Money, Banking and Financial Markets
Money, Banking and Financial Markets tests the functions of money, central-bank operations, interest-rate determination, bond pricing, banking risks, and financial regulation. The exam expects numerical fluency with yields and multipliers plus clear institutional reasoning.
Core rules and concepts
- Money functions as a medium of exchange, unit of account, and store of value. M1 includes currency and checkable deposits; broader aggregates add savings and time deposits.
- Central-bank balance sheet: open-market purchases expand reserves; sales contract them. The central bank controls the short-term policy rate, not every market rate.
- Money multiplier: with currency ratio c, reserve ratio r, and excess-reserve ratio e, m = (1 + c)/(r + e + c). It is an accounting relationship, not a fixed mechanical constant.
- Fisher equation: nominal interest i ≈ real interest r + expected inflation πe. Bond prices and yields move inversely.
- Term structure: expectations, liquidity premia, and segmentation explain yield-curve shape. Banks face liquidity risk, credit risk, and solvency risk; capital absorbs losses, reserves provide liquidity.
- Deposit insurance and lender-of-last-resort facilities reduce panic risk but can create moral hazard.
Worked example
A one-year zero-coupon bond has face value 1000 and price 950. Its yield is (1000 − 950)/950 = 5.26%. If the market yield rises to 6%, the price becomes 1000/1.06 = 943.40. The bondholder suffers a capital loss of 950 − 943.40 = 6.60, showing the inverse price–yield relationship. This reasoning applies to any fixed-cash-flow asset: discount future cash flows at the market yield, and compare the resulting present value with the current price.
Traps that cost marks
Do not treat the money multiplier as a stable policy lever; currency and excess-reserve ratios vary. Distinguish nominal from real interest rates. Coupon rate is not yield to maturity. Bank reserves are not bank capital, and liquidity problems can become solvency problems. Central banks influence short rates and liquidity, but they do not set all lending rates directly.