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

This guide covers syllabus outcomes 9.4.1 to 9.4.5 (Money and banking) in the Cambridge International AS and A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. Topic 9 is A Level content, so it is not examined at AS. The syllabus says AS content is assumed knowledge for the A Level papers. Outcomes 9.4.6 to 9.4.8 (inflation policies, demand for money, interest rates) are taught in separate pages.

All countries, banks and figures below are invented for illustration. They are not real statistics. Country A uses the kora.

Related pages: the Cambridge A Level Economics hub, the printable checklist, the revision notes, the practice set, the monetary policy guide, the current account guide and the free 10-minute diagnostics.

What this unit covers

Outcome	What you must be able to do
9.4.1	Define money; explain its functions and characteristics
9.4.2	Define the money supply
9.4.3	Use the quantity theory, MV = PT
9.4.4	Explain what commercial banks do: deposits, lending, assets and liabilities, reserve and capital ratios, and the objectives of liquidity, security and profitability
9.4.5	Explain causes of changes in the money supply in an open economy: credit creation and the bank credit multiplier, the central bank, deficit financing, quantitative easing and the balance of payments

9.4.1 Money: definition, functions, characteristics

Money is anything that is generally accepted as payment for goods and services and as settlement of debt. Notes, coins and bank deposits are money in most countries.

Functions

• Medium of exchange: it removes the need for a double coincidence of wants. Under barter, a baker who wants tools must find a toolmaker who wants bread. With money, the baker sells bread to anyone and buys tools from anyone.
• Store of value: you can hold it now and spend it later.
• Unit of account: prices, wages and debts are stated in one unit, so values can be compared.
• Standard of deferred payment: debts and contracts can be settled in the future in a fixed unit.

Characteristics of good money: acceptable to everyone; durable; portable; divisible into small units; uniform (one unit equals another); limited in supply, so it keeps its value; and hard to forge.

Worked example (store of value). Households in Country A hold 10,000 kora for one year while prices rise 5%. The goods that cost 10,000 kora today cost 10,000 × 1.05 = 10,500 kora next year. So the saving buys what 10,000 ÷ 1.05 = 9,524 kora buys today, a fall in purchasing power of 476 kora. Inflation weakens money as a store of value, and the standard of deferred payment as well, because lenders are repaid in less valuable money.

9.4.2 The money supply

The money supply is the total amount of money in an economy at a point in time. Money held by banks as their own cash is not counted, because it is not circulating among the public. Countries measure it in a narrow and a broad way. A narrow measure covers the most liquid forms, such as notes and coins held by the public and deposits that can be spent on demand. A broad measure adds less liquid deposits, such as savings.

Component (Country A, million kora)	Amount
Notes and coins held by the public	40
Demand deposits (current accounts)	260
Savings deposits	380

Narrow money = 40 + 260 = 300. Broad money = 300 + 380 = 680. Moving funds from savings to current accounts leaves broad money unchanged and raises narrow money.

9.4.3 The quantity theory of money: MV = PT

M is the money supply, V the velocity of circulation (the average number of times a unit of money is spent in the period), P the average price level and T the number of transactions (a measure of real output sold). MV = PT is an identity: total spending equals the value of transactions. It becomes the quantity theory when V and T are assumed constant, so that P changes in proportion to M.

Worked example. In Country A, M = 600 million kora, T = 1,500 million transactions and P = 2.00 kora. Then V = PT ÷ M = (2.00 × 1,500) ÷ 600 = 5.

1. M rises 20% to 720, with V = 5 and T = 1,500. P = (720 × 5) ÷ 1,500 = 2.40. The price level rises 20%, the same as M.
2. Now M stays at 600 but T rises to 1,800 because firms use spare capacity. P = (600 × 5) ÷ 1,800 = 1.67. Prices fall 16.7%.

Evaluation. The theory predicts that money growing faster than output causes inflation. Weaknesses:

• V is not constant. It falls when people hoard money in uncertain times and rises when they expect inflation.
• T is not fixed. With spare capacity, extra money can raise output instead of prices.
• The money supply may be driven by demand for loans, so causation can run from spending to money, not only the other way.
• There are time lags between M and P.

9.4.4 Commercial banks

Functions. A commercial bank:

• provides deposit accounts: a demand deposit account (withdrawable on demand, used for payments) and a savings account (usually pays more interest, may need notice);
• lends money: overdrafts (flexible borrowing up to a limit, repayable on demand) and loans (fixed sum, fixed term);
• holds or provides cash, securities, loans, deposits and equity (the items on its balance sheet).

The balance sheet. Assets are what the bank owns or is owed. Liabilities are what it owes, including deposits, which are owed to depositors. Equity (capital) is owners’ funds, and assets = liabilities + equity.

