Money and interest rates

Welcome to the World of Money!

Hello! Today we are diving into one of the most important parts of Macroeconomics: Money and Interest Rates. This chapter is part of the "Financial Sector" section. Don't worry if you’ve always thought of economics as just "maths and money"—while we do look at those things, it's really about how the whole economy breathes. By the end of these notes, you’ll understand what money actually is (it's more than just paper!), how banks "create" it, and why the price of borrowing it (interest rates) changes. Let’s get started!

1. What is Money? (Functions and Characteristics)

In Economics, money isn't just the coins in your pocket. It is anything that is widely accepted as payment for goods and services.

The Four Functions of Money

To be considered "money," something must do these four jobs:

1. Medium of Exchange: This is the main one! It allows us to trade without needing a "barter system." Instead of trying to swap a chicken for a haircut, you just use money.
2. Unit of Account: It provides a common measure of value. It’s like a yardstick for wealth. It allows you to know that a car is worth more than a chocolate bar.
3. Store of Value: You can keep it and use it in the future without it rotting or disappearing. It holds its "purchasing power."
4. Standard for Deferred Payment: This allows us to buy things now and pay later (debt). It means you can agree to pay a specific amount of "value" in the future.

Characteristics of "Good" Money

Why don't we use ice cubes as money? Because they fail the characteristics test! Good money must be:

• Portable: Easy to carry around.
• Divisible: You can break it into smaller amounts (like change).
• Durable: It doesn't fall apart or rot.
• Limited in Supply (Scarcity): If it grew on trees, it would have no value!
• Acceptable: Everyone agrees it has value.

Quick Review: Money is a tool that solves the "double coincidence of wants" problem in bartering. To work well, it must be easy to carry, hard to fake, and last a long time.

2. Narrow Money vs. Broad Money

Economists categorize money based on Liquidity. Liquidity is just a fancy word for how quickly and easily you can turn an asset into cash to spend it.

Narrow Money (M0)

This is the most liquid form of money. It is mainly notes and coins in circulation and the reserves held by commercial banks at the Central Bank (like the Bank of England). Think of this as the "spending money" currently in the economy's wallet.

Broad Money (M4)

This includes Narrow Money PLUS other assets that aren't quite "cash" yet but can be turned into cash relatively easily. This includes bank deposits (money in your savings account). While you can't hand a "savings account" to a cashier, you can transfer the money to spend it fairly quickly.

Key Takeaway: Narrow money is "physical" cash; Broad money is cash plus the digital numbers in our bank accounts.

3. The Creation and Supply of Money

Did you know that most of the money in the economy isn't printed by the government? It is actually created by commercial banks (like HSBC, Barclays, or Lloyds) when they give out loans.

How it works: The Step-by-Step

1. You deposit £100 into a bank.
2. The bank keeps a small fraction of that as a "reserve."
3. The bank lends the rest to someone else (e.g., £90) to buy a bike.
4. The bike shop owner receives that £90 and puts it back into their bank.
5. Magic! The original £100 still exists in your account, but now there is an additional £90 in the bike shop's account. The "Money Supply" has increased.

The Supply of Money is often considered to be "fixed" or "exogenous" in simple models, meaning the Central Bank controls it. On a diagram, the Money Supply (Ms) curve is usually a vertical line because it doesn't change based on the interest rate—it is decided by the Bank of England.

4. The Fisher Equation of Exchange

Don't let the name scare you! This is a simple way to show the relationship between Money Supply and Prices (Inflation).

The formula is: \( MV = PT \)

• M: Money Supply (The amount of money in the economy).
• V: Velocity of Circulation (How many times a pound note changes hands in a year).
• P: Price Level (The average price of goods).
• T: Transactions (The total number of goods and services bought).

The "Logic" behind it:

Economists often assume that V (speed of spending) and T (number of things to buy) are constant in the short run. Therefore, if the government increases the Money Supply (M), the Price Level (P) must go up.
Analogy: If everyone in the world suddenly had double the money, but we still had the same number of loaves of bread, the price of bread would simply double!

Common Mistake to Avoid: Students often forget that \( PT \) represents the "Nominal GDP" (Total value of everything sold). Make sure you can identify each letter in the equation!

5. How Interest Rates are Determined

Interest rates are the "price" of money. If you want to "buy" (borrow) money, you pay interest. If you "sell" (save) money, you receive interest.

The Demand for Money (Liquidity Preference)

Why do people want to hold cash instead of investing it? Keynes suggested three reasons (The Liquidity Preference Theory):

1. Transactions Motive: To buy your daily coffee and groceries.
2. Precautionary Motive: To have money for "rainy days" or emergencies.
3. Speculative Motive: Holding cash to wait for better investment opportunities (like waiting for house prices to drop before buying).

The Interest Rate Diagram

In the money market:

• The Demand for Money (Md) curve slopes downwards. Why? Because when interest rates are high, people would rather save money in the bank than hold it as cash. When rates are low, the "opportunity cost" of holding cash is low, so demand for money is high.
• The Supply of Money (Ms) is a vertical line (determined by the Central Bank).
• Where they cross is the Equilibrium Interest Rate.

What happens if the Money Supply increases?
If the Central Bank increases the money supply (shifts the vertical Ms line to the right), the interest rate will fall. This is because there is now "too much" money, so its "price" (the interest rate) goes down.

Quick Summary Box

Functions: Medium of exchange, Unit of account, Store of value, Deferred payment.
Fisher Equation: \( MV = PT \). If M goes up, P usually goes up (Inflation).
Liquidity: How fast you can spend an asset. Cash = High liquidity. House = Low liquidity.
Interest Rates: Determined where the Demand for Money (Md) meets the Supply of Money (Ms).

Don't worry if the Fisher Equation feels a bit abstract at first. Just remember the analogy: more money chasing the same amount of goods always leads to higher prices!