The functions and characteristics of money

Money is anything generally accepted in exchange. It performs four functions:

• Medium of exchange — the decisive one. It removes the need for a double coincidence of wants, making specialisation and the division of labour possible.
• Store of value — purchasing power can be held over time. High inflation destroys this function, which is why hyperinflation drives people back to barter or to foreign currency.
• Unit of account — a common measuring rod, so relative values can be compared and accounts kept.
• Standard of deferred payment — debts and contracts can be written in money terms, which makes credit possible.

Characteristics of good money: durable, portable, divisible, uniform (fungible), limited in supply (scarce), and generally acceptable.

Liquidity is how quickly an asset can be converted into cash without loss of value. It ranks money:

• Narrow money — cash in circulation and instantly accessible deposits. It is the money available for transactions right now.
• Broad money — narrow money plus less liquid savings, time deposits and other near-money. It is the measure most relevant to lending and spending power in the economy.

How banks create money. When a commercial bank makes a loan, it simultaneously creates a deposit — new money. Because only a fraction of deposits is held in reserve, a single injection of cash supports a multiple expansion of deposits (credit creation):

Your turn — the credit multiplier

The Fisher equation and interest rates

The Fisher equation of exchange links the money supply to the price level:

The monetarist argument (Friedman): if V is broadly stable and Q is determined by real supply-side factors, then an increase in M must feed through into P. Hence "inflation is always and everywhere a monetary phenomenon", and hence the case for controlling the money supply.

The counter-argument: V is not stable — it collapsed during the 2008 crisis, which is precisely why enormous QE did not produce the hyperinflation its critics predicted. And if the economy has spare capacity, extra M can raise Q rather than P.

Interest rate determination. The interest rate is the price of money (or of loanable funds). It is determined by the demand for money (Keynes's liquidity preference: transactions, precautionary and speculative motives) and the supply of money, which is set by the central bank. Plot the interest rate against the quantity of money: the demand curve slopes down (a high interest rate is a high opportunity cost of holding idle cash, so people hold bonds instead) and the money supply is drawn vertical (set by the central bank). Where they cross is the equilibrium interest rate.

• Increase the money supply → the vertical supply line shifts right → the interest rate falls. That is the mechanism by which QE lowers rates.

Bond prices and yields move inversely. A bond paying a fixed £5 coupon costs £100 → yield = 5%. If its price falls to £80, the yield rises to 5 ÷ 80 = 6.25%. This is why central bank bond-buying (raising prices) lowers yields.

Your turn — the Fisher equation

Your turn — bond yield

Your turn — the real interest rate

Bond prices and yields

The role of the financial sector in development

The core function of the financial sector is intermediation: channelling funds from savers (who have surplus funds) to borrowers (who have productive uses for them). Around this it:

• provides a payments system and a safe place to store money;
• pools risk (insurance) and spreads it;
• provides liquidity, transforming short-term deposits into long-term loans (maturity transformation — the source of both its usefulness and its fragility);
• runs markets for equity, bonds, foreign exchange and derivatives, allowing firms to raise capital and hedge;
• and it allocates capital to its most productive use, if it works properly.

Savings, investment and growth. The Harrod-Domar model makes the link explicit: growth depends on the savings ratio divided by the capital-output ratio. Higher saving → more investment → a bigger capital stock → faster growth. A developing country with very low savings is trapped: it cannot fund investment, so it cannot grow, so it cannot save.

• Criticisms of Harrod-Domar: it assumes savings are automatically translated into productive investment (they may go abroad, or into unproductive assets); it ignores institutions, corruption and the quality of investment; and it downplays technology and human capital. Its policy conclusion (pour in aid to raise savings) has a poor empirical record.

Microfinance — very small loans to poor entrepreneurs who have no collateral and no credit history, and are therefore excluded from mainstream banking (a missing market caused by asymmetric information). Strengths: it funds small-scale enterprise, empowers women (who are the majority of borrowers), and repayment rates are high through group liability. Criticisms: interest rates can be very high, some borrowers fall into debt traps, and the evidence that it lifts households out of poverty at scale is weaker than the initial enthusiasm suggested.

