Money and Banking – Interest‑Rate Determination (Cambridge IGCSE/A‑Level 9708)
Learning Objectives
- Define money using the syllabus definition and list its four functions.
- Describe the six characteristics of money and explain why each is important for the price mechanism.
- Identify the main money‑supply aggregates (M0, M1, M2, M3/M4), label them correctly and note which are most frequently examined.
- Explain the role of the Central Bank (monetary base, open‑market operations, policy rate, reserve requirements, lender of last resort).
- State and apply the Quantity Theory of Money (MV = PT).
- Describe how commercial banks create money – balance‑sheet items and the credit‑creation process.
- Explain the Loanable‑Funds Theory of interest‑rate determination.
- Explain the Keynesian (Liquidity‑Preference) Theory of interest‑rate determination.
- Compare the two theories and evaluate their relevance for fiscal and monetary policy.
1. Money – Definition, Functions & Characteristics
1.1 Definition (syllabus wording)
Money is any item that is widely accepted as a medium of exchange for goods and services and for the payment of taxes.
1.2 Four Functions of Money
- Medium of exchange – eliminates the need for barter.
- Unit of account – provides a common measure for pricing and accounting.
- Store of value – retains purchasing power over time (subject to inflation).
- Standard of deferred payment – enables borrowing and lending.
1.3 Characteristics of Money (syllabus wording)
| Characteristic | Why it matters for the price mechanism |
|---|
| Acceptability | Ensures that all parties will accept it in exchange, allowing prices to be expressed in a single unit. |
| Durability | Prevents loss of value through wear, keeping the money stock stable. |
| Divisibility | Allows transactions of any size, facilitating precise price setting. |
| Portability | Easy to carry, so transactions can occur quickly and at any location. |
| Uniformity (Standardisation) | Identical units guarantee that one unit always has the same purchasing power as another. |
| Limited supply | Controls inflation; if supply grew unchecked, prices would rise. |
2. Money‑Supply Measures
| Aggregate | Common name (syllabus) | Components (UK example) | Typical exam focus |
|---|
| M0 |
Monetary base |
Physical currency (notes & coins) held by the public + banks’ reserves at the Central Bank |
Most frequently asked – directly controlled by the Central Bank |
| M1 |
Narrow money |
M0 + demand deposits (current accounts) + travellers’ cheques |
Often used for short‑run analysis of liquidity |
| M2 |
Broad money (first tier) |
M1 + savings deposits + time deposits < £100 000 + money‑market funds |
Used for medium‑term policy discussion |
| M3 / M4 |
Broad money (second tier) |
M2 + large time deposits, institutional money‑market funds, etc. |
Long‑run analysis; less common in exam questions |
2.1 Role of the Central Bank
- Control of the monetary base (M0) – by issuing currency and setting reserve requirements.
- Open‑market operations (OMO) – buying or selling government securities to increase or decrease bank reserves.
- Policy interest rate (e.g., Bank Rate, Federal Funds Rate) – the benchmark that influences short‑term market rates.
- Reserve requirements – the proportion of deposits banks must hold as reserves.
- Lender of last resort – provides emergency liquidity to solvent banks facing a temporary shortage of funds.
3. Quantity Theory of Money
The long‑run relationship between the money supply and the price level is expressed by:
$$
MV = PT
$$
- M = nominal money supply (usually M2 or M3 in the syllabus).
- V = velocity of circulation (average number of times a unit of money is spent per period). Assumed roughly constant in the long run.
- P = price level.
- T = real output (transactions or real GDP).
Holding V and T constant, an increase in M leads to a proportional increase in P – the basis for targeting money‑growth rates to control inflation.
4. Commercial‑Bank Functions & Credit Creation
4.1 Simplified Balance‑Sheet
| Assets | Liabilities / Equity |
|---|
| Loans to customers | Deposits (current, savings, time) |
| Reserves (cash & balances at the Central Bank) | Borrowings from other banks / Central Bank |
| Securities (e.g., government bonds) | Capital (shareholder equity) |
4.2 Credit‑Creation Process (numeric example)
- The Central Bank injects £100 million of base money into the banking system (e.g., by purchasing government bonds).
- Bank A receives a £100 million deposit. With a reserve ratio of 10 % it must keep £10 million as reserves and can lend £90 million.
- The borrower spends the £90 million; the recipient deposits it in Bank B.
- Bank B now holds a £90 million deposit, keeps £9 million as reserves, and can lend £81 million.
- Repeating the process generates a total increase in the money supply of
\[
\Delta M = \text{initial base money} \times \frac{1}{\text{reserve ratio}} = £100\text{m} \times 10 = £1\text{bn}
\]
The factor \(\frac{1}{\text{reserve ratio}}\) is the **money multiplier**. In reality, the multiplier is lower because banks also consider capital adequacy ratios, liquidity buffers and risk‑based prudential limits.
5. Interest‑Rate Determination – Loanable‑Funds Theory
5.1 Core Idea
The loanable‑funds market is a competitive capital market where **real saving** (supply) meets **real investment demand**. The real interest rate adjusts to clear the market.
5.2 Supply of Loanable Funds (S)
- Real income (Y) – higher disposable income raises saving.
- Real interest rate (i) – a higher return encourages households to postpone consumption.
- Tax treatment of interest – tax‑exempt interest raises the effective return.
- Expectations of future income or inflation – affect the willingness to save today.
5.3 Demand for Loanable Funds (D)
- Marginal efficiency of capital (MEC) – the expected profitability of the next unit of investment.
- Future interest‑rate expectations – if rates are expected to fall, firms borrow now.
- Business confidence & expected demand for output – optimism raises borrowing.
