The functions and liquidity of money

Money includes various financial instruments that perform essential roles in an economy. These instruments must meet specific criteria to be considered money, and their usefulness depends on how easily they can be used for transactions.

Key functions of money

Any financial instrument, like coins, notes, shares, or bonds, can be classified as money if it has these four main functions:

• Portable - Easy to carry and transfer between people.
• Widely accepted - Recognised and used by many as a means of payment.
• Difficult to forge - Secure against counterfeiting to maintain trust.
• Durable - Able to withstand wear and tear over time.

Liquidity

Liquidity describes how quickly and easily an asset can be converted into something spendable without losing value:

• High liquidity assets - Items like notes and coins, which can be spent immediately.
• Low liquidity (illiquid) assets - Items such as shares or property, which must first be sold or converted into cash before use, often taking time and potentially incurring costs.

Narrow and broad definitions of money

Economists categorise the money supply based on liquidity levels, distinguishing between highly liquid forms and those that are broader but less immediately usable.

Narrow money

• Narrow money focuses on the most liquid forms that can be used instantly for transactions.
• Includes notes and coins in circulation.
• Also covers balances held by banks at a central bank, which can be accessed quickly.

Broad money

• Broad money encompasses a wider range of assets, including those that are less liquid but still form part of the overall money supply.
• Incorporates everything in narrow money.
• Adds less liquid items, such as savings accounts or short-term deposits, which may require some effort to convert into spendable cash.

How banks balance profitability and liquidity

Banks operate as profit-driven businesses while ensuring they can meet customer demands for withdrawals. Striking the right balance between holding liquid assets and investing in higher-return options is crucial for their stability and success.

Profitability considerations for banks

• Banks aim to maximise profits for their shareholders by investing in assets that offer high returns.
• Illiquid assets, like corporate bonds, typically provide higher rates of return compared to more liquid options, such as central bank deposits.
• Holding too many liquid assets reduces profitability, as they generate lower income.

Liquidity needs of banks

• Banks must maintain sufficient liquid assets to allow for immediate withdrawals by depositors, who expect quick access to their funds.
• They provide long-term loans using customer deposits, relying on the fact that not all depositors will withdraw money simultaneously.
• Insufficient liquidity can lead to problems if many customers demand their money at once.

Risks of imbalance and the role of central banks

• A "run on the bank" happens when large numbers of depositors withdraw funds rapidly, often due to a loss of confidence, potentially leaving the bank unable to meet demands.
• Trust in the banking system is vital to prevent such crises.
• Central banks act as a lender of last resort, providing emergency funds to banks facing liquidity shortages to maintain stability.

The role of risk in investments

Risk is a fundamental aspect of financial decisions, influencing the potential rewards and the choices investors make. Understanding risk helps explain why returns vary across different investments.

Relationship between risk and returns

• Riskier investments generally offer higher potential returns to compensate investors for the possibility of loss.
• Safer investments, while more secure, typically yield lower interest rates or profits.

Balancing risk in financial markets

• Different money markets apply varying interest rates based on the level of risk involved.
• Investors, including banks, must weigh the security of an asset against its profitability.
• This balance is particularly critical when handling other people's money or when the investor's decisions could affect the wider financial system's stability.