Cambridge A Level Economics: Controlling inflation, demand for money and interest rate determination (9708) – Revision Notes

Condensed notes for outcomes 9.4.6 to 9.4.8 (policies to reduce inflation, liquidity preference theory, and loanable funds and Keynesian theories of interest rate determination) in the Cambridge International AS and A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. These outcomes are in topic 9, which is A Level content and not examined at AS. All figures are invented.

For full explanations, read the study guide. Then try the practice set, tick off the checklist, see the course hub and take the free 10-minute diagnostics to find weak spots.

9.4.6 Policies to reduce inflation

Policy	Mechanism	Shifts	Best against
Higher taxes or lower government spending	Less disposable income or injection; multiplier	AD left	Demand-pull
Higher interest rates, slower money growth, tighter credit rules	Dearer borrowing; investment and durable spending fall; saving rises	AD left	Demand-pull
Supply-side measures (training, infrastructure, technology)	Productivity up, unit costs down	LRAS and SRAS right	Cost-push and long-run pressure
Currency appreciation	Imported inputs cheaper; net exports fall	SRAS right, AD left	Imported cost-push

Key formulas:

• Inflation rate = (new index ÷ old index − 1) × 100
• Multiplier = 1 ÷ marginal propensity to withdraw
• Change in AD = initial change × multiplier
• Real interest rate ≈ nominal rate − inflation rate
• Unit labour cost change ≈ (1 + wage growth) ÷ (1 + productivity growth) − 1

Method in steps for a policy question

1. Identify the cause of inflation in the case: demand-pull, cost-push or both.
2. Choose the policy that attacks that cause and say which curve shifts.
3. Trace the chain: first effect, second effect, change in the price level and real output.
4. Evaluate: time lags, spare capacity, size of effect, side effects, expectations, global factors.
5. Make a judgement: which policy, in this case, and why.

Small reminder. Spending cut of 12 cu, multiplier 2: AD falls by 24 cu. A currency that rises from 0.50 to 0.60 foreign units per cu cuts the home price of a 30 fu import from 60 cu to 50 cu, a fall of 16.7%.

Evaluation checklist

• Cause: AD cuts are weak against cost shocks.
• Spare capacity: a flat SRAS means output falls more than prices.
• Lags: supply-side policy is slowest, and it is the policy with a lasting effect.
• Side effects: unemployment, slower growth, weaker exports, higher deficit.
• Credibility: expectations of low inflation make wage and price restraint easier.
• Global: imported inflation is beyond national control.

9.4.7 Demand for money: liquidity preference

Motive	Depends on	Slope
Transactions	Income and price level	Not interest-sensitive in the basic model
Precautionary	Income	Not interest-sensitive in the basic model
Speculative	Interest rate (negative)	Downward-sloping

• Bond price (perpetual bond) = coupon ÷ interest rate. Price and rate move in opposite directions.
• High rate: low bond price, expect a rise in price, buy bonds, hold less money.
• Low rate: high bond price, expect a fall in price, hold money.
• Curve L slopes down against the interest rate. A rise in income or the price level shifts it right.
• Liquidity trap: at a very low rate the curve is horizontal, extra money is held, and the rate cannot fall further.

Small reminder. A bond paying 9 cu a year: at 6% it costs 150 cu, and at 10% it costs 90 cu. The 60 cu fall is 40% of the starting price.

9.4.8 Interest rate determination

	Loanable funds	Keynesian
Market	Funds: saving, investment, borrowing	Money: supply and liquidity preference
Demand side	Firms, households, government borrowing	Demand for money, L
Supply side	Saving, foreign savings	Ms, vertical, set by the central bank
Rate set where	Demand for funds = supply of funds	Demand for money = Ms
More saving	Supply shifts right, rate falls	No direct effect
Bigger deficit	Demand shifts right, rate rises (crowding out)	Works through the money market only if it changes L or Ms

Sketch of the Keynesian diagram, in words: the horizontal axis is the quantity of money, the vertical axis is the interest rate. Ms is a vertical line. L slopes down. They cross at the equilibrium rate. A rise in Ms shifts the vertical line right and the rate falls. A rise in income shifts L right and the rate rises.

Sketch of the loanable funds diagram: the horizontal axis is the quantity of loanable funds, the vertical axis is the interest rate. Demand slopes down, supply slopes up, and they cross at the equilibrium rate and quantity.

