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

This guide covers 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. It is macroeconomics content. The specification labels none of it as a separate stage. All figures are invented: Country A, Country B and the small banks and firms below are illustrative, not real statistics.

Pair it with the revision notes and the practice questions. Use the OCR Economics hub, the checklist and the free diagnostics to find gaps. For how a central bank uses interest rates, see the monetary policy guide.

What the specification asks for

Outcome	Where in this guide
Explain the functions of money	Section 1
Explain the characteristics of money	Section 1
Explain what is meant by the money supply	Section 2
Distinguish between narrow and broad money in terms of liquidity	Section 2
Explain how banks create money both in theory and in practice	Section 3
Explain, with a diagram, how the interest rate is determined (liquidity preference and loanable funds)	Section 4
Explain the relationship between the inflation rate and the nominal interest rate	Section 5
Explain the relationship between the money supply and the price level using the Fisher equation of exchange	Section 6
Evaluate the relevance of the quantity theory of money	Section 7

1. Functions and characteristics of money

Money is whatever people will generally take as payment for goods, services and debts. It has four functions:

• Medium of exchange. Trade no longer needs a double coincidence of wants: a seller can accept money without wanting anything the buyer produces.
• Unit of account. Every good gets one price in the same unit, so values can be compared.
• Store of value. Purchasing power can be held from today until a later date.
• Standard of deferred payment. Debts and contracts can be written in money and settled later.

Why a unit of account saves effort. With barter, every pair of goods needs its own exchange rate. For n goods that is n(n − 1)/2 rates. In a market with 8 goods there are 8 × 7 / 2 = 28 rates. With 40 goods there are 40 × 39 / 2 = 780. Once money is the common unit, each good needs just one price: 8 prices for 8 goods, 40 for 40.

Why a store of value is never perfect. Suppose a household keeps 2,000 units of money under a mattress for 4 years while prices rise 3% a year. Its purchasing power in today’s prices is 2,000 / 1.03⁴ = 1,777 units, a loss of 223. High inflation weakens this function.

Characteristics. Good money is:

• acceptable: people trust that others will take it
• durable: it survives repeated use
• portable: it is easy to carry or transfer
• divisible: it can match large and small purchases
• uniform: one unit is the same as any other
• scarce enough to hold value: if anyone could produce it freely, it would lose value.

Link each characteristic to a function. Acceptability and divisibility serve the medium of exchange. Durability and scarcity serve the store of value. Perishable fruit fails on durability. A rare gemstone fails on divisibility and uniformity.

2. The money supply: narrow and broad

The money supply is the stock of money in an economy at a point in time. It counts money held by the public and firms, not cash in a bank’s own tills. Liquidity is how quickly and cheaply an asset can be turned into spending power without losing value. Narrow money consists of the most liquid forms: notes and coins in public hands, plus any deposit that can be spent immediately. Broad money adds less liquid deposits, such as savings and time deposits. The exact list of components differs between countries, so use the definitions given in a question.

Country A (illustrative, m units)	Amount
Notes and coins held by the public	30
Current account (sight) deposits	170
Savings deposits	410
Time deposits	140

Narrow money = 30 + 170 = 200. Broad money = 200 + 410 + 140 = 750. Narrow money is 200 / 750 = 26.7% of broad money.

Now suppose households move 60 from current accounts to savings accounts. Narrow money falls to 140. Broad money stays at 750, because the deposits are still in the system.

3. How banks create money

In theory. Banks keep only a fraction of deposits as reserves, because depositors do not all withdraw at once. They lend the rest, and the loans end up as new deposits. The maximum credit multiplier is 1 / reserve ratio.

Worked example. Households pay 750 units of cash into Bank A. The reserve ratio is 15% and every loan is redeposited in full.

Round	New deposit	Reserves kept	Lent out
1	750.00	112.50	637.50
2	637.50	95.63	541.88
3	541.88	81.28	460.59
4	460.59	69.09	391.50

Each round is 85% of the last. Maximum total deposits = 750 / 0.15 = 5,000. Credit created = 5,000 − 750 = 4,250. The multiplier is 1 / 0.15 = 6.67.

Leakages. Suppose people also withdraw 10% of each new deposit as cash and do not redeposit it. Each round now leaks 15% + 10% = 25%. The limit is 750 / 0.25 = 3,000 and credit created is 2,250.

In practice. The textbook story starts with a deposit and ends with loans. Modern banks usually do the reverse.

• A bank agrees a loan and credits the borrower’s account. The loan is a new asset and the deposit is a new liability, so both sides of the balance sheet grow together. No one has to deposit cash first.
• The bank then checks its reserves. Take a bank with reserves of 90 against deposits of 600, a ratio of 15%. It lends 100. Deposits rise to 700, so the ratio is 90 / 700 = 12.9%. To restore 15% it needs 105 of reserves, a shortfall of 15 to find elsewhere.
• So the limit is set by demand from creditworthy borrowers, the bank’s willingness to lend, and its capital and liquidity requirements. A fixed reserve ratio is not the binding constraint the theory suggests.
• Repayment of loans destroys money, so the money supply can shrink as well as grow.

Evaluation. The theory explains why the multiplier is a maximum. The practical view explains why the money supply can respond to the demand for credit. This matters in Section 7: if money follows spending, money may not cause the price level to change.

