holding or providing cash, securities, loans, deposits, equity

Money and Banking (Cambridge AS & A Level – Section 9.4)

1. Objectives of this Chapter

• Define money and explain its three functions and key characteristics.
• Distinguish the different measures of the money supply (M0, M1, M2, M3).
• State the Quantity Theory of Money (MV = PT) and explain its implication for price‑level changes.
• Describe the role of commercial banks and the central bank, including balance‑sheet mechanics, reserve‑ratio and capital‑ratio requirements, and the three banking objectives.
• Analyse how banks create money through fractional‑reserve banking and the money‑multiplier process.
• Identify the main risks faced by banks and the tools used by central banks to implement monetary policy.
• Link changes in the money supply to the AD/AS model, exchange‑rate policy and the balance of payments.

2. What Is Money?

Definition: Money is any asset that is widely accepted as a medium of exchange, a unit of account and a store of value.

Functions of Money

1. Medium of exchange – enables transactions without barter.
2. Unit of account – provides a common measure for pricing goods and services.
3. Store of value – retains purchasing power over time (subject to inflation).

Key Characteristics (syllabus focus)

• Acceptability
• Durability
• Divisibility
• Portability
• Stability of value

3. Measures of the Money Supply

Aggregate	Typical UK Components	Primary Use in Analysis
M0 (base money)	Notes & coins held by the public + banks’ vault cash	Directly controlled by the central bank; indicator of monetary base
M1	M0 + demand deposits (current accounts) + other highly liquid deposits	Measures the most liquid money; used for short‑term spending analysis
M2	M1 + time deposits (savings accounts, fixed‑term bonds) + retail money‑market funds	Broadens the view to include near‑money assets
M3 (where published)	M2 + large‑time deposits, institutional money‑market funds, repurchase agreements	Very broad measure; useful for long‑run macro‑analysis

4. Quantity Theory of Money

The theory is expressed by the equation:

M V = P T

• M – money supply (usually M1 or M2)
• V – velocity of money (average number of times a unit of money is spent in a period)
• P – price level
• T – real output (transactions or real GDP)

If V and T are relatively stable in the short run, a change in M leads to a *proportional* change in the price level P. This is the basis for the textbook statement that “an increase in the money supply causes inflation”.

Numerical illustration

• Initial situation: M = £500 bn, V = 5, T = £2 000 bn.
  P = (500 × 5) / 2 000 = 1.25 → price level 125 % of the base year.
• If the central bank raises M by 10 % to £550 bn (V and T unchanged):
  P′ = (550 × 5) / 2 000 = 1.375 → price level 137.5 % (a 10 % rise in prices).

5. The Banking System

5.1 Commercial Banks – Functions and Objectives

• Deposit‑taking – demand (current) and time (savings) accounts.
• Lending – loans to households, firms and the government.
• Liquidity management – holding cash reserves and high‑quality marketable securities.
• Capital provision – equity that absorbs losses and supports further lending.

Banking objectives (syllabus)

1. Liquidity – ability to meet short‑term cash‑outflows.
2. Security (solvency) – maintaining sufficient capital to absorb losses.
3. Profitability – earning an acceptable return on assets/equity.

5.2 Key Regulatory Ratios

• Reserve‑ratio (RRR) = ^Reserves⁄_Deposits.
  Determines the minimum fraction of deposits that must be kept as cash or central‑bank reserves.
• Capital (Equity) Ratio = ^{Bank Capital}⁄_{Risk‑Weighted Assets}.
  Ensures a buffer against losses; Basel III sets a minimum of 8 % (including Tier 1 and Tier 2).

5.3 Simplified Bank Balance Sheet

Assets		Liabilities & Equity
Cash reserves (central‑bank & vault cash)		Customer deposits (demand & savings)
Government securities (e.g., Treasury bills)		Inter‑bank borrowings / central‑bank facilities
Loans to households & firms		Bank capital (equity)
Other assets (foreign exchange, fixed assets, etc.)

5.4 Central Bank – Core Roles

• Issue of money – sole authority to create base money (M0).
• Lender of last resort (LLR) – provides emergency liquidity to solvent banks facing temporary shortages.
• Monetary‑policy implementation – conducts open‑market operations, sets reserve requirements and policy rates, and may use quantitative easing (QE).