Evaluation: the two theories are not rivals in every case. A central bank that sets the policy rate directly makes the money supply endogenous in practice. Rates differ by risk and term. Expectations of inflation affect both.

Chains of reasoning to rehearse

Interest rate rise to lower inflation. Policy rate up, so borrowing is dearer and saving more rewarding. Investment and consumer spending on credit fall. AD shifts left and the multiplier amplifies the fall. Real output growth slows and the price level rises more slowly. The effect arrives after a lag, and it is weaker if firms and households are not sensitive to the rate.

Expansion of the money supply in the Keynesian model. Ms shifts right, so there is excess money at the old rate. People buy bonds, bond prices rise, and the interest rate falls. Investment rises, AD shifts right and the multiplier operates. In a liquidity trap the chain stops at the second step.

Government deficit in loanable funds. The government borrows more, so demand for funds shifts right and the rate rises. Some private investment is crowded out, and the net effect on AD is smaller than the size of the deficit suggests.

Supply-side policy against inflation. Training and infrastructure raise productivity. Unit costs fall, SRAS and LRAS shift right, the price level falls relative to the baseline and real output rises. The benefit is lasting but slow, and the policy costs money.

Worked reminder (loanable funds). Demand 80 − 5r, supply 20 + 5r. Then 60 = 10r, so r = 6% and the quantity is 50. If the supply rises by 10 at every rate, 80 − 5r = 30 + 5r gives r = 5% and the quantity is 55.

Must-know distinctions

• Price level versus inflation rate: a lower rate of inflation is disinflation, and prices are still rising.
• Nominal versus real interest rate.
• Bond price versus bond yield.
• Movement along L (interest rate changes) versus shift of L (income or price level changes).
• Money market (a stock) versus market for loanable funds (a flow).

Quick self-test

1. The government of Country X cuts spending by 10 cu and the multiplier is 2. What is the change in AD?
2. A saver earns a nominal rate of 6% and inflation is 2.5%. What is the approximate real rate?
3. A bond pays 4 cu a year. What is its price at a market rate of 5%, and at 8%?
4. Name the three Keynesian motives for holding money.
5. Demand for money is 150 − 10r and Ms is 90. Find r. Then find r when Ms rises to 110.
6. Demand for loanable funds is 120 − 10r and supply is 30 + 5r. Find r and the quantity.
7. Supply in question 6 shifts to 45 + 5r. Find the new r and quantity.
8. Prices rise from 105 to 111.3 on an index. What is the inflation rate?
9. Why is a cut in AD a weak response to cost-push inflation?
10. Define the liquidity trap.

Answers

1. 10 × 2 = a fall of 20 cu.
2. 6 − 2.5 = 3.5%.
3. 4 ÷ 0.05 = 80 cu; 4 ÷ 0.08 = 50 cu.
4. Transactions, precautionary, speculative.
5. 150 − 10r = 90 gives r = 6%. With Ms 110: 150 − 10r = 110 gives r = 4%.
6. 120 − 10r = 30 + 5r gives 90 = 15r, so r = 6% and the quantity is 60.
7. 120 − 10r = 45 + 5r gives 75 = 15r, so r = 5% and the quantity is 70.
8. (111.3 ÷ 105 − 1) × 100 = 6.0%.
9. The cause is higher costs, so the SRAS shift is left. Lower AD reduces output and employment while the price effect is small and slow, and costs are unaffected.
10. A situation in which the interest rate is so low that the demand for money is perfectly elastic, so extra money is held and the rate cannot fall further.

Where marks are usually lost

• Naming a policy without saying which curve shifts, in which direction.
• Applying demand-side policy to a cost-push case without comment.
• Evaluating with a list of generic points and no link to the case.
• Writing that the bond price rises when the interest rate rises.
• Confusing a movement along the demand for money curve with a shift.
• Treating the money supply as responsive to the interest rate in a Keynesian diagram.
• Quoting nominal interest rates in an argument about real borrowing costs.
• Leaving out units, or stating a percentage change without the base.
• Describing loanable funds and liquidity preference as the same theory.

Official syllabus

Cambridge International AS & A Level Economics 9708, syllabus for examination in 2026, 2027 and 2028, published by Cambridge University Press & Assessment (Cambridge International Education), section 9.4, outcomes 9.4.6 to 9.4.8. Topic 9 is A Level content.