Money and central banks
Money makes trade easy, and central banks manage it. Understanding what money is comes before understanding monetary policy.
What money does
Money has three functions: a medium of exchange (accepted in payment, avoiding the 'double coincidence of wants' that barter requires), a unit of account (a common measure of value), and a store of value (holding purchasing power over time). Anything that performs these roles well can serve as money.
Forms of money
Commodity money has value in itself, like gold coins. Fiat money, used today, has value because the government declares it legal tender and people trust it. Most money is not cash but bank deposits, held as digital records.
Measuring money
M1 is the narrowest common measure: currency plus deposits that can be spent directly, such as checking accounts. M2 adds savings deposits, small time deposits, and money market funds. Broad money measures include even more. Definitions differ slightly between countries.
What central banks do
A central bank manages a country's money and banking system. The US Federal Reserve (founded 1913), the European Central Bank (1998), the Bank of England (1694), and the Bank of Japan are major examples. They set monetary policy, supervise banks, act as lender of last resort in crises, and run payment systems.
Mandates and independence
The Federal Reserve has a dual mandate: maximum employment and stable prices. The ECB's primary mandate is price stability. Most central banks are operationally independent from day-to-day politics, because evidence suggests independent central banks deliver lower inflation; politicians may otherwise be tempted to stimulate before elections.
The policy interest rate
The main tool of monetary policy is a short-term policy interest rate, such as the federal funds rate in the US or the Bank Rate in the UK. Changes in this rate ripple through to the interest rates banks charge on loans and mortgages and pay on savings.
How central banks set rates
Central banks steer their policy rate by setting the interest rate they pay on banks' reserves held with them and through lending facilities and market operations. Since the 2008 crisis, with abundant reserves in the system, paying interest on reserves has become the key tool for the Fed and others.
Worked example
A family wants to trade apples for shoes, but the shoemaker wants bread, not apples. Without money, they must find a chain of trades. With money, the family sells apples for cash and buys shoes; the shoemaker uses the cash to buy bread. Money as a medium of exchange removes the need for a double coincidence of wants.
Key takeaways
Money is a medium of exchange, unit of account, and store of value. Modern money is fiat money, mostly bank deposits. M1 and M2 measure money. Central banks set monetary policy, supervise banks, and act as lenders of last resort. The Fed has a dual mandate. Independence helps keep inflation low. The policy interest rate, steered through interest on reserves, is the main tool.
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Which function of money is shown when a shop labels a shirt at 30 dollars?