Question

5. “Money is usually earned through hard work of employees. The employer also needs to get money from somewhere and this brings us the picture of banks and the financial markets.” a) Discuss three functions of money. b) Discuss how banks create money in the economy.

Answer 1

a.  Money serves as a medium of exchange, as a store of value, and as a unit of account.

An exchange medium. Money's most important function is to facilitate transactions as a means of exchange. Both transactions would have to be carried out by barter without cash, which implies direct exchange of one good or service for another. The problem with a barter system is that in order to obtain a specific good or service from a manufacturer, a good or service of equal value must be available

Store of value. Money has to hold its value over time to be a medium of exchange; that is, it has to be a store of value. When money could not be held for a certain period of time and remains valuable in commerce, the double coincidence of want question would not be solved and therefore not accepted as a means of exchange. Money is not unique as a store of value; there are many other value stores, such as land, art works, and even baseball cards and stamps. Money may not even be the best value store because inflation depreciates it.

Unit of Account. Money also acts as an account unit, offering a specific indicator of the price of the traded goods and services. In terms of money, knowing the cost or price of a good helps both the manufacturer and the consumer of the good to make decisions about how much of the good to deliver and how much of the good to purchase.

b. Banks create most of the liquidity in our economy in the form of bank deposits–the numbers appearing in your account. As banks make loans, they create new money. In today's economy, 97% of the money resides as bank deposits, whereas only 3% is physical currency. The money that banks make is not the paper money with the symbol of the Bank of England, which is owned by the government. If you check your balance at an ATM, it's the digital deposit money that pops up on the screen. Right now, more than 97 percent of all the money in the economy is made up of this money (bank deposits). Only 3 percent of the money you can touch is still in that old-fashioned form of cash. Banks can create money when they make loans through the accounting they use. When you check your account balance, the numbers you see are just accounting entries in the computers of the banks. Those amounts are your bank's' liability' and IOU. But you can spend these IOUs using your debit card or internet banking as if they were the same as £ 10 notes. Banks can effectively create a cash replacement by making these digital IOUs.