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Money and Interest Rates

Subject: Economics
Topic: 8
Cambridge Code: 0455 / 2281

What is Money?​

Money - Medium of exchange accepted universally

Functions of Money​

Medium of exchange:

  • Accepted in transactions
  • Solves barter problem (double coincidence of wants)
  • Enables trade

Store of value:

  • Maintain purchasing power
  • Save for future
  • Durable, divisible

Unit of account:

  • Measurement of prices
  • Compare values
  • Keep accounts

Standard of deferred payment:

  • Repay debts in future
  • Loans priced in money

Types of Money​

Commodity money:

  • Has intrinsic value
  • Example: Gold, silver
  • No longer used

Fiat money:

  • No intrinsic value
  • Valuable because accepted
  • Declared legal tender
  • Modern money (notes, coins)

Electronic money:

  • Bank deposits, digital
  • Credit cards, mobile money
  • No physical form

Money Supply​

Money supply - Total amount of money in circulation

M0 (Monetary Base)​

  • Physical cash (notes, coins)
  • Central bank reserves
  • Smallest measure

M4 (Broad Money)​

  • M0 + bank deposits
  • Bank notes and coins
  • Checking and savings accounts
  • Most relevant measure

Inflation​

Inflation - Sustained increase in general price level

Inflation rate=Price level this year−Price level last yearPrice level last year×100%\text{Inflation rate} = \frac{\text{Price level this year} - \text{Price level last year}}{\text{Price level last year}} × 100\%

Causes of Inflation​

Demand-pull inflation:

  • AD > AS (too much money chasing goods)
  • "Too much money"
  • Occurs when economy at full capacity
  • Prices pulled up by demand

Cost-push inflation:

  • Rising production costs
  • Wage increases not matched by productivity
  • Supply shocks (oil prices)
  • Prices pushed up by costs

Effects of Inflation​

Bad (moderate):

  • Uncertainty for business (hard to plan)
  • Savings lose value
  • Exports less competitive
  • Menu costs (repricing)

Severe problems (high inflation):

  • Purchasing power collapses
  • Investment discouraged
  • Hyperinflation destroys economy
  • People use hard currency instead

Not all bad:

  • Borrowers benefit (repay with cheaper money)
  • Encourages spending and investment
  • Very low inflation can lead to deflation

Deflation​

Deflation - Sustained decrease in general price level

Problems:

  • Consumers delay purchases (cheaper later)
  • Reduces investment
  • Debt burden increases (repay with expensive money)
  • Unemployment rises
  • Can trigger deeper recession (deflationary spiral)

Interest Rates​

Interest rate - Cost of borrowing (return on saving)

Nominal vs Real Interest Rate​

Nominal rate:

  • Quoted rate
  • Not adjusted for inflation

Real rate: Real Rate=Nominal Rate−Inflation Rate\text{Real Rate} = \text{Nominal Rate} - \text{Inflation Rate}

Example:

  • Saving rate: 3% nominal
  • Inflation: 2%
  • Real return: 3% - 2% = 1%

Determining Interest Rates​

Supply and demand for loanable funds:

  • Supply: Savers (want return on savings)
  • Demand: Borrowers (businesses, consumers)
  • Interest rate: Balances supply and demand

Factors affecting demand:

  • Business investment opportunities
  • Consumer borrowing desires
  • Government borrowing

Factors affecting supply:

  • Savings rate
  • Foreign capital inflows
  • Central bank policy

Central Bank and Monetary Policy​

Central bank - Controls money supply and interest rates

Objectives:

  • Maintain price stability (low inflation)
  • Support economic growth
  • Maintain financial stability
  • Manage exchange rate

Monetary Policy Tools​

Base rate:

  • Interest rate set by central bank
  • Banks borrow at this rate
  • Influences all other rates

Open market operations (OMO):

  • Buy/sell government securities
  • Increase/decrease money supply
  • Lower purchases = lower money supply = higher rates

Reserve requirements:

  • % of deposits banks must keep
  • Lower requirement = more lending = more money

Expansionary Monetary Policy​

When: Economy weak, low growth, high unemployment

Methods:

  • Lower base rate (cheaper to borrow)
  • Buy securities (inject money)
  • Lower reserve requirements

Effect:

  • More borrowing and investment
  • Increased spending
  • AD shifts right
  • Output and employment rise
  • Risk: Inflation

Contractionary Monetary Policy​

When: Economy overheating, inflation high

Methods:

  • Raise base rate (expensive to borrow)
  • Sell securities (remove money)
  • Raise reserve requirements

Effect:

  • Less borrowing and investment
  • Reduced spending
  • AD shifts left
  • Inflation controlled
  • Risk: Growth slows, unemployment

Banking System​

Commercial Banks​

Functions:

  • Accept deposits (safekeeping, interest paying)
  • Lend to businesses and consumers
  • Provide payment services (checks, transfers)
  • Investment services

Credit Creation​

How banks create money:

  1. Customer deposits £100
  2. Bank lends £80 to business (keeps £20 reserve)
  3. Business spends £80, seller deposits it
  4. Bank lends out £64 of new deposit
  5. Process repeats

Money multiplier effect: Total money created=Initial deposit×1Reserve ratio\text{Total money created} = \text{Initial deposit} × \frac{1}{\text{Reserve ratio}}

Example: 20% reserve requirement, £100 deposit

  • Total money created = £100 × 5 = £500

Banking Crisis​

Causes:

  • Excessive lending
  • Borrowers default
  • Asset prices collapse
  • Banks insolvent (liabilities > assets)

Consequences:

  • Credit freezes
  • Business investment collapses
  • Recession/depression
  • Government bailout needed

Exchange Rate and Interest Rates​

Relationship:

  • Higher interest rates ↑ attract foreign investment
  • ↑ demand for currency
  • → Currency appreciates
  • Exports less competitive

Trade-off:

  • Raising rates controls inflation
  • But may appreciate exchange rate
  • Hurts exports
  • Dilemma for policymakers

Key Points​

  1. Money: Medium of exchange, store of value
  2. Inflation: Sustained price increase, bad if high
  3. Deflation: Sustained price decrease, also bad
  4. Real rate: Nominal rate minus inflation
  5. Demand-pull: Too much demand
  6. Cost-push: Rising production costs
  7. Monetary policy: Manages money supply
  8. Expansionary: Lower rates to boost growth
  9. Contractionary: Higher rates to control inflation
  10. Central bank: Controls base rate and money supply

Practice Questions​

  1. Explain inflation causes
  2. Calculate real interest rates
  3. Analyze monetary policy effects
  4. Predict inflation impacts
  5. Compare policy options
  6. Explain money creation
  7. Analyze banking crisis

Revision Tips​

  • Know money functions clearly
  • Understand inflation causes
  • Know real vs nominal
  • Understand monetary policy
  • Know central bank tools
  • Practice calculations
  • Know policy trade-offs
  • Understand money creation