definition, functions and characteristics of money

Money and Banking (Cambridge IGCSE / A‑Level 9708)

1. Definition of Money

Money is any item or record that is generally accepted as a means of payment for goods and services, and for the repayment of debts, within an economy.

2. Functions of Money

Money performs four inter‑related functions. The first three are the traditional functions; the fourth is the modern function – exactly as phrased in the syllabus.

1. Medium of Exchange – eliminates the need for a double‑coincidence of wants.
2. Unit of Account – provides a common measure for valuing goods, services and assets.
3. Store of Value – preserves purchasing power over time, allowing individuals to defer consumption.
4. Standard of Deferred Payment – used to settle future obligations such as loans and contracts.

3. Characteristics of Money

For an asset to function effectively as money it should possess the following characteristics (as set out in the syllabus). The final characteristic – stability of value – is directly linked to the syllabus’s focus on price‑stability and inflation.

Characteristic	Explanation
Acceptability (Legal Tender)	Widely recognised, trusted and, where applicable, mandated by law to be accepted for payment of debts.
Durability	Resistant to wear and tear; retains its form and recognisability over time.
Portability	Easy to carry and transfer in everyday transactions.
Divisibility	Can be broken down into smaller units without loss of value (e.g., £0.01, $0.01).
Uniformity (Standardisation)	Each unit of a given denomination is identical in appearance and value.
Stability of Value	Purchasing power remains relatively stable over time; high inflation erodes this characteristic and therefore threatens price‑stability.

4. Monetary Aggregates (Money‑Supply Concepts)

The syllabus requires you to know M0, M1 and M2. M3 is occasionally mentioned in textbooks but is not examined.

Aggregate	Components (examples)	Liquidity
M0 (Base Money)	Notes and coins in circulation + banks’ reserves with the central bank	Highest – can be used directly for transactions
M1	M0 + demand deposits (current accounts) + other checkable deposits	Very high – readily spendable
M2	M1 + savings deposits, time deposits (under £100 000), money‑market funds	High – slightly less liquid than M1

Exam tip: Past papers frequently ask you to show how a change in M1 shifts the AD curve in the AD/AS model (e.g., an increase in M1 → lower interest rates → higher consumption and investment → AD shifts right).

5. Quantity Theory of Money (QTM)

The core identity is

$$M \times V = P \times Y$$

• M – money supply (normally measured by M1 or M2)
• V – velocity of money (average number of times a unit of money is spent in a period)
• P – general price level
• Y – real output (real GDP)

Key syllabus points

• The theory assumes V is stable (or constant). This assumption is explicitly stated in the syllabus and is a common source of exam error – students sometimes treat V as variable without justification.
• If V is stable, a sustained increase in M leads proportionally to a rise in P (inflation) unless Y expands at the same rate.
• Policy implication: to control inflation the central bank may tighten the money supply (reduce M) or influence V through expectations.

6. Role of Commercial Banks

Commercial banks sit between savers and borrowers and perform three core functions:

1. Accepting Deposits – demand, savings and time deposits, providing a safe place for the public’s money.
2. Providing Loans & Advances – financing households, firms and the government, thereby creating new deposits.
3. Facilitating Payments – cheques, electronic transfers, debit cards, etc.

Reserve Ratio & Capital Ratio

• Reserve ratio – proportion of deposits that banks must keep as reserves (cash or central‑bank balances).
• Capital ratio – proportion of a bank’s own capital that must be held against its risk‑weighted assets (a safety‑net for solvency).

Money‑Creation Process (simplified)

Credit (Money) Multiplier – simplified version used in the syllabus

$$\text{Money multiplier} = \frac{1}{\text{Reserve ratio}}$$

Note: The syllabus formula ignores cash held by the public, excess reserves, and other leakages. In reality the multiplier is smaller.

Example: With a reserve ratio of 10 % the multiplier is 10. An initial injection of £1 million of reserves can ultimately generate up to £10 million of broad money (M1).

7. Central‑Bank Monetary‑Policy Tools

The central bank (e.g., the Bank of England, Federal Reserve) controls the money supply and influences interest rates through four main instruments.

Tool	Target Variable	Short‑run Effect on Interest Rate	Likely Impact on AD/AS
Open‑Market Operations (OMO)	Base money (M0)	Buying securities ↓ rates; selling securities ↑ rates	Buying → AD shifts right (higher output, upward pressure on price); Selling → AD shifts left.
Policy (Discount) Rate	Bank‑rate/short‑term interest rates	Rate ↓ → market rates ↓; Rate ↑ → market rates ↑	Lower rate → AD right; Higher rate → AD left.
Reserve Requirements	Reserve ratio (hence multiplier)	Requirement ↓ → multiplier ↑ → money supply ↑ → rates ↓	Increase in money supply → AD right; opposite move → AD left.
Quantitative Easing (QE) – unconventional tool	Long‑term government bonds & other assets	Large‑scale purchases push down long‑term yields → lower borrowing costs	Boosts AD when conventional tools are exhausted; may also affect exchange rate.

In A‑Level “evaluate” questions you are expected to discuss both short‑run and long‑run effects, as well as any side‑effects (e.g., asset‑price bubbles, exchange‑rate movements).

8. Demand for Money (Liquidity‑Preference Theory)

Households and firms hold money for three motives. The syllabus often represents the relationship with the linear equation:

$$MD = kY - hi$$

• Transactions motive – money needed for day‑to‑day purchases; proportional to income (Y). Captured by the term kY, where k is the proportion of income held as cash.
• Precautionary motive – money held for unexpected expenses; also related to Y and to the level of uncertainty.
• Speculative motive – money held as an asset to avoid capital‑loss risk; inversely related to the prevailing interest rate (i). Captured by the term -hi, where h measures the interest‑rate sensitivity of speculative demand.

Graphical note: In the money‑market diagram the demand curve (MD) slopes downwards because a higher interest rate raises the opportunity cost of holding money.

Exam tip: When discussing the effectiveness of monetary policy, comment on the interest‑rate elasticity of money demand. If demand is very elastic, a change in rates produces a large change in M/P, making policy more potent; if inelastic, the effect is muted.

9. Interest‑Rate Determination (Loanable‑Funds & LM Framework)

The equilibrium real interest rate is set where the supply of loanable funds (saving) equals the demand for loanable funds (investment).

• Supply of Funds – comes from households’ saving; positively related to the real interest rate.
• Demand for Funds – comes from firms’ investment; negatively related to the real interest rate.

In the IS‑LM model, monetary policy shifts the LM curve (money market) by changing the money supply, which in turn moves the equilibrium interest rate and output.

• Expansionary policy → LM shifts right → lower i → higher Y (AD rises).
• Contractionary policy → LM shifts left → higher i → lower Y (AD falls).

Remember to link the LM shift to the money‑demand equation (MD = kY – hi) and to comment on the role of the interest‑rate elasticity (the parameter h) when evaluating policy effectiveness.

10. Quick‑Reference Summary Diagram (Suggested)