Money, banking and households
Key terms
Define each term.
Multiple choice
Circle the correct answer.
Which function of money is most directly undermined by very high inflation?
Which activity is carried out by a central bank rather than a commercial bank?
A household's disposable income rises. Economic theory predicts that:
According to liquidity preference theory, why does the speculative demand for money rise when interest rates fall?
Worked problems
Show your working.
Working out whether saving is worthwhile. A household deposits $4,000 in a savings account paying 3% interest a year. Inflation over the year is 5%. Calculate the money value of the account after one year, the real interest rate, and the change in what the savings can actually buy.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How banks create money when they lend
- A The bank keeps $100 and lends $900 to a borrower, who spends it.
- B Broad money has grown by far more than the cash originally deposited, because the new deposits are money created by lending.
- C The $900 is paid into another bank account, creating a new deposit of $900.
- D A customer deposits $1,000 in a bank, and the bank must keep 10% as reserves.
- E The process can continue until total deposits reach the original deposit multiplied by 1 / reserve ratio, here $10,000.
- F That bank keeps $90 and lends $810, which is spent and deposited again.
- G Each round creates a smaller new deposit, but deposits keep growing.
Diagrams
Draw a simple flow diagram showing a household's disposable income dividing into spending, saving and debt repayment. Add arrows showing where the saved funds go, through a commercial bank, to firms as loans for investment. Then mark where a rise in the interest rate would change the size of each flow.
Draw a liquidity preference diagram with the interest rate on the vertical axis and the quantity of money on the horizontal axis. Draw a downward-sloping demand for money curve and a vertical money supply curve, and mark the equilibrium interest rate. Show the effect of an increase in the money supply. Then flatten the demand curve at a very low interest rate and show that a further increase in the money supply no longer lowers the rate.
Answers
Central bank: The institution responsible for a country's monetary policy, for issuing currency, for acting as banker to the government and to commercial banks, and for supervising the banking system.
Liquidity preference: Keynes's theory of the demand for money: people's desire to hold wealth in the form of money rather than less liquid assets such as bonds.
B. If prices rise rapidly, money held for even a short time loses purchasing power, so it fails as a store of value. In hyperinflation the other functions eventually fail too, as people refuse to accept the currency and quote prices in a foreign one, but the store of value function is attacked first and most directly.
C. Lender of last resort is a central bank function: it lends to commercial banks facing a shortage of cash, preventing a solvent bank from failing because of a temporary liquidity problem. The other three are retail activities carried out by commercial banks with the public.
B. Higher income allows both more spending and more saving in absolute terms. The proportion saved tends to rise because basic needs absorb a fixed amount, so a greater share of additional income is available to set aside. This is why the marginal propensity to save is generally higher for richer households.
B. At low interest rates holding money costs little in forgone interest, and bond prices are high, so people expect them to fall and prefer to hold money rather than risk a capital loss. The transactions motive depends on income, not the interest rate.
Step 1. Calculate the interest earned. 3% of $4,000 = $120. The account balance after one year is $4,120.
Step 2. Calculate the real interest rate. Real interest rate = nominal rate - inflation = 3% - 5% = -2%.
Step 3. Work out the change in purchasing power. Goods that cost $4,000 at the start of the year cost 5% more by the end, which is $4,200. The household has $4,120, which is $80 short. The savings buy about 2% less than they did, matching the real interest rate.
Step 4. Interpret for household behaviour. The household is worse off despite receiving interest. When the real interest rate is negative, saving loses purchasing power and borrowing becomes cheap in real terms, so households have an incentive to spend or borrow rather than save. This is one channel through which inflation influences the economy.
This is the same real interest rate calculation used in the monetary policy note, applied to a household rather than to policy. The habit worth building is always asking what a rate of return means after inflation, since the money figure alone is misleading.
D, A, C, F, G, E, B
- A customer deposits $1,000 in a bank, and the bank must keep 10% as reserves.
- The bank keeps $100 and lends $900 to a borrower, who spends it.
- The $900 is paid into another bank account, creating a new deposit of $900.
- That bank keeps $90 and lends $810, which is spent and deposited again.
- Each round creates a smaller new deposit, but deposits keep growing.
- The process can continue until total deposits reach the original deposit multiplied by 1 / reserve ratio, here $10,000.
- Broad money has grown by far more than the cash originally deposited, because the new deposits are money created by lending.
The worked calculation, and the reasons the actual expansion is smaller than this maximum, are in the monetary policy note. The point here is that most money is created by commercial banks lending, not printed by the central bank.
The point of drawing it is to see that saving is not money withdrawn from the economy but money redirected: it leaves the household, passes through the banking system and returns as investment. That link is why banks matter to growth and not merely to convenience, and it is the same relationship formalised as the circular flow at A Level.
The flat section is the liquidity trap. At a very low rate everyone expects rates to rise and bond prices to fall, so extra money is simply held, and monetary policy loses its power to reduce interest rates.