Money, Banking and Interest Rates
What the exam tests
Money and banking connects the central bank, commercial banks and interest rates. CB2 tests money functions and measures, credit creation, the money multiplier and the inverse bond price-yield relationship.
Core rules
- Money functions: medium of exchange, unit of account, store of value and standard of deferred payment.
- Measures: M0 is the monetary base (currency plus bank reserves); M1 is currency plus demand deposits; M2 and M3 add broader deposits. Broader measures include less liquid assets.
- Commercial banks create deposits by lending. With reserve ratio r and no leakages, the simple money multiplier is 1/r; total deposits from a new deposit D are D/r.
- The central bank sets the policy rate, conducts open market operations, sets reserve requirements and acts as lender of last resort.
- Bond prices and yields move inversely. Current yield = annual coupon / price. Fisher equation: nominal rate ≈ real rate + expected inflation.
- Money demand arises from transactions, precaution and speculation.
Worked example
A new deposit of 1,000 is made and the reserve ratio is 10%. The simple multiplier is 1/0.10 = 10. Maximum total deposits are 1,000 × 10 = 10,000, so new money created is 9,000. If the bank holds excess reserves or the public holds more currency, the actual expansion is smaller. A bond with a 50 coupon priced at 950 has a current yield of 50/950 = 5.26%. If the market yield rises to 6%, the price must fall to about 50/0.06 = 833.33.
Traps
- Applying the simple multiplier without allowing for currency drain and excess reserves, overstating money creation.
- Confusing the monetary base with broad money; the central bank controls the base directly, not M3.
- Thinking a bond price rise raises its yield; the relationship is inverse.
- Quoting a nominal interest rate as the real cost of borrowing when inflation is high.
- Assuming all bank deposits are backed by reserves; fractional reserve banking means they are not.