Bank X (million kora)
Assets		Liabilities and equity
Cash and reserves	88	Demand deposits	520
Securities	212	Savings deposits	360
Loans	700	Equity	120
Total	1,000	Total	1,000

Reserve ratio = cash and reserves ÷ deposits = 88 ÷ 880 = 10%. Capital ratio = capital ÷ total assets = 120 ÷ 1,000 = 12%. (Regulators often weight assets by risk. That step is beyond this outcome, so the guide uses total assets.) Liquid assets (cash plus securities) are 300, which is 30% of assets.

Objectives. Banks pursue three objectives that conflict:

• Liquidity: being able to pay depositors on demand. Cash is perfectly liquid but earns nothing.
• Security: lending safely so that borrowers repay. Safe lending earns a lower interest rate.
• Profitability: earning more from lending than it pays on deposits. Loans are the most profitable and least liquid assets.

A bank therefore holds a spread of cash, quick-to-sell securities and loans.

Why the capital ratio matters. With equity of 120 and a required ratio of 10%, Bank X can hold assets up to 120 ÷ 0.10 = 1,200, so 200 more of lending is possible. If the requirement rises to 15%, the limit becomes 120 ÷ 0.15 = 800. Bank X must then cut assets by 200 or raise equity. Higher requirements make banks safer but restrict lending.

9.4.5 Causes of changes in the money supply

Commercial banks and the bank credit multiplier

When a bank lends, it creates a deposit. Because only a fraction of deposits is needed in reserve, one new deposit supports many times its value in deposits.

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

Worked example. A customer pays 1,000 kora of new cash into a bank. The reserve ratio is 10%.

Round	New deposit	Kept as reserve	Lent out
1	1,000.00	100.00	900.00
2	900.00	90.00	810.00
3	810.00	81.00	729.00
4	729.00	72.90	656.10

The deposits continue to shrink in a geometric series. Total deposits = 1,000 ÷ 0.10 = 10,000, so credit created = 10,000 − 1,000 = 9,000. At a 20% ratio the total is 1,000 ÷ 0.20 = 5,000.

Limits. The figure is a maximum. If banks keep 15% in practice, not 10%, the total is 1,000 ÷ 0.15 = 6,667. People holding cash instead of redepositing it, weak demand for loans and the capital ratio all reduce it.

The role of the central bank

A central bank issues notes and coins, acts as banker to the government and to commercial banks, and acts as lender of last resort to banks short of liquidity. It can change the money supply by setting reserve or capital requirements, by buying or selling government bonds (open market operations), and by changing the rate at which it lends to banks.

Government deficit financing

A government with a budget deficit borrows. The effect on the money supply depends on the lender. For a deficit of 600 million kora:

• Bonds bought by the non-bank public: money moves from savers to the government and then to those who receive government spending. The money supply is unchanged at the start.
• Bonds bought by commercial banks: the banks create credit for the government. When it spends, deposits rise by 600, so the money supply rises.
• Bonds bought by the central bank: new reserves are created. When the government spends, the banks’ reserves rise by 600, and at a 10% reserve ratio deposits can rise by up to 600 ÷ 0.10 = 6,000. This is the largest effect, and it is the one most associated with inflation.

Quantitative easing

In quantitative easing (QE), the central bank creates reserves electronically and buys assets, usually government bonds, from banks or other investors. It aims to raise the money supply and lending when interest rates are already very low.

Worked example. A bond pays a fixed 5 kora a year and its price is 100, so its yield is 5 ÷ 100 = 5%. Large central bank purchases raise the price to 125. The yield is now 5 ÷ 125 = 4%. If the central bank buys 200 million kora of bonds from a pension fund, the fund’s deposit rises 200 and the fund’s bank gains 200 of reserves.

Evaluation. QE works if banks lend the extra reserves and households and firms borrow. It is weaker if banks hoard reserves, if demand for loans is low, or if asset prices rise and benefit mainly asset owners. QE may also raise inflation later if the extra money continues to circulate once spare capacity is used.

Changes in the balance of payments

In an open economy, a balance of payments surplus brings in foreign currency. Suppose the central bank keeps the exchange rate fixed at 2.00 kora per unit of foreign currency (call it the dalo) and net inflows are 50 million dalos. It buys them and pays 50 × 2.00 = 100 million kora. Banks’ reserves rise 100, which can support deposits of up to 100 ÷ 0.10 = 1,000. A deficit does the opposite: the central bank sells foreign currency and takes kora out of circulation.

The central bank can sterilise the inflow by selling 100 million kora of bonds, which removes the reserves it created. With a floating exchange rate the currency appreciates and the central bank does not need to buy foreign currency, so the money supply is less affected.

Common errors

• Writing that banks lend out “customers’ money” one for one. Say that lending creates new deposits.
• Using 1 ÷ reserve ratio without calling it a maximum.
• Treating MV = PT as proof of causation. It is an identity until V and T are assumed constant.
• Counting a bank’s own cash holdings as part of the money supply.
• Giving one deficit-financing outcome without saying who buys the bonds.

Next steps

Test yourself with the practice set and condense the unit with the revision notes. Run the diagnostics to find weak spots.

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.