Functions of Money and the Role of Commercial Banks

Money is something we use every day, yet few people stop to think about what money really is, why it works the way it does, or how the banking system that surrounds it actually functions. Before money was invented, people exchanged goods directly through a system called barter. As societies grew more complex, barter became increasingly impractical, leading to the development of money and, eventually, sophisticated systems of banking that support modern economies.

The Problem with Barter

Barter is the direct exchange of goods and services for other goods and services, without the use of money. While barter can work in very simple economies, it suffers from a major weakness known as the lack of double coincidence of wants. This means that for a barter trade to take place, each person must want exactly what the other person is offering, at the same time and place. For example, a farmer with yams who wants cloth must find a tailor who happens to want yams at that exact moment. This made trade slow, difficult, and inefficient, which is why societies eventually developed money as a solution.

What Is Money?

Money can be defined as anything that is generally accepted as a medium of exchange for goods and services, and as a measure and store of value. For something to function well as money, it should have certain qualities: it should be portable, divisible, durable, scarce enough to hold value, and generally acceptable to the people using it.

The Functions of Money

Money performs several essential functions in an economy.

• Medium of exchange: Money allows goods and services to be bought and sold without the need for a direct exchange of goods, solving the problem of double coincidence of wants.
• Unit of account: Money provides a common measure of value, allowing the prices of different goods and services to be compared easily.
• Store of value: Money can be saved and used at a later time, allowing people to hold their wealth in a convenient form.
• Standard of deferred payment: Money allows debts to be expressed and settled in agreed amounts over time, such as loan repayments.

Types of Money

Money has taken different forms throughout history and today.

• Commodity money has intrinsic value of its own, such as gold or salt, which were once used as money because they were valuable in themselves.
• Fiat money has no intrinsic value but is declared legal tender by government authority, such as the Naira notes and coins used in Nigeria today.
• Token money refers to money whose face value is greater than the value of the material it is made from, such as coins.
• Bank money refers to money held in bank accounts that can be transferred through cheques, cards, or electronic transfers.

The Role of Commercial Banks

Commercial banks are financial institutions that accept deposits from the public and provide loans and other financial services. They play a central role in the smooth functioning of a modern economy.

• Accepting deposits: Commercial banks provide savings and current accounts where individuals and businesses can keep their money safely.
• Granting loans and overdrafts: Banks lend money to individuals and businesses, charging interest, which allows borrowers to finance purchases, education, or business expansion.
• Agency services: Banks act on behalf of customers to collect and make payments, such as paying bills or transferring funds.
• Credit creation: Through the process of lending out a portion of deposits, commercial banks help expand the overall money supply in the economy.

Types of Bank Accounts

Commercial banks offer different types of accounts to suit different needs.

• Current accounts allow frequent withdrawals, usually by cheque or card, and are commonly used by businesses, though they typically earn little or no interest.
• Savings accounts are designed to encourage saving and usually earn interest, though they may have some restrictions on the number of withdrawals allowed.
• Fixed deposit accounts require money to be kept in the bank for a set period in exchange for a higher rate of interest.

The Central Bank

Every country typically has a central bank, which in Nigeria is the Central Bank of Nigeria (CBN). The central bank differs from commercial banks in that it does not deal directly with the public but instead regulates and oversees the entire banking system.

• It has the sole authority to issue the country's currency (notes and coins).
• It acts as banker to the government and to commercial banks.
• It controls the money supply and interest rates through monetary policy.
• It regulates and supervises commercial banks to ensure the stability of the financial system.

Electronic and Modern Banking

Modern banking has been transformed by technology. Automated Teller Machines (ATMs) allow customers to withdraw cash and perform other transactions without visiting a banking hall. Mobile banking and internet banking allow people to transfer money, pay bills, and check balances from their phones or computers. These innovations have made banking services faster, more convenient, and more accessible to a larger number of people, including those in remote areas.

Interest Rates and the Cost of Borrowing

Interest is the price paid for the use of borrowed money, and it plays a central role in how banks and the wider economy function. When a bank lends money to a customer, it charges interest as compensation for the risk it takes and the opportunity cost of not using that money elsewhere. Similarly, when a customer deposits money into a savings account, the bank pays interest to the depositor as a reward for allowing the bank to use their funds. The Central Bank of Nigeria influences the general level of interest rates in the economy through its Monetary Policy Rate, which affects how much commercial banks charge their own customers for loans.

Inflation and the Value of Money

Inflation refers to a persistent rise in the general price level of goods and services over time, which reduces the purchasing power of money. When inflation is high, the same amount of money buys fewer goods than it did before, which can make it harder for households to afford basic necessities. Central banks often use monetary policy tools, such as adjusting interest rates and controlling the money supply, to try to keep inflation at a stable and manageable level, protecting the value of the currency for everyone who uses it.

Key Terms to Remember

• Barter: The direct exchange of goods and services without the use of money.
• Medium of exchange: A function of money that allows it to be used to buy and sell goods and services.
• Fiat money: Money that has no intrinsic value but is backed by government authority.
• Commercial bank: A financial institution that accepts deposits and provides loans to the public.
• Central bank: The apex financial institution responsible for issuing currency and regulating the banking system.
• Credit creation: The process by which banks expand the money supply through lending.

Summary

Money developed as a solution to the inefficiencies of barter trade, providing a convenient medium of exchange, unit of account, store of value, and standard of deferred payment. Money has taken various forms over time, from commodity money with intrinsic value to modern fiat money backed by government authority. Commercial banks play a vital role in the economy by accepting deposits, granting loans, providing agency services, and creating credit, while the central bank regulates the overall banking system and controls the money supply. Together, money and the banking system form the backbone of economic activity, enabling trade, savings, investment, and growth in modern societies.