Chapter 16

Money and banking

 Learning objectives
By the end of this chapter you will be able to:
State the forms of money
Explain the functions of money
Describe the characteristics of money
Analyse the role of commercial banks
Discuss the importance of commercial banks
Analyse the role of central banks
Discuss the importance of central banks
 16.1 Money
Forms of money
The main forms of money used in most countries
are coins, notes and bank accounts. Coins are often
used to make small purchases and are given in
change. Notes are used to buy more expensive
items. In most countries the main form of money is
bank accounts. These are responsible for the
largest proportion (in terms of value) of payments
made.
 16.1 Money
• . There are a number of ways of transferring
money from one bank account to another. These
include direct debits, credit cards and mobile
phones.
Although bank accounts are the most important
form of money they are not legal tender, whereas
coins (up to a certain value) and bank notes are
Legal tender is any form of payment which, by
law, has to be accepted in settlement of a debt.
 16.1 Money
• So a person has to accept bank notes in
payment. but they have the right to refuse, for
example, a credit card In practice. however,
most people and firms find payment from
bank accounts convenient and hence are
willing to accept it.
 The functions of money
Money carries out four functions It acts as a
• Medium of exchange
• store of value
• unit of account
• standard of deferred payments
 Medium of exchange
• Money allows people to buy and sell products.
In carrying out this function, money is said to
act as a medium of exchange. Products are
exchanged for money and that money is used
to buy other products.
Products- Money- Products
 Store of value
• Acting as a store of value means that money can
be saved. It would be pointless to save eggs, for
example, as eggs go bad over time and no one
will be prepared to accept them a few weeks after
they have been laid .Money, however, does not
deteriorate with time and hence will be
acceptable in the future.
 Unit of account
• Money can also be used to place a value on an item.
Prices are expressed in monetary terms. A newspaper
may be priced at $2 and a book at $30. This function
of acting as a unit of account, or measure of value (as
it is sometimes called), enables buyers and sellers to
agree on what items are worth, relative to each other.
• In the example above, one book is worth fifteen
newspapers With $60 to spend, a person can either
buy two books or thirty newspapers
 Standard of deferred payments
• The fourth function of money is to act as a
standard of deferred payments. This means
that money allows people to borrow and lend.
Someone who wants to buy something now
can get it by borrowing money from someone
who does not want to use it now. They can
make an agreement about the amount to be
repaid in the future
 The characteristics of money
To act as money, an item does not need to
have intrinsic value. This means that it does
not have to be worth something in its own
right.
 Example
• Both silver and bank notes can act as money, but whereas silver
is wanted for a variety of purposes, bank notes have no intrinsic
value. An item does have to possess a number of characteristics
for it to serve as money. The most important one is that it
should be generally acceptable. If people are not prepared to
accept the item as payment, it will not be able to carry out the
functions of money To achieve general acceptability, the item
has to be in limited supply. Why. for instance, should people
accept twigs as payment in a country with many trees?
 Other characteristics
• The other characteristics an item needs are
that it is durable (will last some time).
portable (can be carried around easily),
divisible (can be divided into units of different
values), homogeneous (every note or coin of
the same value should be exactly the same)
and recognisable (people can easily see that
the item is money).
 Answer Group activities 1
• 1 a Leaves are reasonably portable, and they
are recognisable. They are, however, not
limited in supply and hence are unlikely to be
generally acceptable. Also, they are not
durable or homogeneous.
 Answer Group activities 1
B Seashells are durable, portable and
recognisable. They are also divisible, as
seashells come in a variety of sizes. They are,
however, not perfectly homogeneous and may
not be that limited in supply in countries with
coastlines. Hence, they may not be generally
acceptable, although seashells have acted as
money in some countries in the past.
 Answer Group activities 1
C Gold possesses all the characteristics of
money. It has been used as money before and
is still acceptable in most countries. Its use as
money, however, involves an opportunity cost
as it has intrinsic value. Gold can be used for
jewellery and industry. In contrast, notes,
coins and bank notes essentially have only one
purpose.
 16.2 Banking
• Commercial banks
Banking is a major industry in a number of
countries. It helps people to borrow and lend and
carry out a range of other financial activities. By
doing this, it enables more efficient use of
resources and encourages the growth of output
of economies .
 Commercial banks
• Commercial banks are also called retail or
high Street banks. All three names tell us
something about them.
 Commercial
• Commercial indicates that they are business
organisations which usually seek to make a
profit.
 Retail
• Retail suggests that they are selling the public
something — in this case banking services.
 High street
• High street tells us that these banks are found
in most towns and cities. They are the banks
we are most familiar with.
The role and importance of commercial
banks
The three main and traditional functions of
commercial banks are
To accept deposits.
To lend
To enable customers to make payments.
 To accept deposits