6. How Banks Create Money

In a fractional‑reserve system a bank keeps only a part of each deposit as reserves and lends out the remainder. The loan becomes a new deposit in the same or another bank, and the process repeats, expanding the money supply.

Money multiplier

\( m = \dfrac{1}{\text{RRR}} \)

Example: Required reserve ratio = 10 % (0.10) → multiplier = 10.
An initial cash deposit of £1 000 can ultimately increase M1 by up to £10 000.

7. Types of Bank Funding

• Deposits – the primary source of funds; includes demand and time deposits.
• Borrowings – short‑term inter‑bank loans, repurchase agreements, and central‑bank facilities.
• Equity (Capital) – shareholder funds that absorb losses and support lending.
• Securities issuance – bonds or other debt instruments used to raise long‑term capital.

8. Risks Managed by Banks

1. Liquidity risk – ability to meet cash‑outflows when they arise.
2. Credit risk – probability that borrowers will default.
3. Interest‑rate risk – mismatches between the interest rates on assets and liabilities.
4. Equity (capital) risk – adequacy of capital to absorb unexpected losses.

9. Monetary‑Policy Instruments

Central banks influence the quantity of money and the level of interest rates through four main tools:

• Open‑market operations (OMO) – buying or selling government securities to inject or withdraw liquidity.
• Reserve requirements – altering the required reserve ratio (RRR) to affect the multiplier.
• Policy interest rates – setting the base rate, repo rate or discount rate, which guides commercial‑bank lending rates.
• Quantitative easing (QE) – large‑scale purchases of longer‑term securities to lower long‑term yields and increase bank reserves.

10. Linking Money, Banking and the Macro‑Economy

10.1 Effect on Aggregate Demand (AD) and Aggregate Supply (AS)

• Increasing the money supply (e.g., via a lower reserve ratio or QE) raises banks’ lending capacity, lowers market interest rates and stimulates consumption and investment.
  → AD shifts right (higher real GDP at a given price level) in the short run.
• In the long run, output is determined by real factors (technology, labour, capital). The increase in AD mainly pushes the price level up, leaving real output unchanged.
  → Long‑run AD shift leads to higher P but unchanged Y.

10.2 Exchange‑Rate Policy and the Money Supply

• When a central bank intervenes in the foreign‑exchange market, it buys or sells foreign currency for domestic currency.
  • Buying foreign currency (selling domestic) **reduces** the monetary base – a contractionary effect.
  • Selling foreign currency (buying domestic) **increases** the monetary base – an expansionary effect.
• “Sterilised” intervention: the central bank offsets the base‑money change by an opposite open‑market operation, keeping the money supply unchanged while still influencing the exchange rate.

10.3 Balance‑of‑Payments Implications

Changes in the money supply affect the current account through the exchange rate. A larger money supply tends to depreciate the domestic currency, making exports cheaper and imports more expensive, thereby improving the current‑account balance (ceteris paribus). This link is examined in Syllabus 6.3 and 11.1.

10.4 Cross‑Reference to Macro‑Policy (Section 10)

When answering exam questions on macro‑economic objectives (growth, low inflation, full employment, external balance), remember that monetary policy works together with fiscal, supply‑side and exchange‑rate policies. The effectiveness of each option depends on the underlying macro problem (see Syllabus 10.1‑10.3).

11. The Role of Securities in Banking

Banks hold securities for two principal reasons:

1. Liquidity management – high‑quality, marketable securities can be sold quickly to meet cash demands or to satisfy regulatory liquidity ratios.
2. Profit generation – interest income, dividend receipts and capital gains from securities contribute to overall bank earnings.

12. Summary

Money performs three essential functions and is measured through a hierarchy of aggregates (M0‑M3). The Quantity Theory of Money links a stable velocity and output to proportional price‑level changes when the money supply varies. Commercial banks, guided by reserve‑ratio and capital‑ratio requirements, pursue liquidity, security and profitability while transforming deposits into loans and creating money via the fractional‑reserve multiplier. The central bank controls the monetary base, acts as lender of last resort, and steers the economy with open‑market operations, reserve‑requirement changes, policy rates and, when required, quantitative easing. Changes in the money supply shift aggregate demand, influence exchange rates and can affect the balance of payments. Understanding these mechanisms equips students to analyse how monetary policy interacts with other macro‑economic policies to achieve the core objectives of growth, price stability, full employment and external balance.