Money and Banking

1. Why this topic matters

Money is easy to use and hard to define, and the syllabus tests the definition precisely. More importantly, this topic explains where money comes from: most of it is created not by a central bank printing notes but by commercial banks making loans, and understanding that mechanism is what makes monetary policy in chapter 10 intelligible.

The topic supplies the machinery for 9.5, where the money supply meets the demand for money to determine the interest rate.

2. The functions of money

▶

Four functions, and examiners expect all four with an explanation rather than a list.

• Medium of exchange. Money is accepted in return for goods and services, which removes the need for a double coincidence of wants. Under barter, exchange requires each party to want what the other offers. Money breaks that requirement, which allows specialisation and vastly widens the scope for trade. This is the primary function.
• Store of value. Purchasing power can be held over time, so income need not be spent at once. Inflation erodes this function, which is why high inflation drives people towards foreign currency or real assets.
• Unit of account. Values are expressed in common units, so relative prices can be compared and accounts kept. Without it, an economy with n goods requires n(n minus 1) divided by 2 separate exchange rates.
• Standard of deferred payment. Contracts can specify future payments, which makes borrowing and lending possible. Inflation undermines this too, since it transfers value from lender to borrower.

2.1 Characteristics of good money

Acceptability, durability, portability, divisibility, homogeneity, limited supply and difficulty of counterfeiting. Each links to a function: divisibility supports the medium of exchange role, limited supply supports the store of value role.

3. Measuring the money supply

Definitions vary by country, but the principle is a spectrum from most liquid to least.

• Narrow money, often labelled M0 or M1, covers notes and coins in circulation plus balances readily available for transactions. It emphasises the medium of exchange function.
• Broad money, often labelled M2 or higher, adds time deposits and other less liquid assets. It emphasises the store of value function.

Liquidity is the ease with which an asset can be converted into cash without loss of value. Cash is perfectly liquid; property is not.

The measurement matters because policy targets based on a monetary aggregate depend on that aggregate having a stable relationship with spending, which is exactly what became unreliable when financial innovation blurred the boundaries between account types.

4. Credit creation

4.1 The mechanism

This is the examinable core of the topic.

A bank receives a deposit. It knows from experience that depositors will not all withdraw at once, so it needs to keep only a fraction of deposits as reserves. It lends the rest. The borrower spends the loan, and the recipient deposits it, usually at another bank. That bank keeps a fraction and lends the rest. The process repeats.

Each round creates a new deposit, and bank deposits are money. So the banking system as a whole creates money far in excess of the original cash deposit.

4.2 The credit multiplier

If banks keep a fraction r of deposits as reserves, an initial deposit D can support total deposits of:

Total deposits equals D divided by r

The credit multiplier is 1 divided by r, sometimes called the bank or deposit multiplier.

4.3 Worked calculation

A bank receives a cash deposit of $10,000 and the reserve ratio is 10 per cent.

Total deposits converge on $10,000 divided by 0.10, which is $100,000.

Of that, $10,000 is the original cash and $90,000 has been created by the banking system through lending.

Note the parallel with the income multiplier in 9.2. Both are geometric series; the difference is that the leakage here is the reserve ratio rather than the propensity to withdraw.

4.4 A second calculation

Reserve ratio 20 per cent, initial deposit $50,000.

• Credit multiplier: 1 divided by 0.20, which is 5.
• Total deposits: $250,000.
• Money created: $200,000.

Halving the reserve ratio from 20 per cent to 10 per cent doubles the multiplier from 5 to 10. This is why reserve requirements are a potential policy instrument.

4.5 Why the theoretical maximum is rarely reached

• Cash drain: some money is held as cash rather than redeposited, which leaks out of the process.
• Banks hold excess reserves above the required minimum, particularly when they are cautious or when returns on lending are poor.
• Demand for loans may be weak. Banks cannot create credit that nobody wants to borrow, which is why cutting interest rates in a deep recession may fail to raise lending.
• Capital requirements constrain lending independently of reserves.
• Creditworthy borrowers may be scarce in a downturn.

The last three are the reason a central bank cannot simply command an expansion of the money supply, and they are strong evaluation points in monetary policy essays.

5. The role of a central bank

A central bank typically:

• acts as banker to the government, managing its accounts and debt issuance;
• acts as banker to the commercial banks, holding their reserves and settling between them;
• is lender of last resort, supplying liquidity to solvent banks facing a run, which prevents a liquidity problem becoming a solvency crisis;
• issues notes and coin;
• implements monetary policy, principally by setting the policy interest rate; and
• regulates and supervises the banking system, including capital and liquidity requirements.