• The first function enables customers to keep
their money in a safe place. Deposits can be
made into two types of bank account.
 Current account
• One is a current account, sometimes called a
demand account or sight account. There is
easy and immediate access to money in this
type of account, but usually interest is not
paid on money held in such an account.
Customers use current accounts mainly to
receive and make payments.
 Deposit or Time account
• The other type of account is a deposit or time
account. A period of notice often has to be
given before money can be withdrawn from
this account. Interest is paid on any money
held in a deposit account and customers use
deposit accounts as a way of saving.
 Borrowing
• There are two main ways of borrowing from a
bank.
• Overdraft
• Taking a loan
 Overdraft
• One is in the form of an overdraft. This
enables a customer to spend more than what
is in her or his account, up to an agreed limit
Interest is charged on the amount borrowed.
This can be a relatively expensive way of
borrowing and is mainly used to cover short-
term gaps between expenses and income.
 Taking a loan
• The other way of borrowing is by taking a loan.
This is usually for a particular purpose and for a
particular period of time. Interest is charged on the
full amount of the loan but the rate of interest is
likely to be lower than that on an overdraft. A
customer may be asked to provide some form of
security, known as collateral, when taking a loan.
This is to ensure that if the loan is not repaid, the
asset given as collateral can be sold and the money
recovered.
 Functions of banks
• The first two functions of banks, effectively borrowing
from their customers and lending to them, means that
they act as financial intermediaries. They accept
deposits from those with more money than they
currently want to spend and lend it to those with an
immediate desire to spend more money than they
have at hand. In other words, they channel money
from lenders to borrowers.
Lenders —, Banks — Borrowers
 Other Functions of Banks
• Over a period of time, commercial banks have built up a
range of other services that they offer their customers.
• 1 Most commercial banks now provide and change
foreign currency.
• 2 Customers can leave important documents, such as
house deeds and small valuables, with their banks, and
• 3 the banks are also likely to be willing to help with the
administration of customer& wills.
 Other Functions of Banks
• They can provide advice and help with a
number of financial matters, such as
completion of tax forms, and the purchase
and sale of shares, Many banks also now sell
insurance and offer a wide variety of savings
accounts, with a range of conditions and
interest rates. Some now offer mortgage
loans. which are loans to buy houses.
 Answer
• 2 a An overdraft is a way of borrowing money
from a commercial bank. It is the permission
given to a bank’s customer to spend more
money than what is present in her or his
account.
 Answer
• b The banks are charging a high rate of
interest. This may discourage people from
borrowing from the bank and consequently
threaten its profitability. The extent to which
this occurs, of course, will depend on the rate
of interest charged by other banks in Brazil
and the quality of their service.
 Aim of a commercial bank
• The key aim of a commercial bank Is to make a profit for its
shareholders. The main way it does this is by giving loans
(which bankers often refer to as advances). Another aim
which can conflict with the key aim is what is known as
liquidity. Banks have to ensure that they can meet their
customers requests to withdraw money from their
accounts. To do this, banks have to keep a certain amount
of what are called liquid assets .These are items which can
be turned into cash quickly and without incurring loss.
 Long-term loans
• Banks earn most of the interest by giving long-
term loans. However, if they tie up all their
money in such loans, they would not be able
to pay out cash to the customers requesting
it .They have to balance profitability and
liquidity — having some assets earning high
interest but being illiquid, and having others
earning low or no interest but being liquid.
 Islamic Finance
• In a number of Islamic countries, commercial
banks are not allowed to charge interest on
bank loans This is because many Muslims
regard charging of interest, sometimes called
usury. as a sin Traditionally. Islamic banks have
provided finance for firms by lending to them
in return for a share in their profits.
 Islamic Finance
• In recent years. more US and European commercial
banks have sought to expand existing branches and
open up new branches in Islamic countries in the
Middle East and Asia Most employ Islamic sharia
scholars and experts who can issue religious edicts
(fat was ) that approve financial products including
loans. The US-based bank Citigroup, for example,
has created an independent sharia advisory board
of Islamic scholars to offer it advice.
 Answer
• 1 a The extract mentions interest paid on
deposits, so it is referring to the function of
accepting deposits.
 Answer
• b Another function of a commercial bank is
lending. The bank charges a higher interest
rate from borrowers than it pays to those
depositing money with it. Bank customers can
borrow by taking a loan or by arranging an
overdraft. A lower rate of interest is charged
on a loan but it is charged on the full amount
of the loan.
 Central banks
A central bank is the single most important and
influential bank in the country or, in the case of the
European Union, the region. The five most well-known
central banks in the world are probably the Federal
Reserve Bank of the USA (often called the Fed). the
European Central Bank (ECB). the Bank of England. the
Reserve Bank of India and the People’s Bank of China
Central banks are owned by governments and are
responsible to them
The role and importance of central Bank