4. How the interest rate is determined

Liquidity preference theory

This is a theory of the money market. The interest rate is the price of holding money in a form that earns nothing. People demand money for transactions, as a precaution and for speculation, so the demand for money falls as the interest rate rises. The central bank sets the money supply, so it is vertical.

Interest rate (r)
 |\                 | Ms
 | \                |
 |  \               |
r*+---\-------------+   Equilibrium where Md = Ms
 |     \ Md         |
 +------------------+---- Quantity of money

Take Md = 300 − 20r and Ms = 220, with r in per cent. Equilibrium: 300 − 20r = 220, so r = 4%. If the money supply rises to 260, then 300 − 20r = 260 and r = 2%. If incomes rise and demand shifts to Md = 340 − 20r, then with Ms = 220 the rate is 6%.

Mechanism. At a rate above equilibrium, people hold more money than they want. They buy bonds, so bond prices rise and yields fall until the two match. A bond with a fixed payment of 5 a year and a price of 100 yields 5%. At a price of 125 its yield is 5 / 125 = 4%. At 80 it is 6.25%.

Loanable funds theory

This is a theory of the market for saving and borrowing. The supply of loanable funds comes from saving. The demand comes from firms, households and governments that borrow. A higher rate rewards saving and discourages borrowing.

Rate (%)	Funds supplied (Qs = 40 + 8r)	Funds demanded (Qd = 120 − 12r)
3	64	84
4	72	72
5	80	60

Equilibrium is 4% with 72 units of funds lent. If saving rises, supply becomes Qs = 56 + 8r. Then 56 + 8r = 120 − 12r gives r = 3.2% and funds of 81.6. If business confidence falls and demand becomes Qd = 100 − 12r, then r = 3% and funds of 64.

Comparing the theories

	Liquidity preference	Loanable funds
Market	Stock of money	Flow of saving and borrowing
Supply	Set by the central bank	Saving
Demand	Money held	Borrowing
Best for	Short-run rate movements	Longer-run link to saving and investment

Evaluation: in practice a central bank sets a policy rate and markets follow it, so neither diagram alone is a full account.

5. Inflation and the nominal interest rate

The nominal interest rate is the rate quoted. The real interest rate adjusts for inflation: real ≈ nominal − inflation. The exact link is (1 + real) = (1 + nominal) / (1 + inflation).

Worked example. Nominal rate 6%, inflation 4%. Approximate real rate = 2%. Exact real rate = 1.06 / 1.04 − 1 = 1.92%.

A saver puts 10,000 in an account at 3% and inflation is 5%. After a year she has 10,300, which buys 10,300 / 1.05 = 9,810 in today’s prices. The real rate is 1.03 / 1.05 − 1 = −1.9%, so she is worse off by 190 in real terms.

A lender who expects 4% inflation and wants a 3% real return needs a nominal rate near 7%. Exact: 1.03 × 1.04 − 1 = 7.12%. Higher expected inflation therefore pushes nominal rates up. This is often called the Fisher effect.

Borrowers gain when inflation is higher than expected. A loan fixed at 7% with inflation of 9% has a real rate of 1.07 / 1.09 − 1 = −1.8%.

Evaluation. Lenders set rates using expected inflation, not actual inflation. Nominal rates do not always move one for one with it, because policy, risk and saving matter too.

6. The Fisher equation of exchange

MV = PT, where M is the quantity of money, V is velocity (how often the average unit of money changes hands in the period), P the price level and T the volume of transactions. It is an identity: total spending equals the value of what is sold.

Worked example. M = 450, V = 6 and T = 900. Then P = MV / T = 450 × 6 / 900 = 3.00. If M rises 10% to 495 with V and T unchanged, P = 495 × 6 / 900 = 3.30, a rise of 10%.

In growth rates, % change in M + % change in V ≈ % change in P + % change in T. Suppose M rises 8%, V falls 2% and T rises 3%. Then P rises by about 8 − 2 − 3 = 3%. Exactly: 1.08 × 0.98 / 1.03 − 1 = 2.76%.

7. Evaluating the quantity theory

The quantity theory of money turns the identity into a theory. It assumes V is stable and T is fixed at full capacity, so P changes in proportion to M. Monetarists use it to argue that excessive money growth causes inflation.

For:

• Over long periods, faster money growth tends to go with higher inflation.
• It points to a clear policy: control money growth to control inflation.

Against:

• V is not constant. If M rises 10%, V falls 6% and T rises 2%, then P rises only 1.4% (1.10 × 0.94 / 1.02 − 1).
• T is not fixed. With spare capacity, extra spending can raise output.
• Causation may run from spending to money, since banks lend in response to demand.
• Inflation can be cost-push, so money need not be the cause.

Judgement. The theory is most relevant over longer periods and at high inflation. It is least reliable in the short run and when there is spare capacity.

Common errors

• Counting a bank’s own cash holdings in the money supply.
• Treating the multiplier as an actual result. It is a maximum.
• Drawing the money supply as upward sloping in liquidity preference theory.
• Calling MV = PT a theory. It is true by definition and only becomes a theory once V and T are assumed constant.

Official syllabus

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