The functions and characteristics of money

Money is anything generally accepted in exchange for goods and services. It has four functions:

• Medium of exchange — removes the double coincidence of wants that cripples barter. This is the essential function.
• Unit of account (measure of value) — a common yardstick, so relative prices can be compared.
• Store of value — purchasing power can be held over time. Inflation destroys this function, which is why hyperinflation collapses a monetary economy back into barter.
• Standard of deferred payment — makes credit, debt and contracts possible.

Characteristics of good money: durable, portable, divisible, limited in supply, uniform, acceptable.

Money supply: narrow money (M0) is cash and reserves; broad money (M4) adds bank deposits — the vast majority of money in a modern economy is bank deposits created by lending, not notes and coins.

Money markets, capital markets and the bond price puzzle

• Money markets — short-term borrowing and lending (less than a year): Treasury bills, commercial paper, interbank lending. This is where firms and banks manage liquidity.
• Capital markets — long-term finance: equities (shares — ownership, paying dividends) and bonds (debt — a loan, paying a fixed coupon).
• Foreign exchange markets — trading currencies.

Functions of financial markets: channel savings into investment, provide liquidity, allow risk to be spread and hedged, and enable a means of exchange.

Why bond prices and yields move inversely — this is a guaranteed exam question. A bond has a fixed coupon, say £5 a year. If the market price of that bond falls to £80, the buyer still receives £5 a year — so their return has risen to 6.25%. If the price rises to £125, the same £5 is now only a 4% return. The coupon is fixed; only the price can move, so price up = yield down, always.

Why this matters for policy: when the Bank of England buys bonds under QE, it pushes bond prices up — and therefore yields down. Since bond yields anchor long-term interest rates across the economy (mortgages, corporate borrowing), the whole cost of borrowing falls. QE is, at bottom, an exercise in this one relationship.

Your turn — the bond yield

Bond prices and yields

Commercial banks and credit creation

A commercial bank's balance sheet: liabilities are customer deposits (the bank owes you your money) and capital; assets are loans, reserves and securities (what the bank owns or is owed).

Banks face a permanent trade-off between LIQUIDITY, PROFITABILITY and SECURITY. Cash is perfectly liquid but earns nothing; long-term loans are profitable but illiquid and risky. Chasing profitability at the expense of liquidity is precisely what caused Northern Rock to fail in 2007.

Credit creation: banks do not simply lend out existing deposits — lending creates new deposits, and therefore new money. Because only a fraction of deposits is held in reserve, the banking system multiplies an initial deposit:

Be honest about the model. The textbook credit multiplier assumes banks always lend up to the limit and that all the money returns as deposits. In reality lending is constrained by capital requirements, the demand for loans and banks' own risk appetite — in a crisis, banks hoard reserves and the multiplier collapses. Saying so is an evaluation point, not a quibble.

What financial markets do — and how they fail

Functions of financial markets: channel savings into investment; provide liquidity; enable risk to be spread and hedged (insurance, derivatives); facilitate the exchange of goods and services; and provide a market for equities, giving firms long-term capital.

But financial markets fail in every way covered in 4.1.8 — and more spectacularly:

• Asymmetric information — the seller of a complex derivative knows far more than the buyer; borrowers know their own riskiness better than lenders (adverse selection).
• Moral hazard — insured or bailed-out institutions take more risk.
• Externalities — one bank's failure imposes vast costs on everyone else. Systemic risk is a negative externality on a colossal scale, and financial stability is effectively a public good.
• Speculation and market bubbles — herding, momentum trading and irrational exuberance (behavioural economics, 4.1.2) drive prices far from fundamentals, then crash.
• Market rigging — LIBOR, forex manipulation — and monopoly power in a concentrated banking sector.

The exam-ready link: the case for financial regulation is simply the case for correcting market failure, applied to the one market where failure can take the whole economy down with it.

Your turn — credit creation

The Bank of England and monetary policy

Roles of a central bank: implement monetary policy; act as banker to the government and to the banks; act as lender of last resort (supplying emergency liquidity to solvent banks facing a run — the essential firebreak); manage the currency and reserves; and oversee financial stability.

UK monetary policy: the Bank of England has been operationally independent since 1997. The Monetary Policy Committee (MPC) — 9 members — meets 8 times a year and sets Bank Rate to hit the government's symmetric CPI inflation target of 2% (± 1pp). Symmetric matters: undershooting is treated as just as bad as overshooting, because deflation is dangerous.

The transmission mechanism — how a Bank Rate rise reaches inflation:

• Borrowing gets dearer and saving more rewarding → C and I fall (mortgage-holders in particular have less to spend).
• Asset prices (houses, shares) fall → negative wealth effect → C falls further.
• Higher rates attract hot money inflows → the pound appreciates → exports dearer, imports cheaper → X falls, M rises. This also directly reduces imported cost-push inflation.
• All of that reduces AD → the output gap narrows → inflationary pressure falls.

