functions of commercial banks: providing deposit accounts (demand deposit account, savings account)

Money and Banking

1. Money – definition and functions

Money is any item that is widely accepted as a:

• Medium of exchange – used to buy goods and services.
• Store of value – retains purchasing power over time.
• Unit of account – provides a common measure for prices, costs and debts.
• Standard of deferred payment – accepted for settling future obligations (e.g., loans, contracts).

These four functions give money its unique role in the economy and are required knowledge for Cambridge AS‑Level Economics (Section 9.4).

2. Monetary‑aggregate concepts

Economists group money into aggregates to show how much of the economy’s wealth is readily spendable.

• M0 (monetary base) – physical currency (notes + coins) in circulation plus banks’ reserves held at the central bank.
• M1 – M0 plus demand‑deposit accounts (e.g., checking accounts) and other deposits that can be accessed instantly for payments.
• M2 – M1 plus savings accounts, time deposits (e.g., certificates of deposit) and other near‑money assets that are less liquid but can be converted into cash relatively easily.
• M3 (where measured) – M2 plus large‑time deposits, institutional money‑market funds and other long‑term liquid assets.

These aggregates matter because they indicate the amount of money available for spending and saving, influencing inflation, interest rates and central‑bank policy.

3. Functions of commercial banks (Cambridge 9708 – Section 9.4)

1. Accept deposits – provide safe places for households and firms to keep money (e.g., demand‑deposit and savings accounts).
2. Provide loans and advances – use deposited funds (plus other sources) to finance households, businesses and the government.
3. Offer payment‑service facilities – issue cheques, debit cards, online‑banking, standing orders and other mechanisms that enable transactions.
4. Provide ancillary services – wealth‑management, foreign‑exchange, safe‑deposit lockers and other specialised financial services.

4. Deposit accounts – the core product for households and firms

4.1 Demand Deposit Account (DDA)

Used for day‑to‑day transactions; funds can be withdrawn at any time without notice.

• Key features
  • Very high liquidity – money is available on demand.
  • Linked to a cheque book, debit card or electronic‑payment system.
  • Little or no interest paid.
  • No fixed term; balance may fluctuate.
• Benefits to the depositor
  • Convenient access for purchases, bill payments and cash withdrawals.
  • Safety of funds (insured up to the statutory limit).
• Benefits to the bank
  • Provides a stable source of short‑term funds for lending.
  • Forms the base for money creation under fractional‑reserve banking.

4.2 Savings Account

Designed to encourage the accumulation of funds over time; withdrawals are allowed but may be limited.

• Key features
  • Earns interest – usually higher than a DDA.
  • May limit the number of withdrawals per month (e.g., six under Regulation D in some jurisdictions).
  • Typically no cheque‑writing facilities.
  • Balances tend to be larger than those in DDAs.
• Benefits to the depositor
  • Earns a return on idle money.
  • Encourages disciplined saving habits.
  • Funds remain safe and are usually insured.
• Benefits to the bank
  • Provides a relatively stable pool of funds that can be lent out at longer maturities.
  • Interest paid to savers is lower than the interest charged on most loans, creating a profit margin.

5. Reserve‑ratio and fractional‑reserve banking

The required reserve ratio (r) is the proportion of each deposit that commercial banks must keep as reserves (cash in the vault or balances with the central bank). The ratio is set by the central bank as a monetary‑policy tool.

• Required reserves = r × total deposits.
• Excess reserves = reserves actually held – required reserves.
• A lower reserve ratio allows banks to lend a larger share of each deposit, raising the money multiplier.

6. Money‑creation process

1. Deposit – A household places cash (or a cheque) into a demand‑deposit account.
2. Reserve holding – The bank keeps a fraction r as reserves and lends out the rest (1 – r).
3. Loan and redeposit – The borrower spends the loan; the recipient deposits the proceeds in the same or another bank, restarting the cycle.

The repeated “deposit → reserve → loan → new deposit” cycle expands the money supply. The theoretical maximum increase in the money supply (ΔM) from an initial deposit (D) is:

ΔM = 1/r × D

where r is expressed as a decimal (e.g., r = 0.10 for a 10 % reserve ratio). This formula assumes a constant reserve ratio and no leakages (e.g., cash withdrawals), which is why it is described as the *theoretical* money multiplier in the syllabus.

7. Central‑bank role

• Issuance of base money (M0) – Printing currency and providing reserves to commercial banks.
• Open‑market operations (OMO) – Buying or selling government securities to add to or withdraw reserves from the banking system.
• Policy interest rates – Setting the base‑rate (e.g., repo or discount rate) that influences the rates commercial banks charge.
• Lender of last resort – Supplying emergency liquidity to banks facing short‑term funding shortfalls.
• Independence and mandate – Most central banks operate independently of political influence and have a primary mandate such as price stability (inflation targeting) or full employment.

8. Monetary‑policy tools (Cambridge syllabus focus)

• Interest‑rate policy – Adjusting the policy rate to influence borrowing costs and aggregate demand.
• Reserve‑ratio changes – Raising or lowering r to directly affect how much banks can lend.
• Open‑market operations – Buying securities to increase reserves (expansionary) or selling to reduce reserves (contractionary).
• Quantitative easing (QE) – Large‑scale purchase of longer‑term securities when short‑term policy rates are at or near the zero lower bound, to inject liquidity and lower longer‑term yields.
• Discount‑window lending – Providing short‑term loans to banks at the discount rate.

9. Comparison of Demand‑Deposit and Savings Accounts

10. How deposit accounts contribute to money creation

Every new deposit adds to the pool of reserves that banks can use to extend credit. The multiplier effect depends on the reserve ratio.

Example 1 – Reserve ratio 10 % (r = 0.10)

• Initial deposit: £1,000
• Maximum potential increase in broad money: ΔM = (1 / 0.10) × £1,000 = £10,000

Example 2 – Reserve ratio 5 % (r = 0.05)

• Initial deposit: £1,000
• Maximum potential increase in broad money: ΔM = (1 / 0.05) × £1,000 = £20,000

These examples illustrate how a lower reserve ratio amplifies the money‑creation process, a point frequently tested in AO2 (analysis) exam questions.