Explain money
Use the functions and characteristics of money, distinguish liquidity from money itself and compare narrow with broad measures.
Money and Banking
This chapter explains why money matters, how the money stock is defined and created, how banks balance liquidity, security and profit, and how money demand helps determine interest rates.
Functions of moneyMoney supplyMV = PYCommercial banksCredit multiplierCentral bankLiquidity preferenceInterest rates
What this chapter prepares you to do
Analyse money supply
Use the quantity theory, credit multiplier, deficit financing, quantitative easing and exchange-rate intervention.
Explain banking
Distinguish retail, wholesale and central banking, and evaluate the trade-off between liquidity, security and profitability.
Determine interest rates
Use liquidity preference and the loanable-funds model to explain how money demand, money supply, saving and investment interact.
High-grade habit: keep the models separate. MV = PY links money to nominal income under stated assumptions; liquidity preference explains money-market interest rates; loanable funds explains the interest rate through saving and investment.
Chapter sections
27.1
Money in the modern economy
The four functions of money
Money removes the inefficiency of barter, where exchange requires a double coincidence of wants. For a monetary economy to work, people must trust that money received today can be used again later.
Why barter is inefficient
The textbook's simple example is an exchange involving an apple, a banana and an ice cream. Barter works only if each person simultaneously has what the other wants — a double coincidence of wants. Money removes this requirement by providing a generally accepted medium of exchange.
Medium of exchange
Money is accepted in payment for goods and services, allowing transactions without barter.
Store of value
Purchasing power can be carried from the present into the future, provided money retains reasonable value.
Unit of account
Prices expressed in money allow the values of goods, services and assets to be compared.
Standard of deferred payment
Contracts involving future payment — wages, loans or later delivery — can be stated in money terms.
Characteristics of successful money
Practical
Portable enough to carry and divisible into useful denominations.
Trusted
Acceptable to economic agents and scarce enough that unlimited creation or counterfeiting does not destroy confidence.
Reliable
Durable in use and reasonably stable in value, especially if it is to work as a store of value or deferred-payment standard.
Money supply and liquidity
Money supply is the quantity of money in circulation in the economy. Modern money is wider than notes and coins because bank deposits and other highly liquid financial assets can perform many of the same functions.
Liquidity
The ease with which an asset can be converted quickly for transactions without the holder incurring a significant cost.
Near-money
Financial assets that are not cash but can be converted into spendable money relatively easily.
Cash / notes
→Current deposits
→Savings deposits
→Bonds / shares
generally decreasing liquidity →
Narrow and broad money
Narrow money
The textbook describes the traditional UK measure M0 as notes and coins in circulation together with commercial banks' deposits at the central bank. It was intended to capture money held mainly for transactions.
Broad money
M4 includes narrow money plus sterling wholesale and retail deposits with monetary financial institutions. It therefore captures a much wider set of highly liquid balances, some held as wealth as well as for transactions.
Measurement problem: modern finance creates a continuum from money to near-money. Electronic payments and financial innovation make it harder for a central bank to define, measure and directly control one precise money stock.
The quantity theory of money
The starting point is the Fisher equation of exchange:
MV = PY
M = money supply · V = velocity of circulation · P = average price level · Y = real output
M = money supply · V = velocity of circulation · P = average price level · Y = real output
Velocity of circulation is the rate at which money changes hands. Since nominal income is P × Y, velocity can be written as V = PY ÷ M.
Worked example from the textbook
If nominal income is $3,600 million and the money supply is $720 million, then V = PY ÷ M = 3,600 ÷ 720 = 5. Each unit of money changes hands, on average, five times over the period.
From an identity to a theory
MV = PY is an accounting identity. Classical quantity theory becomes a theory only after assumptions are added — especially that V is stable and real output tends towards its full-employment/natural level. Under those assumptions, persistent excessive money growth mainly raises the price level rather than long-run real output.
A monetary expansion
An increase in money supply raises spending and shifts aggregate demand from AD0 to AD1. In the classical long run, output remains at YFE, so the main effect is a higher price level from P0 to P1.
Adapted from the Cambridge International AS & A Level Economics book by Peter Smith (Second Edition, with Adam Wilby and Mila Zasheva).
Nominal and real interest rates
The nominal interest rate is the stated rate. The real interest rate adjusts for inflation and can be approximated as:
real interest rate ≈ nominal interest rate − inflation rate
Textbook example
If the nominal interest rate is 5% and inflation is 2%, the approximate real interest rate is 3%. Inflation reduces the purchasing-power return received by the saver.
27.2
The commercial banks
Commercial banks are financial intermediaries: they channel funds from lenders or depositors towards borrowers. Deregulation and financial innovation have blurred older distinctions between different banking institutions.
