Revise Money and banking for Cambridge 2281 (3.1)

For an economy to operate beyond a basic barter system, it requires a reliable form of money. Money serves four crucial functions. Firstly, it is a medium of exchange, universally accepted for goods and services, thus eliminating the need for a 'double coincidence of wants'. Secondly, it acts as a measure of value (or unit of account), providing a common denominator to price diverse items and understand their relative worth. Thirdly, money must be a store of value, allowing purchasing power to be held over time, although its effectiveness can be eroded by inflation. Finally, it serves as a standard for deferred payment, enabling contracts for future payments and facilitating borrowing and lending. To perform these functions effectively, 'good' money should possess characteristics such as durability, portability, divisibility, and scarcity.

Commercial banks are private sector financial institutions whose primary objective is to maximise profit. They perform several key functions, the most important of which is acting as financial intermediaries. They achieve this by accepting deposits from individuals and firms (savers) and providing loans to other individuals and firms (borrowers). The bank's profit is generated from the 'interest rate spread' – the difference between the interest rate they charge on loans and the interest rate they pay on deposits. Beyond this core function, commercial banks provide essential payment services, such as processing cheques, direct debits, and electronic transfers, which are vital for the smooth functioning of a modern economy. They also offer services like foreign exchange and safe deposit boxes.

Credit creation is the process through which commercial banks expand the money supply by making new loans. This process is foundational to understanding how the money supply can be larger than the amount of physical cash in an economy. It begins when a commercial bank receives a new deposit. The bank is required to hold a fraction of this deposit as liquid assets, known as the liquidity ratio (or reserve ratio). The remaining portion, the 'excess reserves', can be lent out. When this loan is made, it creates a new deposit in the borrower's account, which can then be used for spending. This spent money is deposited in another bank, which in turn holds a fraction and lends out the rest. This chain reaction multiplies the initial deposit, creating a total expansion of the money supply determined by the money multiplier (1 / liquidity ratio).

The central bank is the apex financial institution in an economy, responsible for maintaining monetary and financial stability. It has several unique and critical functions. It is the sole issuer of a country's notes and coins, ensuring a uniform and trusted currency. It acts as the government's banker, managing government accounts, issuing debt (bonds), and providing financial advice. Crucially, it is the 'bankers' bank', holding deposits for commercial banks and operating the clearing system between them. This role extends to being the lender of last resort, providing emergency liquidity to solvent but illiquid banks to prevent bank runs and systemic collapse. Finally, it manages the country's official gold and foreign currency reserves, which are used to manage the external value of the currency and settle international debts.

A primary responsibility of the central bank is the implementation of monetary policy to achieve macroeconomic objectives, most commonly an inflation target. The main tool is the policy interest rate (e.g., the Bank of England's 'Bank Rate'). By changing this rate, the central bank influences the interest rates set by commercial banks for saving and borrowing. A lower policy rate, for example, tends to reduce borrowing costs, encouraging consumption and investment, thereby boosting aggregate demand. Conversely, a higher rate aims to curb inflationary pressures. In recent times, central banks have also employed unconventional tools like Quantitative Easing (QE), where the central bank purchases financial assets (like government bonds) to inject money directly into the financial system, aiming to lower long-term interest rates and stimulate economic activity.