5.1 Lender of last resort and moral hazard

The lender of last resort function stabilises the system, but it creates the moral hazard of 8.4: a bank that expects rescue may take greater risks. Regulation of capital adequacy exists partly to offset this. Being able to link the two is a good evaluative move.

6. Quantitative easing

Where the policy interest rate is already close to zero, a central bank may use quantitative easing (QE): creating new central bank reserves and using them to buy financial assets, usually government bonds, from the private sector.

The intended mechanism:

• buying bonds raises their price and therefore lowers their yield, which is a fall in long term interest rates;
• sellers hold cash or bank deposits instead of bonds, raising the money supply and possibly encouraging lending;
• lower yields encourage investors into riskier assets, raising asset prices and wealth, which raises consumption; and
• the currency may depreciate, raising net exports.

Evaluation:

• the effect on bank lending depends on demand for loans and bank willingness, which is the limitation from 4.5;
• gains accrue disproportionately to asset holders, so QE tends to widen wealth inequality, which links to 8.2; and
• unwinding a large asset holding without disrupting markets is difficult.

Note carefully that QE is not the same as printing money to fund government spending directly. It is an asset purchase in secondary markets, and the assets can in principle be sold back.

<!-- merged from the former 9.5; syllabus 9.4.3, 9.4.7 and 9.4.8 place the quantity theory and interest rate determination here -->

7. Liquidity preference: the Keynesian theory of interest

9.1 The central idea

The rate of interest is determined by the demand for money and the supply of money.

The interest rate is the reward for giving up liquidity. If you hold wealth as money you can spend it immediately but earn nothing; if you hold it as bonds you earn interest but cannot spend it without selling first. The interest rate is what persuades people to part with liquidity.

9.2 The three motives for holding money

• Transactions motive. Money held to meet everyday planned spending. It depends principally on the level of income, since higher income means more transactions, and is largely independent of the interest rate.
• Precautionary motive. Money held against unforeseen events. It also depends mainly on income and on uncertainty.
• Speculative motive. Money held as an alternative to bonds, in the expectation that bond prices will fall. This is the interest-sensitive component and the distinctive Keynesian contribution.

9.3 Why the speculative demand slopes downward

This requires the inverse relationship between bond prices and yields, which is examinable in its own right.

A bond paying a fixed coupon of $8 per year:

• if it costs $100, the yield is 8 per cent;
• if its price falls to $80, the yield is 8 divided by 80, which is 10 per cent; and
• if its price rises to $160, the yield is 8 divided by 160, which is 5 per cent.

Bond prices and interest rates move in opposite directions.

Now the argument. When the interest rate is low, bond prices are high. Investors judge that prices are more likely to fall than rise, and a fall would give them a capital loss. So they prefer to hold money and wait. Speculative demand for money is high.

When the interest rate is high, bond prices are low and expected to rise, so investors buy bonds to capture the gain. Speculative demand for money is low.

The liquidity preference curve therefore slopes downward with respect to the interest rate.

9.4 Determination of the rate

The money supply is set by the monetary authority and is drawn as a vertical line, since it does not depend on the interest rate.

The equilibrium interest rate is where the demand for money curve intersects the money supply line.

• If the interest rate is above equilibrium, people hold more money than they wish. They buy bonds, bidding bond prices up and yields down, until the rate falls to equilibrium.
• If it is below equilibrium, people hold less money than they wish. They sell bonds, pushing prices down and yields up.

9.5 An increase in the money supply

The supply line shifts right. At the original interest rate there is now excess money, so people buy bonds, bond prices rise, and the interest rate falls to a new, lower equilibrium.

Lower interest rates then raise investment and interest-sensitive consumption, which raises aggregate demand. This is the monetary transmission mechanism.

9.6 The liquidity trap

At very low interest rates, the demand for money curve may become perfectly elastic. Bond prices are so high that everyone expects them to fall, so any additional money is absorbed into idle balances rather than used to buy bonds.

In that situation an increase in the money supply does not reduce the interest rate, so it does not raise investment, and monetary policy becomes ineffective. This is the liquidity trap, and it is the Keynesian argument for using fiscal rather than monetary policy in a deep recession.

It also connects to 9.4: even if the central bank supplies reserves, banks may not lend and firms may not borrow.

8. The quantity theory of money

9.1 The Fisher equation of exchange

MV equals PT, sometimes written MV equals PY.

• M is the money supply.
• V is the velocity of circulation, the average number of times a unit of money is used in a period.
• P is the price level.
• T is the number of transactions, or Y for real output.

As written; this is an identity, true by definition. Total spending must equal total value of goods sold. It becomes a theory only when assumptions are added.

9.2 The monetarist assumptions

• V is stable, determined by institutional factors such as payment habits, which change slowly.
• T (or Y) is determined by real factors and is fixed at the full employment level in the long run, which is the classical vertical LRAS of 9.3.

