Cambridge Syllabus Notes

Money and Banking – Policies to Reduce Inflation (Cambridge 9708)

1. Money – Definition, Functions & Monetary Aggregates

Definition: Money is any asset that is widely accepted as a medium of exchange, a store of value (both short‑term and medium‑term) and a unit of account.
Functions (Cambridge syllabus):
1. Medium of exchange – used to buy and sell goods and services.
2. Store of value – retains purchasing power over time (medium‑term).
3. Unit of account – provides a common measure for pricing, accounting and the calculation of the price level.
Monetary aggregates (the syllabus expects familiarity with the main ones):
- M0 (or MB) – physical currency plus banks’ reserves with the central bank.
- M1 – M0 plus demand deposits (chequable accounts).
- M2 – M1 plus savings deposits and time‑deposits.
- M3 – M2 plus other liquid assets (e.g., large‑time deposits, repos).
For most A‑Level questions the focus is on M0/M1, the “narrow” money supply that the central bank can control directly.

2. Quantity Theory of Money

The core identity is:

MV = PY

M = nominal money supply (usually M0 or M1).
V = velocity of money (average number of times a unit of money is spent in a year).
P = price level.
Y = real output (real GDP).

Key assumptions (syllabus wording):

Velocity (V) is constant in the short‑run.
Real output (Y) is at its long‑run potential (full‑employment) level.
Closed economy – no net capital flows or exchange‑rate effects.

When these assumptions hold, a change in the money supply directly changes the price level (inflation) in proportion to the change in M.

3. Money‑Demand Theories

Liquidity‑Preference Theory (Keynesian): M = L(i, Y). Demand for money rises with income (Y) and falls with the interest rate (i) because the opportunity cost of holding cash increases.
Keynesian motives for holding money:
1. Transaction motive – cash needed for everyday purchases; proportional to income.
2. Precautionary motive – cash kept for unexpected expenses; also linked to income.
3. Speculative motive – cash held to take advantage of expected changes in interest rates or bond prices; inversely related to the interest rate.
These three motives together explain why money demand can be both income‑elastic (a) and interest‑elastic (b).
Loanable‑Funds Theory (Classical): S = I(r). Savings (the supply of loanable funds) equals investment demand; the real interest rate (r) equilibrates the two.

4. How Money Is Created – Fractional‑Reserve Banking

Commercial banks keep only a fraction of deposits as reserves and lend out the rest. The central bank sets the reserve‑requirement ratio (RR).

Money‑multiplier (potential maximum):

M = (1 / RR) × R

where R = total reserves held by the banking system.

Example: RR = 10 % (0.10) and reserves = £100 million → maximum money supply = £1 billion.

Limits to the multiplier (syllabus points):

Excess reserves – banks may hold more than the required amount.
Cash holdings by the public – reduces the amount deposited.
Central‑bank policy – open‑market operations, discount‑window facilities and reserve‑requirement changes can raise or lower the multiplier.

5. Why Target Inflation?

High inflation erodes purchasing power.
Creates uncertainty, discouraging long‑term investment.
Can trigger a wage‑price spiral, making inflation self‑reinforcing.
Most advanced economies aim for a low, stable target (≈ 2 %–3 % per year) to anchor expectations and support sustainable growth.

6. Policy Approaches to Reduce Inflation

Two broad categories are examined in the syllabus:

Monetary policy – actions by the central bank that influence the money supply, interest rates, credit conditions and, in an open economy, the exchange rate.
Fiscal and supply‑side policies – government measures that affect aggregate demand (AD) or aggregate supply (AS).

7. Contractionary Monetary‑Policy Instruments

Tool	How It Works (Transmission)	Typical Use in Reducing Inflation
Open‑market operations (selling government securities)	Reduces banks’ reserves → inter‑bank rate rises → market rates increase → borrowing falls.	Quick, precise control of the monetary base.
Policy interest rates (base, repo, discount)	Higher policy rate → higher commercial‑bank rates → higher cost of credit for households and firms.	Clear signal; anchors inflation expectations.
Reserve‑requirement ratio	Higher RR reduces the amount banks can lend for each unit of deposit.	Strong control over credit creation; used as a backup tool.
Standing facilities (discount window, marginal lending rate)	Higher lending rate to banks raises the floor for market rates.	Reinforces the policy‑rate stance.
Exchange‑rate intervention (in an open economy)	Purchase of foreign currency → domestic currency appreciates → import prices fall → lower import‑price inflation.	Effective when import‑price pressures dominate.
Credit controls (e.g., loan‑to‑value limits, sectoral caps)	Directly restricts the volume of new lending, especially in overheating sectors.	Targets sector‑specific price pressures (housing, commodities).

8. Monetary‑Policy Transmission Channels (Syllabus Focus)

Interest‑rate channel: Higher policy rates → higher market rates → reduced consumption & investment.
Credit‑creation channel: Tighter reserves and credit controls lower banks’ willingness/ability to lend.
Exchange‑rate channel: An appreciated currency makes imports cheaper, reducing import‑price inflation.
Expectations channel: A credible commitment to low inflation shapes wage‑price setting behaviour.

9. Fiscal‑Policy Tools that Influence Aggregate Demand

Tool	Effect on AD	Typical Inflation‑Reducing Use
Higher direct taxes (e.g., income tax, corporation tax)	Reduces disposable income → left‑ward shift of AD.	Targeted at high‑income or profit‑making sectors.
Higher indirect taxes (e.g., VAT, excise duties)	Raises the price of consumption goods → reduces real consumption → left‑ward AD shift.	Broad‑based, quick to implement.
Reduced government spending	Directly lowers aggregate demand.	Often combined with tax rises for a balanced fiscal stance.
Automatic stabilisers (e.g., higher unemployment benefits during a downturn)	Mitigate the size of AD fluctuations; in a high‑inflation context they can be tightened (e.g., by reducing benefit levels) to aid disinflation.	Less discretionary; impact depends on the business cycle.

