Economics (9708) | Money and banking

A-Level Macroeconomics (9708): Money and Banking (9.4)

Welcome to one of the most crucial topics in macroeconomics: Money and Banking! This chapter moves beyond simple spending and saving to explore the engine room of the economy—the financial system. Understanding how money works, how it’s created, and how it influences inflation and interest rates is essential for tackling monetary policy and economic stability questions.

Don't worry if concepts like "money multiplier" or "liquidity preference" sound complicated. We will break them down using clear steps and relatable analogies!

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1. Defining Money: Functions and Characteristics (9.4.1)

Before banking, we need to know what money actually is. Money is anything generally accepted as payment for goods and services or for the settlement of debts.

1.1 The Four Functions of Money

Money performs four critical roles that make modern economies possible. (Mnemonic: M-M-S-D)

• Medium of Exchange:

Explanation: Money eliminates the need for a double coincidence of wants required in a barter system. If you want bread, you don't need to find a baker who happens to want your Economics textbook.
Key Idea: It facilitates trade and specialization.

• Measure of Value (or Unit of Account):

Explanation: Money provides a common standard for stating the price of goods and services. Everything can be measured in a single unit (e.g., dollars, pounds).
Key Idea: Allows meaningful comparison of the relative worth of different items.

• Store of Value:

Explanation: Money holds its value over time, allowing people to defer consumption. You can save money today to spend it tomorrow.
Limitation: Inflation erodes money's store of value.

• Standard of Deferred Payment:

Explanation: Money is used to specify the value of debt repayments. It allows for borrowing and lending (credit) with confidence that future payments will be accepted.
Key Idea: Essential for a functioning credit market.

1.2 Characteristics of Money

For something to function effectively as money, it needs several key characteristics:

• Acceptability: Everyone must be willing to take it as payment.
• Divisibility: Can be broken into smaller denominations (e.g., coins).
• Portability: Easy to carry around (unlike gold bars!).
• Durability: Must not perish or wear out quickly (unlike bread).
• Scarcity/Limited Supply: If everyone can easily create it, it loses its value.
• Uniformity: All units of the same denomination must look and be worth the same.

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2. Money Supply and the Quantity Theory (9.4.2, 9.4.3)

The Money Supply (M) is the total amount of money available in an economy at a specific time.

2.1 Defining Money Supply (M)

The money supply is usually measured in different ways, from narrow definitions (most liquid) to broad definitions (less liquid):

• Narrow Money (M1): Physical currency (notes and coins) in circulation plus demand deposits (current accounts) held by commercial banks. This is the most liquid form.
• Broad Money (M2, M3): M1 plus less liquid assets, such as savings accounts and time deposits (fixed deposits).

2.2 The Quantity Theory of Money (QTM) (MV = PT)

The Quantity Theory of Money, often associated with classical and monetarist economists, links the money supply directly to the price level (inflation).

The Fisher Equation of Exchange

The core concept is represented by the formula:

\[MV = PT\]

• M (Money Supply): The total amount of money in the economy.
• V (Velocity of Circulation): The average number of times a unit of money (e.g., a $1 bill) is used to buy goods and services within a given period.
• P (General Price Level): The average price of all transactions.
• T (Volume of Transactions): The total volume of transactions (or sometimes replaced by Real Output, Y).

The Classical Assumption (The QTM Conclusion)

For the QTM to hold true in the long run, classical economists make two key assumptions:

1. Velocity (V) is constant: V is determined by institutional factors (like how often people get paid or the efficiency of payment systems), which change slowly.
2. Volume of Transactions (T) is constant: T is assumed to be fixed at the full employment level of output (i.e., the LRAS is vertical).

If V and T are constant, the equation simplifies to:

\[M \propto P\]

Conclusion: Any change in the money supply (M) leads to a proportional change in the general price level (P). If the money supply doubles, the price level doubles. This means monetary policy is highly effective for controlling inflation.

