Cambridge International AS and A Level Economics: Money, banks and the money supply (9708) – Revision Notes

These notes condense syllabus outcomes 9.4.1 to 9.4.5 (Money and banking) of the Cambridge International AS and A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. Topic 9 is A Level content. For full explanations, read the study guide. Test yourself with the practice set, then check the course hub, the printable checklist and the free 10-minute diagnostics.

All countries, banks and figures are invented for illustration and are not real statistics. Country B uses the sol.

9.4.1 Money

Definition: anything generally accepted as payment for goods and services and for settling debt.

Function	One-line meaning
Medium of exchange	Avoids the double coincidence of wants in barter
Store of value	Purchasing power can be held for later
Unit of account	Prices and debts share one measure
Standard of deferred payment	Future debts are settled in a fixed unit

Characteristics: acceptable, durable, portable, divisible, uniform, limited in supply, hard to forge.

Link to inflation: when prices rise, money loses value as a store of value. If prices rise 4%, 1,040 sol next year buys what 1,000 sol buys now (1,000 × 1.04 = 1,040).

9.4.2 Money supply

Definition: the total amount of money in the economy at a point in time.

• Narrow measure: notes and coins with the public plus demand deposits.
• Broad measure: narrow money plus less liquid deposits such as savings.
• Banks’ own vault cash is not counted.

9.4.3 Quantity theory: MV = PT

Symbol	Meaning
M	Money supply
V	Velocity of circulation
P	Price level
T	Number of transactions (real output sold)

Rearranged: P = MV ÷ T and V = PT ÷ M.

Method in steps

1. Write the identity and the known values.
2. Say which variables you hold constant.
3. Substitute and solve.
4. State the percentage change in P if asked.

Worked reminder. Country B: M = 400, V = 6, T = 1,200. P = (400 × 6) ÷ 1,200 = 2.00. If M rises to 460 with V and T constant, P = (460 × 6) ÷ 1,200 = 2.30, a rise of 15%, equal to the rise in M (60 ÷ 400 = 15%). If T rises 25% to 1,500 instead, with M = 400 and V = 6, P = 2,400 ÷ 1,500 = 1.60, a fall of 20%.

Assumptions needed for the quantity theory: V constant, T constant (full employment or a fixed output), M exogenous. Each can be challenged. V changes with confidence and expected inflation, T rises when there is spare capacity, and M may respond to loan demand.

9.4.4 Commercial banks

Functions

• Deposit accounts: demand deposit (on demand, for payments) and savings (more interest, less liquid).
• Lending: overdrafts (flexible, up to a limit) and loans (fixed sum and term).
• Holding or providing cash, securities, loans, deposits and equity.

Balance sheet identity: assets = liabilities + equity.

Bank Y (million sol)
Assets		Liabilities and equity
Cash and reserves	50	Deposits	500
Securities	175	Equity	125
Loans	400
Total	625	Total	625

• Reserve ratio = cash and reserves ÷ deposits = 50 ÷ 500 = 10%.
• Capital ratio = capital ÷ total assets = 125 ÷ 625 = 20%.

Objectives

Objective	Meaning	Conflict
Liquidity	Can meet withdrawals	Liquid assets earn little
Security	Funds are repaid	Safer lending pays less
Profitability	Earns more than it pays	Profitable loans are least liquid and riskier

Banks balance all three. A bank that chases profit with risky loans risks a run on its deposits.

9.4.5 Changes in the money supply

Credit creation and the bank credit multiplier

Bank credit multiplier = 1 ÷ reserve ratio. Maximum total deposits = initial deposit × multiplier. Maximum credit created = total deposits − initial deposit.

Worked reminder. A new deposit of 800 sol enters a banking system with an 8% reserve ratio. Multiplier = 1 ÷ 0.08 = 12.5. Total deposits = 800 × 12.5 = 10,000. Credit created = 10,000 − 800 = 9,200. If the ratio is 20%, the multiplier is 5 and total deposits are 4,000.

Why the real effect is smaller: people keep some money as cash, banks hold excess reserves, borrowers may not want loans, and capital requirements limit total assets.