10. Supply‑Side Policies (Long‑Run Inflation Control)

Labour‑market reforms – improve flexibility, reduce wage‑push pressures.
Investment in infrastructure & technology – raise productive capacity, shift LRAS right.
Deregulation & competition policy – lower production costs, increase efficiency.
Education & training – enhance human capital, raise potential output.

In the AD–AS framework these measures shift the long‑run aggregate‑supply curve (LRAS) rightward, easing price‑level pressures without sacrificing output.

11. Effectiveness of Each Policy – Evaluation Table

Policy	Mechanism	Advantages	Disadvantages / Limits	Typical Effectiveness (Short‑ vs Long‑run)
Open‑market sales	Withdraws reserves → higher inter‑bank rates.	Fast, precise control of the monetary base.	May be offset if banks hoard excess reserves; transmission lag.	High in the short‑run; limited if liquidity trap.
Policy interest rate increase	Raises cost of borrowing across the economy.	Transparent, signals commitment, influences expectations.	Zero‑lower‑bound problem; effectiveness falls when credit demand is interest‑inelastic.	Very effective when the interest‑rate channel is strong.
Reserve‑requirement rise	Directly caps banks’ lending capacity.	Strong lever on credit creation.	Coarse tool; can destabilise banking sector; rarely changed.	Moderate – usually a backup to rate policy.
Exchange‑rate intervention (appreciation)	Makes imports cheaper → lowers import‑price inflation.	Immediate impact on import prices.	Reduces export competitiveness; depends on capital mobility.	Effective in small open economies with flexible rates.
Credit controls (LTV, sector caps)	Limits new lending in overheating sectors.	Targets specific price pressures (e.g., housing).	Can be circumvented; may slow growth in the targeted sector.	High for sector‑specific inflation; low for economy‑wide inflation.
Higher direct taxes	Reduces disposable income → lower consumption.	Can be targeted (luxury goods, carbon taxes).	Politically unpopular; may discourage labour supply.	Moderate – depends on tax‑elasticity of demand.
Reduced government spending	Direct cut to AD.	Clear fiscal signal; improves public‑finance balance.	Risk of recession; long implementation lag.	Low‑to‑moderate – limited by the fiscal multiplier.
Supply‑side reforms	Shift LRAS right → higher potential output, lower structural inflation.	Long‑run growth benefits; reduces cost‑push pressures.	Long implementation lag; political resistance.	High in the long run, low in the short run.

12. Factors that Influence Policy Effectiveness (Syllabus Checklist)

Time lags
- Recognition lag – 6‑12 months to identify inflationary pressure.
- Decision lag – time taken by the central bank or government to decide.
- Implementation lag – e.g., passing a fiscal bill or executing an OMO.
- Impact lag – 12‑24 months (monetary) or up to several years (supply‑side) before the full effect is felt.
Expectations – Credibility of the inflation target influences wage‑price setting; unanchored expectations can cause a wage‑price spiral.
State of the economy – In a recessionary gap, tightening may depress output with little price‑level effect; in an inflationary gap, the same policy is more potent.
Financial‑market conditions – Excess liquidity or a credit crunch can amplify or dampen the transmission of monetary tools.
Global factors – Commodity price shocks, exchange‑rate movements and imported inflation can offset domestic policy actions.
Zero‑lower‑bound – Limits the effectiveness of interest‑rate cuts (or raises) when rates are already near 0 %.

13. Evaluating Policy Choice – Exam Guidance

When answering an evaluation question, candidates should consider the following criteria (as set out by the syllabus):

Speed of implementation and impact – e.g., OMO is immediate, fiscal cuts take longer.
Side‑effects on growth, employment and the exchange rate – tightening may raise unemployment; exchange‑rate intervention may hurt exports.
Credibility and institutional independence – an autonomous central bank can better anchor expectations.
Interaction with other policies – coordination between monetary and fiscal actions can enhance overall effectiveness.
State of the economy and external environment – policy that works in a closed, inflationary economy may be less effective in an open economy hit by import‑price shocks.

14. Suggested Diagram for Exams

AD–AS diagram illustrating the effect of a contractionary monetary policy. The left‑ward shift of AD (from AD₁ to AD₂) moves the economy from an inflationary equilibrium (E₁) to a lower‑price equilibrium (E₂) with a smaller output gap.

15. Summary Checklist (Exam Revision)

Define money and list its three functions (including medium‑term store of value).
State the main monetary aggregates (M0‑M3) and which one the syllabus emphasises.
Write the quantity‑theory equation MV = PY and list its key assumptions.
Explain the three Keynesian motives for holding money and the liquidity‑preference function M = L(i,Y).
Describe fractional‑reserve banking, the money‑multiplier formula and its limits.
List and briefly explain each contractionary monetary‑policy tool.
Outline the four transmission channels (interest‑rate, credit, exchange‑rate, expectations).
Show how fiscal tools (direct tax, indirect tax, spending cuts, automatic stabilisers) shift AD.
Identify supply‑side measures and explain how they shift LRAS rightward.
Use the evaluation table to discuss short‑run vs long‑run effectiveness of each policy.
Discuss the role of time lags, expectations, economic conditions, financial‑market and global factors.
Apply the AD–AS diagram to illustrate the impact of a policy mix on inflation and output.
When evaluating, weigh speed, side‑effects, credibility, and policy coordination.

policies to reduce inflation and their effectiveness