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3. The Role of Commercial Banks (9.4.4)

Commercial Banks (like HSBC or Chase) are financial institutions owned by shareholders that accept deposits and make loans, aiming to maximize profit.

3.1 Functions of Commercial Banks

Commercial banks perform crucial roles for the economy:

• Providing Deposit Accounts: Offering demand deposits (current/checking accounts) and savings accounts.
• Lending Money: Providing various forms of credit, including loans, mortgages, and overdrafts. This is their primary source of profit.
• Acting as a Payments Agent: Facilitating transactions via cheques, debit cards, and electronic transfers.
• Holding Assets: Holding cash, securities, and loans.

3.2 Objectives of Commercial Banks

Banks must manage a constant conflict between three core objectives (The LSP Trilemma):

1. Liquidity: The ability to meet customers' demands for cash immediately. A bank must keep enough cash reserves (liquid assets).
2. Security: The safety of the assets held by the bank. Banks invest in low-risk securities (like government bonds) to ensure they won't lose their customers' money.
3. Profitability: Generating profit for shareholders by lending out money at a higher interest rate than they pay to depositors. (Loans are the least liquid and most profitable asset.)

The Conflict: Liquidity and Security often reduce Profitability. Holding vast amounts of cash (high liquidity) earns no interest, reducing profit. Making risky, high-interest loans (high profitability) reduces security. Banks must find the optimal balance.

3.3 Key Ratios

• Reserve Ratio: The proportion of a bank’s total deposits that must be held in reserve (either as vault cash or deposits at the Central Bank).

  \[\text{Reserve Ratio} = \frac{\text{Cash Reserves}}{\text{Total Deposits}}\]

• Capital Ratio: The ratio of a bank's capital (its own funds/equity) to its risk-weighted assets. This ensures the bank has enough buffer to absorb losses. Regulated internationally (e.g., by Basel Accords).

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4. Money Supply Creation (Credit Creation) (9.4.5)

Contrary to common belief, governments or central banks do not create most of the money supply; commercial banks do, through the process of Credit Creation.

4.1 Commercial Banks and the Bank Credit Multiplier

When a bank grants a loan, it doesn't hand over physical cash; it simply creates a deposit in the borrower's account. This new deposit is new money.

Step-by-Step Credit Creation Process

1. A customer deposits $100 (new money into the system).
2. The bank is required to keep a certain percentage, say 10% (the reserve ratio, r), as reserves ($10).
3. The bank lends out the remaining 90% ($90). This $90 becomes a deposit at another bank (or returns to the original bank).
4. The second bank keeps 10% ($9) and lends out $81.
5. This process continues until the original $100 of cash has supported a much larger total money supply in the form of deposits.

The total expansion of the money supply is determined by the Bank Credit Multiplier (k).

\[k = \frac{1}{r}\]
(Where r is the reserve ratio.)

Example: If the reserve ratio (r) is 0.10 (10%), the multiplier (k) is \(1 / 0.10 = 10\). An initial deposit of $1,000 can ultimately support $10,000 worth of total deposits (money supply).

4.2 Causes of Changes in the Money Supply (M) (9.4.5)

The money supply can change due to actions by the central bank, commercial banks, or external factors:

1. Commercial Banks’ Behaviour: If commercial banks decide to reduce their reserve ratio (lend more aggressively), the credit multiplier increases, leading to a higher money supply.
2. Role of the Central Bank: The Central Bank can influence the money supply by changing mandatory reserve requirements or performing Open Market Operations (buying/selling government debt).
3. Government Deficit Financing: If a government spends more than it taxes (running a deficit) and finances this deficit by borrowing directly from the Central Bank, this injects new money into the economy.
4. Quantitative Easing (QE): A modern tool where the Central Bank purchases financial assets (like government bonds) from commercial banks to increase bank reserves, hoping to encourage greater lending. (This directly increases the monetary base, leading to an expansion of M.)
5. Changes in the Balance of Payments (BoP): A persistent BoP surplus means foreign currency flows into the country, increasing the domestic money supply (assuming a floating or managed exchange rate system).