If V and T are both fixed, then a change in M must produce a proportionate change in P.

Inflation is therefore a monetary phenomenon, caused by the money supply growing faster than real output.

9.3 Worked calculation

An economy has a money supply of $400 billion, velocity of 5 and real output of 2,000 billion units.

• MV equals 400 multiplied by 5, which is $2,000 billion.
• P equals MV divided by T, which is 2,000 divided by 2,000, so P equals 1.

Now the money supply rises 12 per cent to $448 billion, while V and T are unchanged.

• MV equals 448 multiplied by 5, which is $2,240 billion.
• P equals 2,240 divided by 2,000, which is 1.12.

The price level has risen 12 per cent, exactly matching the money growth. That proportionality is the quantity theory's central prediction.

9.4 A second calculation with output growth

Money supply grows 9 per cent, real output grows 3 per cent, velocity is constant.

Rearranging in growth rates: percentage change in P is approximately the percentage change in M plus the percentage change in V minus the percentage change in Y.

Inflation is approximately 9 plus 0 minus 3, which is 6 per cent.

This is the practical form of the theory and the basis of the monetarist policy rule: allow the money supply to grow at the rate of growth of real output, and the price level is stable.

9.5 Evaluation

• Is V stable? This is the decisive question. Financial innovation, changes in payment technology and shifts in confidence all move velocity, and it proved much less stable in practice than the theory required. If V falls when M rises, the effect on P is muted or absent.
• Is Y fixed? Only if the economy is at full employment. On the Keynesian horizontal section, extra money that raises demand raises output, not prices.
• Direction of causation. The theory assumes M causes P. Keynesians argue causation can run the other way: rising prices and output raise the demand for credit, and banks create deposits to meet it, so M is endogenous and responds to the economy rather than driving it.
• Time lags between money growth and price changes are long and variable, which makes control by monetary targeting difficult in practice.

The empirical record is worth a sentence: monetary targeting was adopted in several countries and largely abandoned, because the relationship between the targeted aggregate and inflation proved unstable. That is evidence for the evaluation, not merely opinion.

9. Comparing the two theories

The two are not strictly contradictory. They emphasise different links in the same chain, and they differ over whether output can respond, which returns to 9.3.

10. Integrated analysis and common traps

7.1 A complete chain

A central bank cuts the policy rate and reduces the reserve requirement from 12 per cent to 8 per cent. The credit multiplier rises from approximately 8.3 to 12.5, so a given base of reserves can support substantially more deposits. Banks have both more capacity and more incentive to lend, so the money supply and credit expand, which lowers market interest rates and raises investment and consumption.

Evaluation: the expansion depends entirely on there being willing and creditworthy borrowers. In a recession, when confidence is low, banks may hold excess reserves and firms may not wish to borrow at any rate, so the money supply grows far less than the multiplier suggests. The theoretical maximum is a ceiling, not a forecast.

7.2 Common examination errors

• Saying banks lend out depositors' money one to one, missing the creation of new deposits.
• Confusing the credit multiplier with the income multiplier from 9.2.
• Using the reserve ratio the wrong way round, dividing by 10 rather than by 0.10.
• Treating the theoretical maximum as what actually happens.
• Saying QE is the central bank printing money to give to the government.
• Listing the four functions of money without explaining the double coincidence of wants.
• Confusing liquidity with profitability. The most liquid assets typically earn the least, which is precisely the trade-off a bank manages.

11. Paper 3 and Paper 4 mastery

Paper 3 tests: the four functions, calculating total deposits or money created from a reserve ratio, calculating the credit multiplier, and identifying what QE involves.

Practise the reverse calculation. If an initial deposit of $20,000 supports total deposits of $160,000, the credit multiplier is 8, so the reserve ratio is 12.5 per cent.

Paper 4 essays on monetary policy should use this topic to explain why policy may fail to transmit. The strongest evaluation is that a central bank controls the base and the price of money but not the willingness of banks to lend or of firms to borrow, and the credit creation mechanism shows exactly where that control breaks.

12. Final checklist

A fully prepared learner can:

• state and explain all four functions of money, including the double coincidence of wants;
• list the characteristics of good money and link each to a function;
• distinguish narrow from broad money and define liquidity;
• explain credit creation round by round;
• calculate total deposits, money created and the credit multiplier from a reserve ratio;
• calculate the reserve ratio backwards from a given multiplier;
• give at least four reasons the theoretical maximum is not reached;
• list the functions of a central bank;
• explain lender of last resort and the moral hazard it creates;
• explain the intended transmission of QE and at least three limitations; and
• explain why a central bank cannot simply command an increase in the money supply.