Money as a medium of exchange
A medium of exchange is something accepted by everyone in return for goods and services, so that trade does not require both sides to want what the other has.
The alternative shows why it matters. Without money, exchange is barter — swapping goods directly. Barter requires a double coincidence of wants: a baker who needs shoes must find a shoemaker who happens to want bread, at the same time, and they must agree how many loaves a pair of shoes is worth. Most potential trades never happen, so specialisation from 2.1 becomes impossible, and the economy stays small.
Money solves this. The baker sells bread to anyone for money, and buys shoes from anyone with it. Trade no longer needs the two wants to match, so specialisation and exchange can develop — which is why money is described as the thing that makes a modern economy possible.
- Medium of exchange
- something accepted by everyone in return for goods and services, so that trade does not require both sides to want what the other has
- Barter
- exchange by swapping goods directly, which requires a double coincidence of wants
The financial sector
The financial sector is the part of the economy that handles money: taking deposits, lending, moving payments and covering risk. The specification names three kinds of institution.
Evaluating the importance of the financial sector, group by group, is what the specification asks for:
For consumers, it provides somewhere safe to keep money and earn interest, the means to borrow for a house or a car, insurance against disaster, and a way to pay for things without carrying cash. Against that, borrowing can be taken on too easily and leave households in debt, and a banking failure puts savings at risk.
For producers, it supplies the finance to start up, to buy machinery and to expand — investment that would otherwise wait years for a firm to save the money itself. It also insures the business and handles its payments. Against that, loans must be repaid with interest whether or not the investment succeeds, and firms can become dependent on credit.
For the government, a strong financial sector supports growth and employment, and pays substantial tax. It is also a large export earner for the UK. Against that, the sector concentrates risk: when banks fail, governments face the choice of rescuing them at enormous cost or allowing the damage to spread through the whole economy.
Interest rates
The interest rate is the cost of borrowing money and the reward for saving it, expressed as a percentage per year. It is one number doing two jobs, which is why a change in it pulls households and firms in the same direction.
When the interest rate rises:
• Saving rises — a saver earns more, so saving becomes more attractive than spending • Borrowing falls — loans and mortgages cost more, so households and firms borrow less • Investment falls — firms borrowing to buy equipment face higher costs, so fewer projects are worth doing, and saving the money becomes the safer option • Consumer spending falls — partly because borrowing is dearer, and partly because those with a mortgage have less left over each month
When the interest rate falls, all four reverse: saving becomes less rewarding, borrowing and investment become cheaper, and spending rises.
That chain is the mechanism behind monetary policy in 3.6, so it is worth being able to state it in order rather than just knowing the direction.
Worked example
Ella has £4,000 in savings paying 3% a year. She also has a £6,000 loan charged at 7% a year. Calculate her interest for the year, then find the effect if both rates rise by 2 percentage points.
- Interest earned on savings: 3% of £4,000 = £120.
- Interest paid on the loan: 7% of £6,000 = £420.
- Net position: she pays £420 and earns £120, so she is £300 worse off over the year.
- Now raise both rates by 2 percentage points: savings pay 5%, the loan charges 9%.
- Savings: 5% of £4,000 = £200. Loan: 9% of £6,000 = £540.
- New net position: £540 − £200 = £340.
Answer: At the original rates she earns £120 and pays £420, a net cost of £300. After the rise she earns £200 and pays £540, a net cost of £340 — £40 worse off. She loses despite earning more on her savings, because she owes more than she has saved, so the rise costs her more on the larger balance than it gains her on the smaller one.
Common mistake
A rise in interest rates does not make everyone better off just because savers earn more. Anyone who owes more than they have saved — most households with a mortgage — is worse off, which is why higher rates reduce spending overall.
- Interest rate
- the cost of borrowing money and the reward for saving it, expressed as a percentage per year
Before you practise
- Money is a medium of exchange, accepted by everyone in return for goods and services.
- Barter requires a double coincidence of wants, which makes most trades impossible.
- Money makes specialisation and exchange practical.
- Banks take deposits, lend and process payments; building societies specialise in mortgages and are owned by members; insurance companies spread risk.
- The financial sector channels money from savers to borrowers.
- It benefits consumers, producers and the government, but concentrates risk and encourages debt.
- The interest rate is both the cost of borrowing and the reward for saving.
- A rise raises saving and reduces borrowing, investment and spending; a fall does the reverse.
- Calculate interest as a percentage of the balance, and compare what is earned against what is paid.