Money is so familiar that it is easy to forget how strange it is: paper, metal or numbers in a computer that people accept in exchange for real goods and work. Understanding what money does, and how banks and central banks manage it, explains much of economic life.

What money does

Economists define money by its three functions:

• Medium of exchange: it is accepted in payment for goods and services. Without money, people would have to barter, which requires a double coincidence of wants: each side must want what the other offers, so a baker who wants shoes must find a shoemaker who wants bread.
• Unit of account: it provides a common measure of value, so prices can be compared.
• Store of value: it holds value over time, so you can earn today and spend later.

Most money today is fiat money: it has value not because it is backed by gold but because governments declare it legal tender and people trust that others will accept it.

Banks

Banks take deposits and make loans. They keep only a fraction of deposits as reserves and lend out much of the rest, a system called fractional reserve banking. When a bank makes a loan, it credits the borrower's account, creating a new deposit. In this way, most money in modern economies is created by commercial banks when they make loans.

This system channels savings into investment, but it carries risk. If many depositors want their money at once, more than the bank has on hand, the result is a bank run. Waves of bank failures helped turn the downturn after 1929 into the Great Depression. Deposit insurance, created in the United States in 1933, and emergency lending by central banks aim to prevent runs.

Inflation

Inflation is a general rise in prices across the economy, so each unit of money buys less. It is usually measured by a price index, such as the consumer price index, which tracks the cost of a typical basket of goods. Causes discussed by economists include:

• Demand-pull: spending grows faster than the economy can produce.
• Cost-push: costs such as energy rise and are passed on in prices.
• Money growth: as Milton Friedman stressed, when the money supply grows much faster than output for a long time, prices rise.

Moderate, predictable inflation does limited harm. High inflation erodes savings, hurts people on fixed incomes and makes planning hard. Hyperinflation, as in Germany in 1923 or Zimbabwe in the late 2000s, can destroy a currency. Falling prices, called deflation, can also hurt: people delay purchases and debts become heavier.

Central banks and interest rates

A central bank, such as the Bank of England (founded 1694) or the US Federal Reserve (created 1913), manages a country's money and banking system. Its main tool is setting a key short-term interest rate, which influences the rates banks charge each other and their customers.

• Raising interest rates makes borrowing more expensive, which slows spending and tends to reduce inflation, at the risk of higher unemployment.
• Lowering interest rates encourages borrowing and spending, which can support jobs in a slump, at the risk of higher inflation.

Many central banks aim for low, stable inflation, often around 2 percent a year. Most are given some independence from elected politicians, on the reasoning that politicians facing elections might keep rates too low. Critics argue that such powerful bodies should be more directly accountable.

Worked example: how a rate rise travels

Suppose inflation has been running at 6 percent a year, well above the central bank's 2 percent target, and the bank raises its key interest rate from 2 percent to 4 percent. How does a decision made in one meeting reach the price of groceries?

1. Borrowing costs rise. Banks raise rates on mortgages, car loans, credit cards and business loans.
2. Spending slows. Some families delay buying a home or car. Firms postpone new equipment because borrowing for it now costs more. Saving becomes a little more attractive.
3. Demand cools. With less spending, shops sell less and firms feel less able to raise prices. Some hire fewer workers.
4. Inflation eases. Over time, slower demand means prices rise more slowly. Expectations matter too: if people believe the central bank is serious, workers and firms build lower inflation into wage deals and prices.

Three complications are worth noticing.

• Lags. The full effect can take a year or more, so central banks must act on forecasts, and may overshoot.
• Trade-offs. Cooling demand can raise unemployment. Those who lose jobs bear much of the cost of lower inflation, which is why the decision involves values as well as technical judgment.
• The cause matters. If inflation comes from a supply shock, such as a jump in energy prices, higher rates cannot produce more oil. They lower inflation by reducing demand elsewhere, which some economists see as a painful remedy.

Who wins and who loses? Savers earn more interest; borrowers with variable-rate loans pay more. Knowing these channels helps you follow, and judge, news about central bank decisions.