Money, the quantity theory and commercial banks
Money, the quantity theory and commercial banks: build the core model, apply it to evidence and qualify conclusions where outcomes depend on context.
9708 section 9.4; A Level. Checked against Cambridge's 2026–2028 Version 2 (latest version published December 2025) and 2029 Version 1 (published September 2026). Cambridge states that neither version has significant changes affecting teaching. Always follow the syllabus for the candidate's examination year.
Before you begin
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
Which combination lists the four conventional functions of money?
What you will learn
- Explain money’s functions, characteristics and money supply
- Apply MV = PT with its assumptions
- Analyse commercial-bank functions and balance-sheet constraints
- Explain reserve and capital ratios
Core model and terms
Money commonly acts as a medium of exchange, unit of account, store of value and standard of deferred payment. It is more useful when accepted, portable, divisible, durable and scarce relative to demand. The money supply is the stock of money defined by a stated measure. The quantity equation MV = PT relates money, velocity, prices and transactions; if velocity and real transactions are fixed, a percentage increase in M produces a similar percentage increase in P, but those assumptions may not hold in the short run.
Apply and evaluate
Commercial banks provide demand and savings deposits, lend through loans and overdrafts, and hold assets such as cash and securities against deposits, equity and other liabilities. They balance liquidity, security and profitability. Reserve and capital ratios constrain lending and help protect against withdrawals and losses. A simple reserve-ratio multiplier illustrates possible deposit expansion, not a guaranteed amount: banks’ capital, risk, regulation and customers’ demand for credit also matter.
Pause and explain
Which statement best applies money, the quantity theory and commercial banks?
Worked example
In MV = PT, money supply rises from $500bn to $550bn while velocity and real transactions stay fixed. Find the implied price level if the initial level is 100.
Show the worked solution
- Initial MV = 500V = 100T
- Money rises by 10% while V and T are fixed
- P rises by 10% to 110 in this simplified quantity-theory case
Answer Initial MV = 500V = 100T → Money rises by 10% while V and T are fixed → P rises by 10% to 110 in this simplified quantity-theory case
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Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
In MV = PT, money supply rises from $500bn to $550bn while velocity and real transactions stay fixed. Find the implied price level if the initial level is 100.
Give me a hint
Rearrange for P and apply the unchanged V and T assumption.
Compare my reasoning
- Initial MV = 500V = 100T
- Money rises by 10% while V and T are fixed
- P rises by 10% to 110 in this simplified quantity-theory case
Initial MV = 500V = 100T Money rises by 10% while V and T are fixed P rises by 10% to 110 in this simplified quantity-theory case
Look for these in your work
- Initial MV = 500V = 100T
- Money rises by 10% while V and T are fixed
- P rises by 10% to 110 in this simplified quantity-theory case
A deposit account lets a buyer pay a seller without bartering goods directly. Which function of money is being used?
Give me a hint
Identify the role that enables exchange.
Compare my reasoning
- The account transfers purchasing power between buyer and seller
- Money is acting as a medium of exchange
- It avoids the need for a double coincidence of wants
The account transfers purchasing power between buyer and seller Money is acting as a medium of exchange It avoids the need for a double coincidence of wants
Look for these in your work
- The account transfers purchasing power between buyer and seller
- Money is acting as a medium of exchange
- It avoids the need for a double coincidence of wants
A bank receives a new cash deposit of $100 and the required reserve ratio is 10%. In the simplified model, calculate the maximum total deposits and possible new lending.
Give me a hint
Use the reciprocal of the reserve ratio, then subtract the original deposit to find expansion beyond it.
Compare my reasoning
- Simple deposit multiplier = 1 ÷ 0.10 = 10
- Maximum total deposits = $100 × 10 = $1,000
- Potential new lending is $900 under the model’s assumptions
Simple deposit multiplier = 1 ÷ 0.10 = 10 Maximum total deposits = $100 × 10 = $1,000 Potential new lending is $900 under the model’s assumptions
Look for these in your work
- Simple deposit multiplier = 1 ÷ 0.10 = 10
- Maximum total deposits = $100 × 10 = $1,000
- Potential new lending is $900 under the model’s assumptions
Why might a bank not lend the full amount suggested by a simple reserve multiplier?
Give me a hint
Consider capital, risk, regulation and borrowers rather than reserves alone.
Compare my reasoning
- The multiplier assumes deposits are re-lent and re-deposited
- Banks may face capital or liquidity limits and weak credit demand
- Actual credit creation can be smaller
The multiplier assumes deposits are re-lent and re-deposited Banks may face capital or liquidity limits and weak credit demand Actual credit creation can be smaller
Look for these in your work
- The multiplier assumes deposits are re-lent and re-deposited
- Banks may face capital or liquidity limits and weak credit demand
- Actual credit creation can be smaller
Common mistakes
- Treating MV = PT as a guaranteed short-run causal law or confusing the simple deposit multiplier with a forecast of actual lending.
What can you explain now?
Which combination lists the four conventional functions of money?
Compare with the explanation
Medium of exchange, unit of account, store of value and standard of deferred payment
Together these explain how money supports transactions, valuation and saving over time.
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Make it stick
Before moving on, explain the central idea in money, the quantity theory and commercial banks and state one condition that could change its effect.
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