Central bank

• Issues notes and coins.
• Banker to the government and to commercial banks.
• Lender of last resort.
• Can change the money supply through reserve and capital requirements and open market operations.

Deficit financing

Who buys the new government bonds	Effect on the money supply
Non-bank public	Little or none at first (existing money is transferred)
Commercial banks	Rises (banks create credit for the government)
Central bank	Rises most: new reserves, then credit multiplier

Quantitative easing (QE)

The central bank creates reserves and buys assets, mostly government bonds, to raise the money supply and lending when policy interest rates are already very low.

Chain: bond purchases raise bond prices, which lowers yields. Banks and sellers gain reserves and deposits, which can lower borrowing costs and raise lending.

Worked reminder. A bond pays 4 sol a year and costs 80, so yield = 4 ÷ 80 = 5%. At a price of 100, yield = 4 ÷ 100 = 4%.

Evaluation: limited if banks hoard reserves or demand for loans is weak. It may raise asset prices more than spending. Possible inflation risk later.

Balance of payments

• Surplus: foreign currency flows in. Under a fixed exchange rate the central bank buys it with domestic currency, so reserves and the money supply rise.
• Deficit: the central bank sells foreign currency, so domestic money leaves circulation and the money supply falls.
• The central bank can sterilise by selling bonds to offset the change.
• Under a floating rate the exchange rate adjusts, so the effect on the money supply is smaller.

Worked reminder. Net inflow 30 million units of foreign currency at a fixed rate of 4.00 sol per unit. The central bank pays 30 × 4.00 = 120 million sol. At a 10% reserve ratio, deposits can rise by up to 120 ÷ 0.10 = 1,200.

Must-know distinctions

• Money supply versus the monetary base: the second is cash and bank reserves, and it supports the first through the multiplier.
• QE versus deficit financing by the central bank: QE buys existing assets in the market. In deficit financing, the central bank funds new government borrowing directly.
• Reserve ratio versus capital ratio: the first is a share of deposits, the second a share of assets.
• Identity versus theory: MV = PT always holds. The quantity theory needs V and T constant.

Quick self-test

1. State two functions of money.
2. M = 500, V = 4, T = 1,000. Find P.
3. Using question 2, find P if M rises to 575.
4. A bank has cash of 36 and deposits of 360. Find its reserve ratio.
5. A bank has equity of 60 and assets of 480. Find its capital ratio.
6. Find the credit multiplier for a 25% reserve ratio.
7. A new deposit of 600 enters a system with a 25% ratio. Find the maximum credit created.
8. A bond paying 3 a year rises in price from 60 to 75. Find the change in yield.
9. Name the objective that conflicts with liquidity.
10. Which method of deficit financing has the largest effect on the money supply?

Answers

1. Any two of medium of exchange, store of value, unit of account, standard of deferred payment.
2. P = (500 × 4) ÷ 1,000 = 2.00.
3. P = (575 × 4) ÷ 1,000 = 2.30, a 15% rise.
4. 36 ÷ 360 = 10%.
5. 60 ÷ 480 = 12.5%.
6. 1 ÷ 0.25 = 4.
7. Total = 600 × 4 = 2,400. Credit created = 2,400 − 600 = 1,800.
8. Yield falls from 3 ÷ 60 = 5% to 3 ÷ 75 = 4%, a fall of 1 percentage point.
9. Profitability (liquid assets earn less than loans).
10. Sale of bonds to the central bank.

Where marks are usually lost

• Defining money by one function only, usually as a medium of exchange.
• Leaving out the units or saying “percentage” when the change is in percentage points.
• Using the multiplier formula without saying that the result is a maximum.
• Mixing up the reserve ratio (cash over deposits) and the capital ratio (capital over assets).
• Using 1 ÷ reserve ratio to find extra credit but forgetting to subtract the initial deposit.
• Describing QE as “printing money” with no chain from bond purchases to yields, lending and spending.
• Stating that a payments surplus raises the money supply without saying that this needs a fixed exchange rate or central bank intervention.
• Listing a conclusion on evaluation questions without a judgement tied to conditions, such as spare capacity or bank willingness to lend.

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), outcomes 9.4.1 to 9.4.5.