using both quantitative and qualitative tools to steer the economy.
• Effective central‑bank action promotes price stability, sustainable growth, financial stability and confidence in the national currency.