Money, Banking, Inflation, Monetary Policy and the Financial System
Money and banking
Know the functions of money (medium of exchange, unit of account, store of value, standard of deferred payment) and the money aggregates M1 (currency + demand deposits) and broader M2/M3. Commercial banks create deposits through the credit multiplier: maximum deposit creation = initial reserves × 1/reserve ratio. The central bank controls the monetary base, sets reserve requirements, the discount rate and conducts open market operations.
Inflation
Distinguish demand-pull from cost-push inflation, and anticipated vs unanticipated. Costs include menu costs, shoe-leather costs, redistribution from creditors to debtors, and erosion of purchasing power. The Fisher relation links nominal and real interest: i ≈ r + π. Phillips curve trade-off between inflation and unemployment is short-run.
Monetary policy
Expansionary policy (buy bonds, lower reserve ratio, lower discount rate) raises money supply and lowers interest rates; contractionary policy does the reverse. Transmission: money supply → interest rate → investment and consumption → aggregate demand → output and prices.
Traps
- Confusing the money multiplier with the Keynesian expenditure multiplier.
- Saying inflation always hurts everyone; borrowers with fixed-rate debt may gain.
- Mixing fiscal and monetary tools (taxes and spending are fiscal).
- Assuming central banks control all interest rates directly.
Worked example
If the reserve ratio is 10% and banks receive a new deposit of 1,000, maximum new money = 1,000 × (1/0.10) = 10,000, of which 9,000 is created credit.