• The role a central bank plays in an economy

means that it can have a significant impact on
households, firms and the performance of the
economy. Its functions include:
 Acts as a banker to the government
• Tax revenue is paid into the government’s
account at the central bank. and payments by
the government for goods and services are
made out of this account.
 Operates as a banker to the commercial
banks
• Holding accounts at the central bank enables
commercial banks to settle debts between
each other and to draw out cash. if their own
customers are taking more cash from their
branches than usual.
 Acts as a lender of last resort
• This means it will lend to banks which are
temporarily short of cash .
 Manages the national debt
The national debt is the total amount the
government owes. Over time, government
debt tends to build up. The central bank
carries out borrowing on behalf of the
government by issuing government securities,
for example government bonds, pays interest
on these and repays them when they fall due.
 Holds the country’s reserves of foreign
currency and gold
• The central bank keeps foreign currency and
gold to influence the exchange rate.
 Issues bank notes
• The central bank is responsible for printing
notes and destroying notes which are no
longer suitable for circulation. It also
authorises the minting of coins,
 Implements the government’s monetary
policy
• The prime aim of this is to keep inflation low and
steady. This involves controlling the money supply and
influencing interest rates throughout the economy, by
changing the interest rate it charges on its loans. The
government may instruct the central bank to increase
or decrease the money supply. In some cases. central
banks implement interest rate changes decided by
their respective governments. In other cases, central
banks have been given the responsibility to set interest
rates.
 Controls the banking system
• Many central banks play a key role in
regulating and supervising the banking
system.
 Represents the government
• Represents the government at meetings with
other central banks and international
organisations such as the World Bank and the
International Monetary Fund.
 Answer
• 2a
A central bank is owned by the government,
whereas a commercial bank is owned by its
shareholders.
 Answer
• b The key feature of a sensible lending policy
is to lend only to those who will be able to
repay the loan.
 Answer
C Another function is to act as banker to the
commercial banks. The commercial banks keep
accounts at the central banks. These are like the
current accounts kept at commercial banks and
are used for the same two main purposes. One is
to make and receive payments, but this time the
commercial banks are transferring money from
and into their accounts from other commercial
banks. The other is to withdraw cash, when
needed.
 Multiple choice questions
I Money enables people to save. Which
function of money does this describe?
A Medium of exchange
B Store of value
C Unit of account
D Standard for deferred payments
 Multiple choice questions
• 2 What would make an item unsuitable to act
as money?
A It is easy to carry
B it is generally acceptable
C It is perishable
D It is recognizable
 Multiple choice questions
• 3 What is a function of a central bank?
A Controlling the money supply
B Deciding on the amount of government
expenditure
C Issuing shares
D Raising taxes
 Multiple choice questions
• 4 What is the main aim of a commercial bank?

