What is money?

The new Economics and BTEC National specifications have included some new topics around the role of money. The inclusion of these topics in the new specifications may well reflect a renewed interest in money since the Global Financial Crisis as well as a concern that traditional economic theory has tended to ignore the role of money and credit in its models.

Banking and the modern economy

In 2014, the Bank of England published two papers on money. The first paper is really useful as an introduction to the functions of money and helps one to understand how money allows transactions to have three parties. In a barter economy there is only a buyer and a seller (two parties). In a modern economy there are three parties to a transaction, buyer, seller and bank. This means that banking is a key component of a modern economy.

The article starts by defining money through the functions it performs and these functions directly reference our Economics A, IAL and BTEC National specifications.

The first function it explains is of money storing value, the second how money is used in pricing goods and services where money provides a unit of account, and the third, how money is used as a medium of exchange. The article draws links between these functions illustrating how money is acceptable as a medium of exchange if one is confident that it will keep its value. If this confidence disappears then people are likely to use other currencies in their exchanges but this can make it difficult to understand the price as one would need to know the rate of exchange between the two currencies.

Adam Smith (an 18th century economist) suggested that money allowed people to specialise because it opened up the possibility that they could consume goods other than what they produced themselves. Money also allowed people to spread their consumption because they could store value and spend when they most wanted to consume something.

The Bank of England has produced a short introductory video which introduces the idea of money as an IOU.

Watch the Bank of England video:

The changing role of money

In the past money was a commodity with a value in its own right, such as gold or silver, but today we use paper money or fiat money which is like an IOU.

An IOU can be thought of as a financial asset created as a claim on someone else. If money is an asset for one person it has to be a liability for someone else. If I deposit money in a bank account that is an asset for me and a liability for the bank. If a household borrows money to buy a house from a bank (a mortgage), that represents a liability for the household and an asset for the bank. Theoretically we could all write our own IOUs but why would others trust them? Money gets over the trust problem because in a modern economy, everyone trusts it. If they trust it they will accept it as a means of exchange.

The article then goes on to explain that there are three types of money.  This goes further than our specifications but does allow students to develop their understanding of money in terms of assets and liabilities.

1. Currency

An asset held by households and firms and a liability for the central bank (Bank of England).

Currency is mainly banknotes and on them is a ‘promise to pay’ whoever has the note a set amount (i.e. £5, £10, £20, £50). The Bank of England was set up in 1694 and at that time, the ‘promise to pay’ was for an equivalent amount in gold. This lasted until 1931 when the bank notes became paper money or fiat money and could not be converted to gold.

So the ‘promise to pay’ is now a promise to exchange paper money for paper money and not gold. However, the government makes sure that households and firms still need and use the money by declaring it to be ‘legal tender’ and by demanding that taxes are paid using that currency (using money as a unit of account) and by controlling the rate of inflation (so that money can be a store of value).

The government also has to ensure that the money is hard to counterfeit and this is done as part of the process of printing bank notes which the Bank of England arranges, printing enough to meet households’ and firms’ demand for these bank notes. Commercial banks can swap old banknotes for new bank notes and can also pay for extra bank notes out of their reserves held at the central bank.

For households and firms, one problem of currency is that it doesn’t pay interest and another is that it is not very secure. So households and firms prefer to store their financial assets as bank deposits rather than ‘under a mattress at home’.

2. Bank deposits

An asset held by households and firms and a liability for commercial banks.

Bank deposits can be current accounts, savings accounts or savings bonds and these are now usually recorded electronically.

Households swap their currency for bank deposits because they are confident that the commercial banks will let them use the money when they need it and/or take it out of their bank as currency. The government helps this confidence by guaranteeing bank deposits up to a certain value (£85,000 at the time of writing) so that households know that they would get their money back from the government if the commercial bank went out of business.

Most households and firms now use their bank deposits as money, using debit cards, credit cards, telephone and online banking to move money from their accounts to the accounts of other households and firms providing them with goods and services. This is much more convenient than having to convert a bank deposit into currency before being able to buy anything.

If the Bank of England creates new currency, commercial banks create new money. They do this electronically every time they make a new loan. They effectively create a new IOU, a liability for the household or firm which has borrowed the money and an asset for the bank. This is how most money is created in the economy. There are limits to the amount of money commercial banks can create, partly down to commercial factors and partly to the regulatory policies of the Bank of England.

3. Central bank reserves

An asset for commercial banks and a liability for the central bank.

These are a bit like a household current account that commercial banks hold at the Bank of England. They can transfer money to other commercial banks and the Bank of England guarantees that they can swap their reserves for currency if they need it. So if households suddenly wanted to convert their bank deposits into currency, commercial banks could swap their reserves for currency to give to their customers.

So households and firms have assets in the form of currency and bank deposits, and have liabilities in the form of mortgages and bank loans.

Commercial banks have assets in the form of mortgages, bank loans to firms and reserves held at the central bank. They have liabilities in the form of households’ and firms’ bank deposits.

The central bank has liabilities in the form of reserves from commercial banks and currency (notes and coin in circulation). It has assets in the form of government debt.

Specification links

Economics A
1.1.5d The functions of money
4.4.3 Role of central banks

Economics B
1.4.1 Role of banks in the economy
1.4.3e the role and impact of credit on the economy
4.5.3 The role of the central bank

IAL Economics
1.3.1.5b The functions of money
1.3.1.5c The role of financial markets: to facilitate saving; to make funds available to businesses and individuals.

BTEC Nationals in Business and in Enterprise & Entrepreneurship
Unit 3 Personal and Business Finance, A1 The functions and role of money.