Money and banking

Before money existed, people used barter to trade. Barter is the direct exchange of goods and services for other goods and services. For example, a farmer might trade a sack of potatoes for a pair of shoes from a shoemaker. This system has a major flaw: it requires a 'double coincidence of wants'. This means that not only does the farmer have to want shoes, but the shoemaker must also want potatoes at the same time and in the same place. In a large, complex economy where people specialise in producing a vast range of items, finding this double coincidence for every transaction would be almost impossible. It makes trade slow, inefficient, and limits economic growth. To solve this, societies developed money – a single, accepted item that everyone is willing to take as payment, breaking the need for a double coincidence of wants.

To be considered money, an asset must successfully perform four key functions. These functions are what distinguish money from other assets like houses or stocks.

1. Medium of Exchange: This is the most important function. Money acts as an intermediary in trade, eliminating the need for barter. People accept money as payment because they know they can use it to buy other things.
2. Store of Value: Money must hold its value over time, allowing people to save their purchasing power for the future. If money lost its value quickly, people would not want to hold it. Inflation can erode money's ability to act as a good store of value.
3. Unit of Account (Measure of Value): Money provides a common measure of value across all goods and services. It allows us to state the price of an item in a way everyone understands (e.g., £10, $20), making it easy to compare the value of different items.
4. Standard for Deferred Payment: Money is used to value future payments. This function allows for borrowing and lending. Loans are taken out and repaid in monetary terms, and contracts for future payments are specified in money.

For an item to function effectively as money, it should possess several key characteristics. The better it meets these criteria, the better it will serve as money.

• Acceptability: People must be willing to accept it in exchange for goods and services.
• Durability: It must be able to withstand being passed from person to person without wearing out quickly. A banana would be poor money; a coin is good money.
• Portability: It should be easy to carry around. Large bricks would be impractical.
• Divisibility: It must be easily divisible into smaller denominations to allow for transactions of different values. A cow is not easily divisible.
• Scarcity: It must be limited in supply. If money is too easy to find or create, it will lose its value.
• Uniformity (Homogeneity): Every unit of money must be the same as every other unit of the same denomination. A £10 note is identical to any other £10 note.

Commercial banks are businesses that provide financial services to the public (individuals and firms) with the aim of making a profit. They are the 'high street' banks we use every day. Their key role is to act as financial intermediaries, channelling funds from those who have a surplus (savers) to those who have a shortage (borrowers). Their main functions include:

• Accepting Deposits: Providing safe places for individuals and firms to store their money, such as in current accounts (for daily transactions) and savings accounts (to earn interest).
• Making Payments: Facilitating payments through services like debit cards, cheques, and bank transfers, allowing the economy to function smoothly.
• Providing Loans: Lending money to individuals and firms. This includes overdrafts (short-term borrowing on a current account), personal loans, mortgages (loans to buy property), and business loans for investment.
• Other Financial Services: Offering services like foreign currency exchange, insurance, and financial advice.

Every country has a central bank, which is a government-owned institution at the heart of the financial system. It does not provide services to the general public. Instead, it manages the country's currency, money supply, and banking system. Its functions are very different from a commercial bank. Key Functions:

1. Implements Monetary Policy: The central bank manages the economy's interest rates and money supply to achieve government objectives like low inflation and stable economic growth.
2. Banker to the Government: It manages the government's bank accounts, handles payments, and manages the national debt by issuing government bonds.
3. Banker to Commercial Banks: Commercial banks hold accounts at the central bank. The central bank acts as a 'lender of last resort', providing emergency loans to commercial banks that are in financial difficulty to prevent a collapse of the banking system.
4. Issues Notes and Coins: It is the sole authority responsible for designing and issuing the nation's legal tender (cash).
5. Manages Foreign Reserves: It holds and manages the country's official reserves of foreign currency and gold.

A stock exchange is a marketplace where shares of public limited companies (PLCs) are bought and sold. It plays two crucial roles in an economy.

Primary Market Function: This is its most important economic role. It allows companies to raise new, long-term finance by selling shares to the public for the first time in an Initial Public Offering (IPO), or by issuing more shares later on. This money, known as share capital, can be used for investment, expansion, and innovation. It is permanent capital because the company never has to repay it.

Secondary Market Function: This involves the buying and selling of existing, second-hand shares between investors. The company does not receive any money from these transactions. However, this function is vital because it provides liquidity. It gives shareholders the confidence that they can sell their shares easily if they need to, which makes them more willing to buy new shares in the primary market in the first place. The price of shares in the secondary market reflects the company's performance and future prospects.