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5. Demand for Money and Interest Rate Theories (9.4.7, 9.4.8)

5.1 Demand for Money: Keynes’ Liquidity Preference Theory (LPT) (9.4.7)

Keynes argued that people demand (or hold) money for three main reasons, known as the Liquidity Preference:

1. Transactionary Motive: Money needed for everyday purchases (e.g., paying bills, buying groceries). This demand is related to the level of National Income (Y). Higher income means more transactions, so more money needed.
2. Precautionary Motive: Money held aside for unexpected events (e.g., sudden medical bills, car repairs). This demand is also related to National Income (Y).
3. Speculative Motive: Money held as an asset, waiting for the right moment to invest in bonds or other assets. This demand is inversely related to the Rate of Interest (r).

The Speculative Motive is crucial:

• When interest rates are high, bond prices are low. People hold less cash because the opportunity cost (the interest they forgo) is high. They prefer to buy bonds.
• When interest rates are low, bond prices are high. People expect interest rates to rise (and bond prices to fall), so they hold onto cash (liquidity) to avoid capital loss.

5.2 Interest Rate Determination (9.4.8)

5.2.1 The Loanable Funds Theory (Classical/Neoclassical)

This theory views the interest rate (r) as the price determined by the market for Loanable Funds—the actual physical amount of money available for borrowing and lending.

• Supply of Loanable Funds (S): Comes from household saving, budget surpluses, and new credit creation. It is positively related to the interest rate.
• Demand for Loanable Funds (D): Comes from firms needing investment (I) and government spending (G). It is negatively related to the interest rate.

Equilibrium: The interest rate is set where the supply of funds equals the demand for funds. The interest rate is a reward for saving (sacrificing present consumption).

5.2.2 The Keynesian Theory (Liquidity Preference)

Keynes argued that the interest rate is determined purely by the supply and demand for Money (Liquidity).

• Demand for Money (L): The total demand based on the three motives (Transactionary, Precautionary, Speculative).
• Supply of Money (M): Controlled by the Central Bank. Assumed to be vertical (fixed).

Equilibrium: The interest rate is determined where the supply of money (M) intersects the liquidity preference curve (L). The interest rate is a reward for forgoing liquidity (not hoarding cash).

Key Difference: Classical theory views interest rates as a real phenomenon (reward for saving/production), while Keynesian theory views them as a monetary phenomenon (reward for sacrificing liquidity).

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6. Policies to Reduce Inflation (9.4.6)

Since inflation is defined as a sustained rise in the price level (P), the goal of policies stemming from this chapter is often to manage the money supply (M), as suggested by the QTM.

6.1 Effectiveness of Monetary Policy in Controlling Inflation

Monetary policy, executed by the Central Bank, directly addresses the drivers of the money supply.

1. Contractionary Monetary Policy (High Interest Rates):

Mechanism: Raising the policy interest rate increases borrowing costs for commercial banks and consumers. This discourages investment (I) and consumption (C), shifting the Aggregate Demand (AD) curve left, dampening demand-pull inflation.
Effectiveness: Generally effective, provided the economy is not in a liquidity trap and consumers/firms are sensitive to interest rates.

2. Controlling the Money Supply:

Mechanism: The Central Bank can use tools like open market sales (selling government bonds) or raising the required reserve ratio. This reduces the reserves available to commercial banks, decreasing their lending capacity and thus shrinking the money supply via the credit multiplier.
Effectiveness: Directly attacks the M variable in MV=PT. If the QTM holds, this is the most effective long-term policy against inflation.

Common Mistake to Avoid:

Do not confuse the Monetary Policy tools (interest rates, QE, reserve ratios) with the underlying Theories (LPT, Loanable Funds). The theories help explain *why* the tools have the effects they do on the interest rate and the economy.