- Government borrowing – budget deficits shift the demand curve to the right.
5.4 Market Equilibrium
The equilibrium real interest rate \(i^{*}\) satisfies:
$$
S(i^{*}) = D(i^{*})
$$
Graphically, the supply curve slopes upward (more saving as i rises) and the demand curve slopes downward (less investment as i rises). Diagram placeholder: Supply and demand for loanable funds showing equilibrium i*.
5.5 Policy Implications
- Fiscal expansion (higher government borrowing) → right‑shift of demand → higher real interest rate.
- Tax incentives for saving → right‑shift of supply → lower real interest rate.
- Monetary policy influences the loanable‑funds market indirectly by altering banks’ willingness and capacity to lend (through the policy rate and reserve conditions).
6. Interest‑Rate Determination – Keynesian (Liquidity‑Preference) Theory
6.1 Money‑Demand (Liquidity Preference)
Money demand consists of three motives:
- Transactions motive – proportional to real income \(Y\).
- Precautionary motive – also linked to \(Y\) (uncertainty about future expenses).
- Speculative motive – desire to hold cash when bond prices are expected to rise (i.e., when interest rates are high). Inverse relation with the interest rate.
Linear representation (commonly used in the syllabus):
$$
L = kY - hi
$$
- \(k>0\) – sensitivity of transactions & precautionary demand to income.
- \(h>0\) – sensitivity of speculative demand to the interest rate.
6.2 Money Supply
The Central Bank sets the nominal money supply \(M\). In the short run \(M\) is treated as exogenous.
6.3 Money‑Market Equilibrium
Equilibrium occurs where money demand equals money supply:
$$
M = L = kY - hi
$$
Solving for the interest rate gives the Keynesian interest‑rate function:
$$
i = \frac{kY - M}{h}
$$
6.4 Key Implications
- Higher real income \(Y\) raises money demand → higher \(i\) (all else equal).
- Higher money supply \(M\) lowers \(i\) (the classic monetary‑policy transmission channel).
- The impact of a change in \(M\) is larger when \(h\) is small (i.e., when people are less willing to hold cash for speculative reasons).
Diagram placeholder: Vertical money‑supply curve, downward‑sloping money‑demand curve, equilibrium determining i.
7. Comparison of the Two Theories
| Aspect |
Loanable‑Funds Theory |
Keynesian Liquidity‑Preference Theory |
| Primary market |
Capital market (savings ↔ investment) |
Money market (cash balances ↔ bonds) |
| Key variable that determines i |
Relative supply and demand for loanable funds (real terms) |
Balance between money demand and exogenous money supply (nominal terms, usually expressed as real balances M/P) |
| Role of expectations |
Future interest rates & expected profitability affect borrowing and saving. |
Speculative motive depends on expected changes in bond prices (i.e., expected future interest rates). |
| Policy focus |
Fiscal policy (government borrowing) and incentives for saving. |
Monetary policy (control of M and the policy rate). |
| Assumptions about the price level |
Usually expressed in real terms; short‑run price changes are ignored. |
Uses real money balances \(M/P\); explicitly incorporates the price level. |
| Time horizon |
Long‑run analysis – capital formation and growth. |
Short‑run fluctuations in liquidity preference and output. |
8. Integrating Both Approaches
- Monetary‑policy transmission: An increase in the Central Bank’s money supply lowers the interest rate in the money market (Keynesian). The lower rate then reduces the cost of borrowing in the loanable‑funds market, shifting the investment demand curve rightward and expanding real investment.
- Fiscal‑policy interaction: A larger budget deficit raises demand for loanable funds (higher i). The resulting rise in national income also lifts money demand, which can partially offset the monetary‑stimulus effect of a simultaneous increase in M.
- Time‑frame distinction for exam questions:
- Use the loanable‑funds model when the question asks about long‑run capital costs, crowding‑out, or the effect of sustained government borrowing.
- Use the liquidity‑preference model for short‑run analysis of monetary‑policy moves, changes in the policy rate, or the impact of a change in M on output and inflation.
- Empirical relevance: In practice, central banks target a short‑run policy rate (influencing the money market). Governments, meanwhile, monitor the effect of their borrowing on the long‑run cost of capital, which is captured by the loanable‑funds framework.
9. Summary (Key Points to Remember for the Exam)
- Money is any widely accepted medium of exchange and has four functions: medium of exchange, unit of account, store of value, and standard of deferred payment.
- Six characteristics (acceptability, durability, divisibility, portability, uniformity, limited supply) enable money to work efficiently in the price mechanism.
- Money‑supply aggregates:
- M0 – monetary base (exam favourite).
- M1 – narrow money.
- M2, M3/M4 – broader measures.
- The Central Bank controls M0 through currency issuance, reserve requirements, open‑market operations, the policy interest rate and acts as lender of last resort.
- Quantity Theory (MV = PT) shows that, with V and T stable, a rise in M leads proportionally to a rise in the price level.
- Commercial banks create money via the credit‑creation process; the money multiplier is roughly \(1/\text{reserve ratio}\) but is reduced by prudential constraints.
- Loanable‑Funds Theory: real interest rate equilibrates saving (supply) and investment (demand) in the capital market.
- Keynesian Liquidity‑Preference Theory: interest rate equilibrates money demand (transactions + precautionary + speculative) with the exogenously set money supply.
- Both models are useful:
- Loanable‑funds → long‑run fiscal analysis, crowding‑out, growth.
- Liquidity‑preference → short‑run monetary policy, inflation control.
- Effective exam answers should identify which market the question is referring to, state the relevant equilibrium condition, and discuss the likely policy impact.