A To act as banker to the government

B To issue bank notes
C To make a profit
D To manage the national debt
 Answers Multiple choice questions

• 1B
• Money enables people to save, as it can be
stored.
• 2C
• To act as money, an item must be durable. A, B
and D are all desirable characteristics of
money.
 Answers Multiple choice questions

• 3A
• Controlling the money supply is another key
function of a central bank. B and D are functions
carried out directly by the government. C is
undertaken by private sector financial institutions.
• 4C
• Commercial banks are in the private sector and
their key aim is to make a profit. A, B and D are
functions of a central bank.
 Four-part question
a Identify two characteristics of money. (2)
b Explain two functions of a central bank. (4)
c Analyse in what circumstances a commercial
bank wlI increase its lending. (6)
d Discuss whether or not gold rings can carry
out the functions of money. (8)
 Answers Four-part question
• a E.g., general acceptability and durable.
 Answers Four-part question
B One function of most central banks is to issue
bank notes. It prints the notes and gets them into
circulation through the commercial banks. It also
acts as a banker to the commercial banks.
Deposits are held by commercial banks at the
central bank and, in times of need, the central
bank may lend to the commercial banks. Lending
by the central bank to commercial banks in
difficulty is referred to as the central bank acting
as lender of last resort.
 Answers Four-part question
C A commercial bank will increase its lending if it
thinks it will make more profit. For this to be
achieved there would have to be more demand
for loans from creditworthy borrowers it thinks
will repay. Households and firms tend to
borrow more when the economy is doing well.
For instance, households may borrow to buy a
better home, expecting that higher pay in the
future may help to repay loans.
 Answers Four-part question
Firms may also borrow more to expand to
meet rising demand. A commercial bank
would also have to possess the funds to
support any loans. It has to ensure that it has
enough liquid assets to meet its customers’
demand for cash.
 Answers Four-part question
There also has to be enough difference
between the interest rate the bank can charge
to lenders and the interest rate it pays to
savers. Some commercial banks may make
other arrangements, such as taking a share of
the profits of the businesses they lend to. In
such a case, a commercial bank would still
have to expect a good return.
 Answers Four-part question
D There are some reasons why gold rings may be able to
carry out the functions of money. Some people may be
prepared to accept the rings in settlement of debts and
in return for goods and services. In times of financial
crisis, when people are losing confidence in their
currency, some people move some of their saving into
gold bars. Gold rings are very portable. Being able to
carry the rings easily would mean that the rings have
one of the characteristics of money. Rings would not
take up much more space than coins and they have a
higher value.
 Answers Four-part question
Gold rings are also limited in supply. Gold is a
relatively scarce commodity and has a high
value. They are not like, for instance, seashells,
which may be in very abundant supply in a
country. There are, however, stronger reasons
why gold rings are not generally acceptable as
money. It is not necessarily easy to judge
whether a ring is a gold ring or not. So, gold
rings may not be recognisable.
 Answers Four-part question
This may mean that people will not use them
as a medium of exchange. Gold rings are also
not divisible. They do not enable low value
change to be given. They are also not
homogeneous. The weight of gold in gold rings
and their attractiveness varies. This means it is
difficult for people who are offered rings in
return for goods and services to assess their
value.
 Answers Four-part question
This makes it difficult for them to carry out the
function of a unit of account. While gold rings
are limited in supply, their supply is influenced
by gold mines in a small number
of countries such as South Africa.
Governments in other countries are unlikely to
be happy having the money supply in their
countries being controlled outside their
countries.
 Answers Four-part question
The price of gold rings may change by
significant amounts. This may make it difficult
for them to act as a standard for deferred
payments and a store of value. For these
reasons, gold rings are not likely to be
generally acceptable.