Money, Banking, Inflation and Monetary Policy
What the domain tests
Money, banking, inflation and monetary policy tests the functions and supply of money, credit creation, central banking and the transmission of interest-rate decisions to inflation and output.
Core rules
- Money functions as a medium of exchange, unit of account, store of value and standard for deferred payment.
- Commercial banks create credit through lending; the simple money multiplier is 1/reserve ratio, though cash leakage and capital requirements limit it.
- Central banks set the policy rate, manage reserves, act as lender of last resort and target inflation.
- Monetary policy tools include policy interest rates, open market operations, reserve requirements and quantitative easing.
- Demand-pull inflation comes from excess aggregate demand; cost-push from rising costs. The short-run Phillips curve suggests a trade-off between inflation and unemployment.
- Real interest rate ≈ nominal interest rate − inflation.
Worked example
A central bank raises the policy rate from 5% to 6.5%. Commercial banks pass this on, so borrowing becomes dearer and saving more attractive. Investment and consumption fall, aggregate demand falls and inflationary pressure eases. The cost is lower output and higher unemployment in the short run. If inflation is cost-push, higher interest rates may worsen output without quickly reducing inflation.
Traps
Do not confuse the central bank with commercial banks. Raising interest rates does not instantly reduce inflation; transmission takes time. Inflation is not the same as a high price level. Nominal interest rates can be high while real rates are negative.