Retail banks
Provide banking services to households and smaller firms, accept deposits, make loans and provide transaction services.
Wholesale banks
Operate on a larger scale with companies, other banks and financial markets. Investment banks are an example.
Universal banks
Operate across both retail and wholesale activities rather than remaining in only one traditional segment.
Secured versus unsecured lending
A mortgage is secured on property, giving the lender collateral if the borrower defaults. An overdraft or credit-card balance is normally unsecured and therefore carries greater risk. The textbook uses this difference to explain why unsecured borrowing usually attracts a higher interest rate.
Liquidity management
Banks profit from lending, but they cannot lend every deposited unit because customers may want to withdraw funds. They therefore balance earning returns against holding liquid assets.
Liquidity ratio = liquid assets ÷ total assets
Reserve (cash) ratio = cash holdings ÷ total assets
Reserve (cash) ratio = cash holdings ÷ total assets
Short-run liquidity can be managed through interbank lending. A bank can also use a repo: selling a financial asset with an agreement to repurchase it later, which operates like secured short-term borrowing.
Forms of borrowing and interest-rate differences
| Form | Typical feature | Why the rate may differ |
|---|---|---|
| Mortgage | Long-term loan secured on property | Collateral reduces default risk relative to unsecured lending. |
| Unsecured personal / short-term loan | No specific collateral | Higher risk normally means a higher interest rate or risk premium. |
| Overdraft | Customer can spend beyond current deposits up to an agreed limit | Flexible short-term credit usually carries a noticeable borrowing cost. |
| Credit card | Convenient revolving credit | Unsecured balances can carry high rates because of default risk and convenience. |
The bank's three objectives
Liquidity
Hold enough liquid reserves to meet withdrawals. Failure can trigger loss of confidence and a bank run.
Security
Assess borrowers carefully, use collateral where appropriate and maintain sufficient capital against risky assets.
Profitability
Earn a margin by charging borrowers more than is paid to depositors, while controlling costs and risk.
The capital adequacy ratio relates a bank's capital to its risk-weighted assets and is intended to give a buffer against losses and loan defaults.
Evaluation: profitability, liquidity and security can conflict. Aggressive lending may raise expected profit but can weaken liquidity or increase default exposure; excessive caution may make a bank safer but reduce lending and earnings.
27.3
Causes of changes in money supply
The credit creation multiplier
When commercial banks receive additional deposits, they can hold a fraction as reserves and lend the remainder. The loan is spent and may return to the banking system as another deposit, allowing further lending. This repeated process can make the increase in deposits and credit larger than the original injection.
credit multiplier = 1 ÷ desired cash ratio
Worked example: with a desired cash ratio of 10%, the simplified multiplier is 1 ÷ 0.10 = 10. An initial $100 increase in cash can ultimately support up to $1,000 of deposits in the simplified textbook model — $100 of cash and $900 of additional loans.
Credit creation
With a desired cash ratio of 10%, an extra $100 deposit allows $90 to be lent. When that is redeposited, $81 can be lent, and so on. In the simplified textbook model the final position is $100 cash and $900 loans.
Adapted from the Cambridge International AS & A Level Economics book by Peter Smith (Second Edition, with Adam Wilby and Mila Zasheva).
Why control is imprecise: the textbook multiplier is a simplified model. Actual credit creation depends on banks' desired liquidity, demand for loans, regulation and whether funds remain inside the banking system. A central bank may influence reserves without mechanically determining the final money stock.
The central bank
A central bank performs system-wide functions rather than ordinary retail banking. Depending on the country, its roles can include:
Currency & government
Issue notes and coins, act as banker to government and help manage government borrowing.
Bankers' bank & regulation
Provide services to commercial banks, oversee financial institutions and help maintain confidence and stability.
Policy & reserves
Manage foreign-exchange reserves and, where delegated, use interest rates or other tools to pursue inflation and wider macroeconomic objectives.
Government deficit financing
If government spending exceeds tax revenue, the deficit must be financed. The government may issue bonds. According to the textbook treatment, sales to the central bank or commercial banks can add to the base on which further credit creation occurs, whereas selling bonds to the non-bank private sector draws down existing deposits and does not create the same initial monetary effect.
Quantitative easing (QE)
Quantitative easing involves the central bank purchasing assets, especially government securities, to increase liquidity in the financial system and encourage lending when conventional interest-rate cuts have limited room.
Central bank buys assets
Bank reserves / liquidity rise, which is intended to support credit and aggregate demand.
Transmission is not automatic
Banks may still be cautious about lending and firms or households may be unwilling to borrow.
Open-economy effects
Foreign-exchange intervention can change domestic money supply, especially under a fixed or managed exchange rate.
