5.1 - Money, liquidity and interest rates

What makes something money

Money is an asset widely accepted in payment for goods, services and debts.

Its medium of exchange function removes the need for a double coincidence of wants: a teacher need not find a baker who wants a lesson before buying bread. Its unit of account function expresses different prices in a common measure, making costs and contracts comparable. As a store of value, money transfers purchasing power into the future, although inflation erodes that power. As a standard of deferred payment, it states a debt to be settled later. A £500 loan specifies a nominal repayment obligation; it does not guarantee the purchasing power of £500 will stay constant.

Useful money is recognisable and generally acceptable, portable, durable, divisible into small amounts, and reasonably uniform. Its supply must be controlled sufficiently to support trust in its value. These characteristics explain why perishable fruit is inconvenient money and why a widely accepted electronic deposit can perform the functions without being a physical object. Fiat money derives its acceptance from trust, institutions and its use in payments; it does not require conversion into gold.

Money and wealth are different. A house is wealth but cannot normally settle a small grocery purchase immediately. A loan creates money available to spend and an obligation to repay: the borrower has not received an equal increase in net wealth merely because their account balance rises.

Liquidity and money measures

Liquidity is the ease and speed with which an asset can be used for payment, or converted into a means of payment with little loss of value.

Cash is immediately spendable. An accessible current-account deposit is also highly liquid because payments can be made directly from it. A notice account may require waiting or paying a withdrawal penalty. Property may take months to sell and its sale price is uncertain. Liquidity is therefore a spectrum, rather than a synonym for profitability or safety.

Narrow money captures the most liquid means of payment; a common teaching definition includes cash held by the public and readily transferable demand deposits. Broad money also includes less immediately spendable deposits and related monetary liabilities. Exact statistical definitions differ between economies and measures. Central-bank reserves are balances used by eligible institutions at the central bank; a household cannot spend a reserve account in a shop. Adding reserves to household deposits without checking the chosen definition can double-count or combine different aggregates.

In an illustrative economy, the public holds £20 billion in cash, £80 billion in transferable deposits and £100 billion in qualifying notice deposits. Under the definitions given here, narrow money is £100 billion and broad money is £200 billion. Narrow money is $100/200=0.5$, or 50% of broad money. Moving £10 billion from a current account into a qualifying notice account lowers narrow money to £90 billion but leaves broad money at £200 billion. A changed aggregate can reflect a change in liquidity classification, rather than newly created money.

The purpose of measuring money is to understand payment capacity and financial conditions. No aggregate alone tells us how rapidly its holders will spend it.

How banks create deposits

A commercial bank usually creates a matching deposit when it grants a new loan, rather than handing the borrower a fixed stock of another customer's deposits.

For an illustrative £10,000 loan, the bank records a £10,000 loan asset and a £10,000 deposit liability. The borrower records an available deposit and an equal debt. If the borrower pays a supplier at another bank, the deposit moves and the lending bank must settle with the receiving bank, normally using reserves. Repaying the loan principal reduces the loan asset and the corresponding money deposit; it destroys that bank-created money. The deposit-creation mechanism is explained in the Bank of England's money-creation article.

This does not make lending unlimited. A bank needs sufficiently profitable lending opportunities and creditworthy borrowers. It must manage repayment losses, obtain funding and settlement liquidity, and comply with capital and liquidity rules. A customer can spend newly created deposits outside the bank, creating a need for payments resources. Interest rates, confidence and regulation affect these constraints. The Bank of England's explainer distinguishes deposits from cash and reserves.

The central bank creates base money, including reserves, through its balance-sheet operations. Asset purchases can raise reserves and, when a non-bank seller receives a deposit, broad money. The resulting reserves do not force commercial banks to lend. A textbook deposit multiplier assumes fixed reserve holdings, willing borrowers, repeated lending and no cash leakage; it is a conditional model, not a mechanical description of modern UK lending.

Savings still matter for financing and real investment. Creating a deposit does not create skilled workers, steel or an extra machine. Financial claims organise access to resources; the quantity and productive use of those resources determine real output.

Money, spending and prices

The Fisher equation of exchange connects the money stock with nominal expenditure, but explaining inflation requires additional assumptions.