HKDSE Economics Practice Paper: Money And Banking

HKDSE Economics Practice Paper: Money and Banking

2026-11-03

HKDSE Economics: Money and Banking

HKDSE Economics practice paper: money and banking, 12 questions, 100 marks, 75 minutes, with answers, marking points and A4 printing.

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Paper details　Level: S6 | Subject: Economics | Time: 75 minutes | Marks: 100 | Questions: 12

Section A (Questions 1 to 4, 30 marks)

Read each question and write the correct answer with an explanation.

#	Question	Answer and marking notes
1	State the four functions of money and identify which function is most seriously damaged during hyperinflation. Explain your answer.	Medium of exchange, unit of account, store of value and standard of deferred payment. The store of value function is most damaged, because prices can multiply within days and the purchasing power of money collapses, so people prefer to hold goods or foreign currency. The standard of deferred payment is also damaged.
2	In a banking system the required reserve ratio is 20 per cent, the public holds no cash, and banks initially hold 50 billion dollars of excess reserves. Find the deposit multiplier, the maximum total deposits and the total amount of new loans.	Deposit multiplier = 1 / 0.2 = 5; maximum total deposits = 50 billion x 5 = 250 billion; new loans = 250 minus 50 = 200 billion, because 50 billion must be kept as required reserves.
3	An economy has these monetary assets: currency held by the public 80 billion, demand deposits 120 billion, savings and time deposits 300 billion, negotiable certificates of deposit 30 billion, and foreign currency deposits 40 billion. Find M1, M2 and M3.	M1 = 80 + 120 = 200 billion; M2 = 200 + 300 + 30 = 530 billion; M3 = 530 + 40 = 570 billion. Foreign currency deposits count only in M3, not in M1 or M2.
4	Assume the quantity theory MV = PY holds, with money supply M of 50 billion, velocity V of 4 and price level P of 2. Find nominal and real output. If M rises by 10 per cent while V and Y stay constant, find the new price level and the inflation rate.	Nominal output = 50 x 4 = 200 billion; real output = 200 / 2 = 100 billion. After M rises by 10 per cent to 55 billion, the price level is 55 x 4 / 100 = 2.2, so the inflation rate is (2.2 / 2 – 1) x 100 per cent = 10 per cent.

Section B (Questions 5 to 8, 32 marks)

Answer the following questions. Show your working and units.

#	Question	Answer and marking notes
5	The central bank sells government bonds in the open market. Explain the effect on bank reserves, the monetary base, the money supply and short term interest rates.	Selling bonds drains reserves from the banking system, so the monetary base falls; through the deposit multiplier the money supply contracts by a multiple; interbank liquidity tightens and short term interest rates rise.
6	What are the effects of a rise in interest rates on depositors, borrowers and business investment? Give one reason for each group.	Depositors earn more interest, though the real return still depends on inflation. Borrowers face higher interest costs and a heavier burden. Business investment falls because the cost of capital rises, with long payback projects hit hardest.
7	Under a fractional reserve banking system, why can a bank with sound assets still fail because of a run? State two preventive measures and explain how each works.	Banks fund long term loans with short term deposits, so the maturity of assets and liabilities is mismatched. If many depositors withdraw at once the bank must sell assets at a discount and can fail from illiquidity even when assets exceed liabilities. Deposit insurance steadies depositor confidence, and a central bank acting as lender of last resort supplies emergency liquidity.
8	The nominal interest rate is 6 per cent and the inflation rate is 4 per cent. Calculate the real interest rate to two decimal places and explain why a depositor may still lose out during inflation.	Real interest rate = (1.06 / 1.04 – 1) x 100 per cent = 1.92 per cent. If interest income is taxed, or if the prices the depositor actually pays rise faster than the general inflation rate, the after tax real rate may be near zero or negative.

Section C (Questions 9 to 12, 38 marks)

Write fuller answers and support them with examples from Hong Kong.

#	Question	Answer and marking notes
9	Hong Kong operates a linked exchange rate system with a convertibility range of 7.75 to 7.85 Hong Kong dollars per US dollar. Explain how the strong side and weak side convertibility undertakings work, and state the constraint this places on interest rate policy in Hong Kong.	When inflows push the rate to 7.75, the Monetary Authority buys US dollars and sells Hong Kong dollars, expanding the monetary base. When outflows push it to 7.85, it sells US dollars and buys Hong Kong dollars, contracting the base. The band is 0.10 wide with a midpoint of 7.80. The constraint is that Hong Kong cannot set interest rates independently and must follow US rates.
10	Compare monetary policy and fiscal policy in terms of inside and outside lags, and explain why the two often need to work together.	Monetary policy is decided by the central bank, so the inside lag is short, but the outside lag from a rate change to investment and output is long. Fiscal policy needs legislative approval, giving a long inside lag, yet once enacted government spending affects aggregate demand directly. The two must work together because a single tool struggles to handle recession and inflation at the same time.
11	The money supply of an economy rises from 80 billion to 88 billion while velocity falls from 5 to 4.75 and real output stays at 200 billion. Find the original and the new price levels, and the inflation rate over the period.	Original price level = 80 x 5 / 200 = 2.0. With money supply of 88 billion and velocity of 4.75, the price level is 88 x 4.75 / 200 = 2.09, so the inflation rate is (2.09 / 2.0 – 1) x 100 per cent = 4.5 per cent.
12	Stored value payment tools such as Octopus and fast payment systems such as FPS are increasingly common. Discuss whether these tools change the definition of money and state their likely effect on the velocity of circulation.	Stored value balances such as Octopus are electronic money, usually counted separately from deposits and included only in broad money. FPS is merely a transfer channel and settlement still ends in bank deposits, so the definitions of M1 and M2 do not change. However, easier payment reduces cash holding and raises velocity, so a central bank must watch the size of electronic money when setting policy.

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