OCR A Level Economics: Money, banks and the determination of interest rates (H460) – Revision Notes

These notes condense the money outcomes in the role of the financial sector topic of the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. The specification labels none of this macroeconomics content as a separate stage. For full explanations and worked examples, use the study guide. Test yourself with the practice questions, then check the OCR Economics hub, the checklist and the free diagnostics. All figures here are invented.

Money in one page

Item	Key points
Functions	Medium of exchange; unit of account; store of value; standard of deferred payment
Characteristics	Acceptable, durable, portable, divisible, uniform, limited in supply
Money supply	Stock of money held by the public and firms at a point in time. A bank’s own till cash is not counted
Liquidity	How quickly and cheaply an asset becomes spending power without losing value
Narrow money	Most liquid: notes and coins held by the public plus deposits spendable on demand
Broad money	Narrow money plus less liquid deposits such as savings and time deposits

Match each characteristic to a function. Acceptable and divisible serve exchange. Durable and limited supply serve a store of value. Uniform units serve the unit of account.

Barter arithmetic. Rates needed = n(n − 1)/2. For 9 goods that is 36 rates. With money there are 9 prices.

Narrow and broad. Notes and coins 25, current accounts 95, savings 210, time deposits 70. Narrow = 25 + 95 = 120. Broad = 120 + 210 + 70 = 400. Moving 40 from current to savings: narrow 80, broad 400.

Formulas

Result	Formula
Bank credit multiplier (maximum)	1 / reserve ratio
Maximum total deposits	Initial deposit / reserve ratio
Credit created	Maximum deposits − initial deposit
Multiplier with cash drain	1 / (reserve ratio + cash drain ratio)
Real interest rate (approximate)	Nominal rate − inflation rate
Real interest rate (exact)	(1 + nominal) / (1 + inflation) − 1
Nominal rate needed	(1 + real) × (1 + expected inflation) − 1
Fisher equation of exchange	MV = PT
Price level	P = MV / T
Velocity	V = PT / M
Growth form	%ΔM + %ΔV ≈ %ΔP + %ΔT
Bond yield	Annual payment / price × 100

Method: bank credit creation

1. Write the reserve ratio as a decimal.
2. Maximum total deposits = initial deposit / ratio.
3. Credit created = total minus the initial deposit.
4. If cash is withdrawn and not redeposited, add the drain ratio to the reserve ratio before dividing.
5. State that this is a maximum.

Reminder. New deposit 500, reserve ratio 20%. Maximum deposits = 500 / 0.20 = 2,500. Credit created = 2,000. Multiplier = 5.

Theory versus practice.

	Theory	Practice
Starting point	A deposit arrives	A loan is agreed and a deposit is credited
Constraint	Reserve ratio	Demand for loans from creditworthy borrowers, bank willingness to lend, capital and liquidity requirements
Direction	Money supply set by reserves	Money supply responds to demand for credit
Repayment	Not considered	Repaying a loan removes a deposit, so money is destroyed

Interest rate determination

Liquidity preference theory (money market).

• Money demand slopes downward: a higher rate raises the opportunity cost of holding money.
• Money supply is vertical, set by the central bank.
• Axes: interest rate on the vertical axis, quantity of money on the horizontal axis.
• Increase in money supply: supply shifts right, rate falls.
• Increase in income or spending: demand shifts right, rate rises.
• Adjustment: excess money is used to buy bonds, bond prices rise and yields fall.

Loanable funds theory (saving and borrowing).

• Supply of funds slopes upward: it comes from saving.
• Demand for funds slopes downward: it comes from borrowers.
• Higher saving: supply shifts right, rate falls, more funds lent.
• Higher business confidence: demand shifts right, rate rises, more funds lent.

Reminder numbers. Liquidity preference with Md = 200 − 10r and Ms = 120: r = 8%. With Ms = 150: r = 5%. Loanable funds with Qs = 20 + 5r and Qd = 110 − 10r: 15r = 90, so r = 6% and funds are 50.

Bond reminder. A bond paying 6 a year at a price of 120 yields 5%. At a price of 75 it yields 8%. Price and yield move in opposite directions.

Distinctions.

	Liquidity preference	Loanable funds
Market	Stock of money	Flow of saving and borrowing
Supply	Central bank	Saving
Demand	Money held	Borrowing
Emphasis	Short run	Link to saving and investment

Diagram checklist

Draw both interest rate diagrams with the interest rate on the vertical axis.