Under a floating exchange rate, the exchange rate carries more of the adjustment to external shocks. Under a fixed exchange rate, intervention to defend the rate changes the domestic money supply. This is why a central bank cannot independently control both a fixed exchange rate and money supply.
Excess supply of domestic currency
To support a fixed rate, the authorities can sell foreign exchange and buy domestic currency. Domestic money supply is reduced.
Excess demand for domestic currency
The authorities can buy foreign exchange and sell domestic currency. Domestic money supply rises and the banking system may multiply the increase in credit.
Policy constraint: under a fixed exchange-rate system, intervention to defend the currency can change money supply. The central bank therefore cannot freely fix both the exchange rate and domestic money supply independently.
Money, credit and inflation
Monetary authorities can influence aggregate demand through interest rates and the availability of credit. Higher interest rates tend to restrain consumption and investment; lower rates or QE can support spending. The effectiveness of these policies is developed further in Chapter 28.
27.4
The demand for money and the determination of interest rates
Opportunity cost of holding money
Money is highly liquid but usually gives up the return that could be earned on an interest-bearing asset. The interest rate can therefore be regarded as the opportunity cost, or price, of holding money balances.
Easy way to remember liquidity preference
When interest rates are high, holding cash means giving up a larger return that could have been earned on interest-bearing assets, so people tend to hold less money. When rates are low, that opportunity cost is smaller, so desired money holdings are higher.
Three motives for holding money
Transactions demand
Money is needed for everyday purchases and payments. It depends strongly on income and the timing/frequency of receipts and payments.
Precautionary demand
Households and firms hold liquid balances against emergencies or unexpected opportunities. Uncertainty and the interest rate influence this motive.
Speculative demand
People may hold money instead of bonds when they expect bond prices to fall. Because bond prices and interest rates move inversely, speculative money demand is interest-sensitive.
Liquidity preference and money-market equilibrium
Keynes's liquidity preference theory suggests that economic agents desire to hold money as an asset. Since the opportunity cost rises with the interest rate, the demand for money slopes downward against the interest rate.
The demand for money
The MD curve slopes down because the interest rate is the opportunity cost of holding money. With money supply fixed at M*, equilibrium is at interest rate r*.
Adapted from the Cambridge International AS & A Level Economics book by Peter Smith (Second Edition, with Adam Wilby and Mila Zasheva).
Important constraint: in this framework, money supply and the interest rate cannot both be fixed independently. If one is targeted, the other must be consistent with money-market equilibrium.
What shifts money demand?
- Higher income: increases the transactions demand and shifts overall money demand right.
- Greater uncertainty: can raise precautionary balances.
- Expectations about bond prices / interest rates: affect speculative holdings.
- Payment technology and institutional change: can alter how much liquidity is needed for transactions.
The market for loanable funds
The interest rate can also be analysed as the price that brings household saving and firms' desired investment together. Firms invest less at high borrowing costs, so investment demand slopes downward; households are generally encouraged to save more as the return rises, so the supply of loanable funds slopes upward.
The market for loanable funds
Investment demand slopes down because fewer projects are worthwhile at high borrowing costs, while saving tends to rise with the return. The equilibrium interest rate r* occurs where planned S = I.
Adapted from the Cambridge International AS & A Level Economics book by Peter Smith (Second Edition, with Adam Wilby and Mila Zasheva).
Keynesian evaluation and the central bank
Keynes argued that saving and investment may be relatively insensitive to the interest rate and that volatile business expectations can move investment strongly. In practice, the central bank also sets or guides a policy rate, influencing a range of market interest rates. This makes actual interest-rate determination more complex than either simple diagram alone.
Bond-price relationship: bond prices and market interest rates move inversely. If existing bond prices rise, their yield to a new buyer falls; if bond prices fall, the return relative to price rises.
Chapter 27 revision checklist
□ State and explain the four functions of money.
□ Explain the six characteristics of successful money.
□ Define money supply, liquidity and near-money.
□ Distinguish narrow money from broad money.
□ Define velocity of circulation and use V = PY ÷ M.
□ Explain the Fisher equation MV = PY.
□ State the classical assumptions behind the quantity theory of money.
□ Distinguish nominal and real interest rates.
□ Distinguish retail, wholesale and universal banks.
□ Explain liquidity and reserve ratios.
□ Explain interbank lending and repos.
□ Evaluate liquidity, security and profitability as bank objectives.
□ Explain the capital adequacy ratio.
□ Calculate and explain the credit multiplier.
□ Explain the main functions of a central bank.
□ Explain how deficit financing and QE can affect money supply.
□ Explain how foreign-exchange intervention can affect domestic money supply.
□ Explain transactions, precautionary and speculative demand for money.
□ Use liquidity preference to determine the money-market interest rate.
□ Explain and evaluate the loanable-funds approach to interest-rate determination.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.