Money, commercial banks and the central bank

Last time

Before we start: last time, in Division of labour, labour mobility and productivity, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Why we use money

Imagine a farmer with wheat who wants a pair of shoes. Without money, he must find a shoemaker who wants wheat, at the same time. That is barter. Money solves the problem, because everyone accepts it. In this lesson: what money does, what makes it work, and the banks that look after it.

The problem with barter

Barter needs a double coincidence of wants: each person must want exactly what the other has, at the same time. It is also hard to value goods. How many shoes is a sack of wheat worth? And some goods cannot be divided, like a cow. Money removes all of these problems, so trade, specialisation and saving become much easier.

The four functions of money

A medium of exchange: it is accepted in payment for goods and services, so barter is not needed. A measure of value, or unit of account: every product can be priced in the same unit, so values are easy to compare. A store of value: it can be saved and spent later. And a standard of deferred payment: debts can be paid back later in money.

The characteristics of money

Generally acceptable: people must trust it and agree to take it. Durable: it must not wear out quickly. Portable: easy to carry. Divisible: it can be split into small amounts, such as coins for small purchases. Homogeneous: each note of the same value is the same. Limited in supply and hard to forge, so it keeps its value.

Functions with examples

Do not confuse functions with characteristics. A function is a job money does; here each one has an example.

Forms of money today

Notes and coins are only a small part of money today. Most money is held as deposits in bank accounts. People pay with debit cards, bank transfers and mobile wallets, which move bank deposits from one account to another. These still do all four functions, and they are more portable and safer than cash.

Commercial banks

A commercial bank is a bank that serves households and firms, and aims to make a profit. Most are in the private sector. It accepts deposits and keeps them safe, often paying interest. It lends, through loans and overdrafts, and charges interest. It also makes payments, exchanges foreign currency and gives financial advice. It profits from charging more interest on loans than it pays on deposits.

The central bank

A central bank is the bank at the centre of a country's banking system. In Pakistan it is the State Bank of Pakistan. It issues notes and coins, is the government's bank, and is the bankers' bank, holding commercial banks' accounts. It is the lender of last resort to banks in trouble, manages the foreign currency reserves, sets interest rates and regulates commercial banks.

Central and commercial banks

The examiner found many answers just listed what a central bank does and added 'a commercial bank does not'. Compare them on the same points instead.

Why banks matter to households

Households can save safely and earn interest, instead of keeping cash at home. They can borrow to buy a house, a car or pay for education, and repay over time. And they can pay bills and receive wages quickly, without carrying cash.

Explaining a function

Questions often ask you to explain two functions of a central bank, for four marks. Each function needs a name and an explanation. For example: it is the lender of last resort, one mark, so it lends to commercial banks that are short of money, to stop them failing, one mark. Or: it sets the interest rate, one mark, to control inflation by changing borrowing and spending, one mark.

Mistakes that lose marks

Mistake one: giving a characteristic, such as durable, when the question asks for a function. Mistake two: saying a central bank takes deposits from the public. It deals with the government and the banks. Mistake three: comparing the banks with 'a commercial bank does not do this'. Give what each one does. The fix: compare both banks on ownership, aim and customers.

The full-marks tip

The full-marks tip: learn the four functions as a list, and the characteristics as a separate list. When comparing the banks, give a point for each bank, side by side.

On one card

So, on one card: money and banking. Keep it for revision.