Money in the modern economy: an introduction – Quarterly Bulletin article

Amar, we’re here in the Bank of England’s
gold vaults to talk about money, and for some periods historically, money could be converted
at the Bank into gold. Now, your article is about money in the modern economy. Could you
start by saying a few words on why it is that we have and use money in our everyday lives? People have and use money because they want
various things. Money allows us to acquire the goods and services that we want when we
want them. Without money, this would be difficult. People would typically only be able to consume
what they produce. So let’s take a very simple example of a farmer
who would only be able to consume the produce that he grows on his land. Without money,
he would only be able to consume other goods, such as fish, if he were able to find a fisherman
willing to exchange some fish for some of his produce, say, some berries.
In practice, people produce and want to consume different things at different times. So the
fisherman may not have any catch until autumn but might want berries during the summer when
they are in season. One solution to this problem is for the fisherman to give the farmer an
IOU in exchange for some berries and when autumn comes, the fisherman would then be
able to fulfill his IOU by giving the farmer some fish. I see. So the IOU then, which is simply a
promise to repay someone something at a later point in time for something they’ve received
today, emerges as a means of exchanging goods or services. But what then is the link between
the IOU in that example and money? Well, money is just a special form of IOU.
You can imagine where there’s lots of people interacting, trading lots of different goods
and services. If everyone was just issuing their own IOUs, things would get very complicated
very quickly. And crucially, for that system to work, everybody would have to trust one
another. So even though I may trust you, if you give me an IOU and your ability to fulfil
the IOU depends on an IOU that you have from somebody else, I would then have to trust
that person in order for me to think that your IOU was worth anything. So if we consider money today, in what sense
is a £20 note, say, an IOU? In the case of banknotes, the Bank of England,
the central bank, is a monopoly supplier of banknotes in England and Wales. In addition,
some commercial banks in Scotland and Northern Ireland are also authorized to issue banknotes.
So the £20 note that you’re talking about is an IOU from the central bank to you. That’s
where the famous “promise to pay” inscription comes from. What exactly does that mean, though? Does
that mean that the Bank of England could give me £20’s worth of gold in exchange for a
£20 note? Not anymore, no. While that was true in the
past, the monetary system today is very different. While it is still true that the £20 note
represents an IOU from the Bank to the holder of that note, banknotes today are what’s known
as “fiat”, or paper money. A £20 note is worth £20 precisely because everybody believes
that it will be accepted as a means of payment both today and in the future. And for everyone
to believe that, it is important that the money maintains its value over time and is
difficult to counterfeit. It’s the central bank’s job to ensure that that is the case. Now, you mentioned money held in bank accounts
as the other main type of money. That’s right. In fact, banknotes and coins
make up just 3 percent of the money held by individuals and companies in the British economy
today. The remainder, and that’s the vast majority, is held in people’s bank accounts. So how is the money in my current account
different from the cash in my wallet, for example? As we discussed, money is an IOU. So the cash
in your wallet is an IOU from the Bank of England to you, and the money in your bank
account is an IOU from your bank to you. For example, if you have £200 in your current
account, that means that your bank owes you £200, and that money functions just the same
way that the currency in your wallet does. In fact, today, most people get paid directly
into their bank accounts and frequently use that money to pay for goods and services,
for example, when you use your debit card at the supermarket. For bank deposits to be
trusted as money, they have to be convertible with currency. So just as you can pay money
into your account at your local branch, you can withdraw cash from an ATM machine. So making sure that customers can exchange
money in their current accounts for currency is one of the key services then that banks
provide. Exactly, and it’s worth noting here that even
in the unlikely event of a bank failure, households deposits up to £85,000 are protected by the
Financial Services Compensation Scheme.

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