Money has four functions: a medium of exchange or means of payment, a store of value, a
unit of account and a standard of deferred payment. Its use as a medium of exchange
distinguishes money from other assets.
In a barter economy, trading is costly because there must be a double coincidence of
wants. Using a medium of exchange reduces the costs of matching buyers and sellers,
letting society devote scarce resources to other things. A token money has a higher value
as a medium of exchange than in any other use. Because its monetary value greatly
exceeds its production cost, token money economizes a lot on the resources needed for
transacting.
Token money is accepted either because people believe it can subsequently be used to
make payments or because the government makes it legal tender. The government controls
the supply of token money.
Banks create money by making loans and creating deposits that are not fully backed by
cash reserves. These deposits add to the medium of exchange. Deciding how many
reserves to hold involves a trade-off between interest earnings and the danger of insolvency.
Modern banks attract deposits by acting as financial intermediaries. A national system of
clearing cheques, a convenient form of payment, attracts funds into sight deposits. Interestbearing
time deposits attract further funds. In turn, banks lend out money as short-term
liquid loans, as longer-term less liquid advances, or by purchasing securities.
Sophisticated financial markets for short-term liquid lending allow modern banks to operate
with very low cash reserves relative to deposits. The money supply is currency in circulation
plus deposits. Most is the latter.
The monetary base M0 is currency in circulation plus banks’ cash reserves. The money
multiplier, the ratio of the money supply to the monetary base, is big. The money multiplier is
larger (a) the smaller the desired cash ratio of the banks and (b) the smaller the private
sector’s desired ratio of cash in circulation to deposits.
Financial deregulation has allowed building societies into the banking business. M4 is a
broad measure of money and includes deposits at both banks and building societies.
The demand for money is a demand for real money, for its subsequent purchasing power
over goods. The demand for narrow money balances the transactions and precautionary
benefits of holding another pound with the interest sacrificed by not holding interest-bearing
assets instead. The quantity of real money demanded falls as the interest rate rises. Higher
real income raises real money demand at each interest rate.
For wide money such as M4, the asset motive for holding money also matters. When other
interest-bearing assets are risky, people diversify by holding some safe money. With no
immediate need to transact, this leads to an asset demand for holding interest-bearing bank
deposits. This demand is larger the larger the total wealth to be invested and the lower the
interest differential between deposits and risky assets.