Evaluate monetary policy: it is flexible and can be reversed quickly, and independence gives it credibility (anchoring expectations — remember the Phillips curve). But: long and variable time lags (up to 18–24 months to full effect); it is a blunt instrument hitting mortgage-holders and exporters hardest; it is powerless against cost-push inflation from an oil shock without crushing output; and it hits the zero lower bound — you cannot cut much below zero, which is exactly why QE was invented.

Your turn — the real interest rate

Quantitative easing and unconventional policy

When Bank Rate is already near zero (the zero lower bound), conventional cuts are exhausted. Quantitative easing is the unconventional alternative: the central bank creates new electronic money and uses it to buy financial assets — mainly government bonds (gilts) — from pension funds, insurers and banks.

How it is supposed to work:

• Buying bonds pushes bond prices up → yields down → long-term interest rates across the economy fall → C and I rise.
• The sellers now hold cash and rebalance into other assets → share and house prices rise → a positive wealth effect → C rises.
• Banks hold more reserves → more capacity to lend.
• The extra money supply tends to depreciate the pound → boosting net exports.
• It signals that the central bank is serious — supporting confidence and expectations.

Risks and criticisms: it is inflationary if pursued for too long (a large body of opinion links post-2020 QE to the 2022 inflation surge); it inflates asset prices, which are held disproportionately by the rich, so it worsens wealth inequality; banks may simply sit on the reserves rather than lend; it distorts markets and encourages excessive risk-taking; and unwinding it (quantitative tightening) is difficult and can destabilise bond markets.

Also on the spec: forward guidance — the Bank committing publicly to keeping rates low for a long period, which works purely by shaping expectations, at no direct cost.

Expansionary, contractionary or regulation?

Tap a measure, then tap the category it belongs to.

How QE works

Financial regulation after 2008

What went wrong in 2007–08: banks took excessive risks with too little capital, funded long-term illiquid assets with short-term borrowing, and built opaque products (sub-prime mortgage-backed securities) that nobody could value. Because banks are deeply interconnected, one failure threatened all of them — systemic risk. And because governments could not let them fail, banks enjoyed an implicit guarantee: moral hazard — the incentive to take bigger risks precisely because you expect to be bailed out. Profits are private; losses are socialised.

The UK regulatory architecture now:

• Financial Policy Committee (FPC), at the Bank of England — macro-prudential regulation: watches systemic risk across the whole system, runs stress tests, can set countercyclical capital buffers and limits on mortgage lending.
• Prudential Regulation Authority (PRA) — micro-prudential: the safety and soundness of individual banks and insurers (capital and liquidity requirements, following Basel III).
• Financial Conduct Authority (FCA) — conduct: protecting consumers, market integrity, promoting competition (the mis-selling scandals sit here).

Other reforms: ring-fencing retail banking from investment banking; higher capital and liquidity ratios; deposit insurance (FSCS, up to £85,000) to stop bank runs; and resolution regimes so a failing bank can be wound down without a bailout.

Evaluate: tighter regulation makes the system safer, but heavier capital requirements restrict lending and can slow growth; compliance costs are large and fall hardest on small banks; and regulation risks regulatory capture and simply pushes risk into the less-regulated shadow banking sector. Financial stability is itself a classic public good — which is why the market will not supply enough of it on its own.

Match the function of money

Tap a description on the left, then the concept it defines.

Moral hazard

The limits of monetary policy

Monetary, fiscal and macro-prudential policy together

Real policy is never one instrument alone. AQA rewards students who can compare them.

• Monetary policy — fast to change, flexible, credible when independent. But long lags (18–24 months), blunt, ineffective at the zero lower bound, and powerless against cost-push inflation without crushing output.
• Fiscal policy — direct, powerful (multiplier), and can be targeted at regions or groups; capital spending also raises LRAS. But it has long implementation lags, worsens the deficit, and may crowd out.
• Macro-prudential policy — the FPC's tools (capital buffers, loan-to-income caps) let the authorities cool a housing or credit bubble without raising Bank Rate for the whole economy. This is the great post-2008 innovation: a targeted instrument for a targeted problem.
• Supply-side policy — the only route to raising the trend rate of growth, but slow and uncertain.

The rule of thumb to carry into any macro essay: match the instrument to the cause. Demand-deficient recession → monetary and fiscal stimulus. Demand-pull inflation → tighten. Cost-push shock → neither works well; look to supply-side measures and to protecting expectations. Structural unemployment or weak productivity → supply-side only. Credit bubble → macro-prudential.

The big ideas to know

You have covered the whole of AQA 4.2.4. Press Finish to see your score.