Event	Liquidity preference diagram	Result
Central bank raises money supply	Ms shifts right	Rate falls
Central bank cuts money supply	Ms shifts left	Rate rises
Incomes and spending rise	Md shifts right	Rate rises
Greater caution about spending	Md shifts left	Rate falls

Event	Loanable funds diagram	Result
Households save more	Supply shifts right	Rate falls, more funds lent
Firms become more pessimistic	Demand shifts left	Rate falls, fewer funds lent
Firms become more optimistic	Demand shifts right	Rate rises, more funds lent

Always label both axes, both curves, the original and new equilibrium and the arrow showing the direction of the shift.

Inflation and the nominal interest rate

• Nominal rate: the quoted rate. Real rate: adjusted for inflation.
• Reminder: nominal 9%, inflation 6%. Approximate real = 3%. Exact = 1.09 / 1.06 − 1 = 2.83%.
• Savers lose in real terms when inflation exceeds the nominal rate. Borrowers gain when inflation is higher than expected when the loan was agreed.
• Lenders look at expected inflation. A lender wanting a 2.5% real return with 3% expected inflation needs 1.025 × 1.03 − 1 = 5.6%.
• Higher expected inflation tends to raise nominal rates. This is often called the Fisher effect.
• Evaluate: nominal rates do not always move one for one with expected inflation. Central bank policy, risk and the supply of saving also matter.

The Fisher equation of exchange and the quantity theory

Reminder. M = 60, V = 5, T = 100. P = 60 × 5 / 100 = 3.00. If M rises 10% to 66, P = 3.30. The rise is 10%.

Identity or theory? MV = PT is true by definition. It becomes the quantity theory of money when V and T are assumed constant, so that P changes in proportion to M.

Case for	Case against
Long-run link between faster money growth and higher inflation	V can change, for example when people hold more money in uncertain times
Clear policy implication	T can rise when there is spare capacity
Explains high inflation	Money may follow spending if banks lend on demand
	Inflation can be cost-push

Judgement. Strongest over the long run and at high inflation. Weakest in the short run and when there is spare capacity. Always say which assumption fails and what happens to P as a result.

Quick self-test

1. Among 9 goods, how many separate exchange rates would barter need, and how many prices would a money economy need?
2. M = 60, V = 5 and T = 100. Find P.
3. P = 2.5, T = 400 and M = 200. Find V.
4. A bank holds a 20% reserve ratio. A new cash deposit of 500 is made. Find the maximum credit created.
5. Nominal rate 9%, inflation 6%. Find the exact real rate.
6. A lender wants a 2.5% real return and expects 3% inflation. Find the exact nominal rate.
7. Loanable funds: Qs = 20 + 5r and Qd = 110 − 10r. Find the equilibrium rate and funds lent.
8. Liquidity preference: Md = 200 − 10r. Find the rate when Ms = 120 and when Ms = 150.
9. A bond pays 6 a year. Find the yield at a price of 120 and of 75.
10. Notes and coins 25, current accounts 95, savings 210, time deposits 70. Find narrow and broad money.

Answers

1. 9 × 8 / 2 = 36 rates; 9 prices.
2. P = 60 × 5 / 100 = 3.
3. V = PT / M = 2.5 × 400 / 200 = 5.
4. Maximum deposits = 500 / 0.20 = 2,500, so credit created = 2,000.
5. 1.09 / 1.06 − 1 = 2.83%.
6. 1.025 × 1.03 − 1 = 5.575%, about 5.6%.
7. 20 + 5r = 110 − 10r, so r = 6%; funds = 20 + 30 = 50.
8. 200 − 10r = 120 gives 8%; 200 − 10r = 150 gives 5%.
9. 6 / 120 = 5%; 6 / 75 = 8%.
10. Narrow = 120; broad = 400.

Where marks are usually lost

• Writing “the multiplier is 5” without saying it is a maximum.
• Including a bank’s own cash in the money supply.
• Describing narrow money as “cash only” when it includes spendable deposits.
• Drawing a diagram without labelled axes, the equilibrium rate or the direction of the shift.
• Shifting the wrong curve: an increase in the money supply moves the supply curve, not demand.
• Quoting the nominal rate as if it were the real return.
• Calling the quantity theory proven. It rests on assumptions about V and T, and so test them.
• Giving a list of weaknesses without a judgement about when the theory is more or less relevant.
• Mixing up the two theories: liquidity preference is about money, loanable funds is about saving and borrowing.

Official syllabus

OCR A Level in Economics (H460), Version 3.0 (June 2026), for first assessment in 2021, published by OCR.