Market failure in the financial sector

The financial sector is the most heavily regulated part of the economy, and market failure theory explains exactly why.

• Asymmetric information — the borrower knows their own riskiness far better than the lender. This causes adverse selection (the riskiest borrowers are the keenest to borrow at a given rate, degrading the pool) and it is why lenders demand collateral, credit scores and covenants.
• Moral hazard — the defining failure of 2008. Banks that believe they are "too big to fail" know the state will rescue them, so they take risks whose downside they will not bear. Deposit insurance, however necessary, makes it worse. Bankers paid bonuses on short-run profit had a private incentive to take risks that were catastrophic socially.
• Negative externalities — the collapse of one bank imposes vast costs on third parties who never dealt with it: a credit crunch, recession, mass unemployment. The social cost of bank failure massively exceeds the private cost, so banks take on more risk than is socially optimal.
• Speculative bubbles — behavioural failure at scale: herding, extrapolative expectations ("house prices always rise"), overconfidence and momentum trading push asset prices far above fundamentals. The subsequent crash destroys wealth, confidence and AD.
• Market rigging and monopoly power — LIBOR fixing, forex manipulation; and the concentration of retail banking in a few hands.
• Missing markets — the poor and small firms are excluded from credit entirely.

The systemic point: what makes finance unique is contagion. Banks lend to each other, so one failure cascades through the system. The externality is not a nuisance at the edge of the market — it is a threat to the entire economy. That is why "let it fail" is a far harder argument to make about a bank than about a shoe shop.

Moral hazard in banking

Why regulate banks?

Central banks and financial regulation

The roles of a central bank (the Bank of England):

• Monetary policy — setting Bank Rate (via the MPC) to hit the 2% inflation target, and conducting QE.
• Banker to the government and to the commercial banks; manager of the national debt and the foreign exchange reserves.
• Issuing currency.
• Lender of last resort — lending to a fundamentally solvent bank facing a temporary liquidity crisis, to stop a bank run turning into a system-wide collapse. (Bagehot's rule: lend freely, at a penalty rate, against good collateral.) Note the tension: doing this is essential for stability, yet it is itself a source of moral hazard.
• Financial stability and regulation — through the Prudential Regulation Authority and the Financial Policy Committee.

Methods of financial regulation:

• Capital requirements (Basel III) — banks must hold a minimum ratio of equity to risk-weighted assets, so shareholders lose before taxpayers do. This directly attacks moral hazard.
• Liquidity requirements — enough liquid assets to survive a run.
• Stress testing — simulating a severe recession to check banks would survive it.
• Ring-fencing — separating retail deposits from risky investment banking, so ordinary depositors are not exposed to trading losses.
• Deposit insurance (the UK's FSCS protects deposits up to a limit) — prevents panic-driven bank runs, but note the moral hazard it creates.
• Conduct rules, bonus deferral and clawback, and market abuse rules.

Evaluate regulation. It reduces systemic risk — but tighter capital rules mean banks lend less, which can slow growth; compliance costs are large and fall hardest on small challenger banks (reducing competition); activity migrates to the unregulated shadow banking sector; and regulatory capture is a permanent danger in an industry this wealthy and this technical. Regulation is itself vulnerable to government failure.

The IMF lends to countries in balance of payments crisis (with conditionality attached, which is criticised as imposing austerity) and monitors the global system. The World Bank lends for long-term development projects. Both are criticised for their governance being dominated by rich countries.

Lender of last resort

Capital requirements

Speculative bubbles

Function of money, role of a central bank, or a market failure?

Tap a card, then tap where it belongs.

Match the financial term to its meaning

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered the financial sector from the OCR A-level Economics (H460) specification. Press Finish to see your score.