Forms, functions and characteristics of money
Money and Banking (Cambridge IGCSE Economics 0455)
Objective
To understand the forms, functions and characteristics of money, the role of central and commercial banks, and the relationship between money supply and the banking system.
1. What is Money?
Money is any item or record that is generally accepted as a:
- medium of exchange for goods and services,
- a unit of account for measuring value,
- a store of value for preserving purchasing power, and
- a standard of deferred payment for settling debts.
It removes the need for barter by providing a common, widely‑accepted means of transaction.
2. Functions of Money
- Medium of Exchange – enables buying and selling without a double coincidence of wants.
- Unit of Account – provides a single, standard measure for valuing goods, services and assets.
- Store of Value – allows purchasing power to be transferred into the future.
- Standard of Deferred Payment – used to settle debts and contracts over time.
3. Characteristics (Qualities) of Money
| Characteristic | Why it matters |
|---|---|
| Durability | Must withstand repeated handling without deteriorating. |
| Portability | Easy to carry and transfer between people. |
| Divisibility | Can be broken into smaller units without loss of value. |
| Uniformity (Standardisation) | Each unit is identical in appearance and value. |
| Limited Supply (Scarcity) | Scarcity – a resource not available in unlimited quantities – helps maintain value; too much money would cause inflation. |
| Acceptability | Widely accepted by the public, businesses and the state. |
| Stability of Value | Low and predictable inflation preserves purchasing power; central banks aim to maintain price stability. |
4. Forms of Money
The syllabus recognises five main forms. Each form satisfies the functions and characteristics listed above.
- Commodity Money – items that have intrinsic value (e.g., gold, silver, cattle, salt).
- Representative Money – tokens that represent a claim on a commodity (e.g., gold certificates, banknotes that could be exchanged for gold).
- Fiat Money – currency declared legal tender by government decree; it has no intrinsic value but is accepted because the state requires it.
- Bank Money (Deposits) – balances held in commercial‑bank accounts; accessed by cheques, debit cards or electronic transfers.
- Electronic/Digital Money – purely electronic balances used for online transactions (e‑wallets, mobile‑money services). Cryptocurrencies are an optional example of electronic money but are not required for the IGCSE.
5. The Banking System
5.1 Central Bank
The central bank (e.g., the Bank of England, the Federal Reserve) is the authority that:
- Issues the national currency (base money).
- Sets the reserve‑requirement ratio for commercial banks.
- Acts as lender of last resort to prevent bank failures.
- Conducts monetary policy using three main tools:
- Interest‑rate policy – setting the official rate that influences borrowing costs.
- Open‑market operations – buying or selling government securities to change the amount of base money.
- Reserve‑requirement changes – altering the proportion of deposits banks must hold as reserves.
5.2 Commercial Banks
Commercial banks:
- Accept deposits from households and firms.
- Provide payment services (cheques, debit cards, online transfers).
- Make loans, thereby creating “bank money” through the deposit‑multiplication process.
6. Money Supply and the Money‑Multiplier
Money supply (M) refers to the total amount of money available in the economy for transactions. In the IGCSE context it is sufficient to treat it as the aggregate of cash, bank deposits and electronic balances.
The theoretical maximum money supply that can be created from a given amount of base money (B) is:
M = (1 / r) × B
where r = reserve‑requirement ratio (as a decimal) and B = base money.
Worked Example
- Base money supplied by the central bank = £10 million.
- Reserve ratio set by the central bank = 20 % (r = 0.20).
- Money multiplier = 1 / 0.20 = 5.
- Maximum potential money supply = 5 × £10 million = £50 million.
In practice the realised money supply is lower because banks hold excess reserves and some cash is withdrawn for non‑bank uses.
Linking Central‑Bank Action to the Money Supply
- If the central bank lowers the reserve ratio, the multiplier rises, allowing a larger money supply for the same amount of base money.
- If the central bank conducts open‑market purchases of government securities, it injects additional base money, expanding the money supply.
- Conversely, raising the reserve ratio or selling securities withdraws base money and contracts the money supply.
7. Summary Table – Functions, Required Characteristics and Typical Forms
| Function | Key Characteristic(s) Required | Typical Form(s) Used |
|---|---|---|
| Medium of Exchange | Acceptability, Portability, Divisibility | Fiat notes & coins, Bank deposits, Electronic money |
| Unit of Account | Uniformity, Stability of value | Fiat money, Electronic money |
| Store of Value | Durability, Limited supply (scarcity), Stability of value | Gold (commodity), High‑quality fiat, Some digital money (optional) |
| Standard of Deferred Payment | Acceptability, Stability of value | Fiat money, Bank deposits |
8. Diagram – The Money‑Multiplier Process
