S5 Economics Practice Paper: Money, Banking And The Financial System (12 Questions, 100 Marks, 75 Minutes)

S5 Economics Practice Paper: Money, Banking and the Financial System (12 questions, 100 marks, 75 minutes)

2026-11-09

HKDSE Economics: Money, Banking and the Financial System

S5 Economics: money and banking — functions of money, linked exchange rate, M1 to M3, deposit creation, bank profits and inflation. 12 questions, 100 marks, 75 minutes, full answers.

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Instructions: This paper has three sections, A, B and C. Answer all questions. Total marks: 100. Time allowed: 75 minutes.

Show all working. Answers without working earn no method marks. Write down a formula before substituting numbers.

Give numerical answers to three significant figures unless stated otherwise, and state the correct units.

Spend about 30 minutes on money and money supply in Section A, then bank profits in Section B, and finish with interest rates, inflation and regulation in Section C.

Section A　Functions of Money and Hong Kong’s Monetary System

Section A: Show all working, and relate each function of money to the situation given.

#	Question	Answer and marking notes
1	(a) State the four functions of money. (4 marks) (b) Mr Chan buys a reference book for 500 dollars. Which function of money does this show? (1 mark) (c) Mr Chan deposits 5,000 dollars into a savings account to pay his school fees three months later. Which function of money does this show? (2 marks) (d) In an economy with a very high inflation rate, does money become less effective as a store of value? Explain briefly. (2 marks)	(a) Medium of exchange, unit of account, store of value, and standard of deferred payment (4 marks, 1 each). (b) Medium of exchange: money is used as the intermediary in the exchange for the book (1 mark). (c) Store of value: purchasing power is kept from now until it is used three months later (2 marks). (d) Yes. Inflation raises prices continuously, so the same amount of money buys fewer goods a year later; its purchasing power falls and it stores value less effectively (2 marks).
2	The Hong Kong dollar is linked to the US dollar at a central rate of 7.80, with a strong-side guarantee of 7.75 and a weak-side guarantee of 7.85. A note-issuing bank issues 78 billion dollars of banknotes and must hold US dollar backing at 7.80. (a) Find the difference between the upper and lower guarantee levels in Hong Kong dollars, and express it as a percentage of 7.80, correct to three significant figures. (3 marks) (b) Find the amount of US dollars, in billion, that the bank must hold. (2 marks) (c) If the rate moves from 7.80 to 7.85, how many billion Hong Kong dollars more can the same amount of US dollars buy? (2 marks) (d) State one feature of the banknote-issuing arrangement in Hong Kong. (2 marks)	(a) Difference = 7.85 − 7.75 = 0.10 Hong Kong dollars (2 marks); as a percentage of 7.80 it is 0.10 ÷ 7.80 × 100% = 1.282%, that is 1.28% to three significant figures (1 mark). (b) US dollars needed = 780 ÷ 7.80 = 100 billion (2 marks). (c) 100 × 7.85 = 785 billion Hong Kong dollars, which is 5 billion more than the original 780 billion (2 marks). (d) Hong Kong has no central bank that issues notes; three note-issuing banks issue banknotes against full US dollar backing at 7.80 under a currency board system (2 marks).
3	The money data of an economy are: notes and coins 50 billion dollars, demand deposits 80 billion dollars, savings deposits 150 billion dollars, time deposits 270 billion dollars, negotiable certificates of deposit issued by licensed banks 10 billion dollars, deposits with restricted licence banks and deposit-taking companies 30 billion dollars, and other negotiable certificates of deposit 10 billion dollars. (a) Find M1. (2 marks) (b) Find M2. (3 marks) (c) Find M3. (2 marks) (d) What mainly makes up the difference between M1 and M2? (1 mark)	(a) M1 = notes and coins + demand deposits = 500 + 800 = 1300 billion dollars (2 marks). (b) M2 = M1 + savings deposits + time deposits + NCDs of licensed banks = 1300 + 1500 + 2700 + 100 = 5600 billion dollars (3 marks). (c) M3 = M2 + deposits with restricted licence banks and deposit-taking companies + other NCDs = 5600 + 300 + 100 = 6000 billion dollars (2 marks). (d) The difference of 4300 billion dollars consists mainly of savings deposits, time deposits and NCDs issued by licensed banks, that is broader quasi-money (1 mark).
4	The banking system has excess reserves of 10 billion dollars and the required reserve ratio is 20%. (a) Find the deposit multiplier. (2 marks) (b) Find the maximum total new deposits the banking system can create. (2 marks) (c) If banks keep an extra 5% as excess reserves, so that the actual reserve ratio is 25%, find the new deposit multiplier and the maximum total new deposits. (3 marks) (d) State two reasons why actual deposit creation falls short of the theoretical maximum. (2 marks)	(a) Deposit multiplier = 1 ÷ required reserve ratio = 1 ÷ 0.20 = 5 (2 marks). (b) Maximum new deposits = excess reserves × multiplier = 100 × 5 = 500 billion dollars (2 marks). (c) Actual reserve ratio = 20% + 5% = 25%, so the new multiplier = 1 ÷ 0.25 = 4 and the maximum new deposits = 100 × 4 = 400 billion dollars (3 marks). (d) The public may hold cash instead of depositing it (cash leakage), and banks may choose not to lend all their excess reserves or borrowers may have no demand for loans (2 marks).

Section B　Banking, Deposit Creation and Bank Profits

Section B: Give money amounts in billion dollars and state the formula used.

#	Question	Answer and marking notes
5	A person deposits 10,000 dollars of cash into Bank A. The required reserve ratio is 20%. (a) Find the required reserves and the excess reserves. (3 marks) (b) Find the maximum amount Bank A can lend. (2 marks) (c) If Bank A lends out that whole amount, describe briefly how its assets and liabilities change. (2 marks) (d) Will this loan eventually increase the money supply? (1 mark)	(a) Required reserves = 10000 × 0.20 = 2000 dollars; excess reserves = 10000 − 2000 = 8000 dollars (3 marks). (b) The maximum amount Bank A can lend is the excess reserves, 8000 dollars (2 marks). (c) On the asset side cash falls by 2000 dollars while reserves rise by 2000 dollars and loans rise by 8000 dollars; on the liability side deposits rise by 10000 dollars, so both sides of the balance sheet expand (2 marks). (d) Yes. The loan is credited to the borrower’s account and becomes a new deposit, so the money supply rises and further deposits can be created through the banking system (1 mark).
6	A bank takes 1 billion dollars of deposits at a deposit rate of 1%, makes loans of 800 million dollars at a lending rate of 4%, and places the remaining 200 million dollars with the HKMA at a return of 0.5%. Assume there are no other costs. (a) Find the interest income, in ten thousand dollars. (3 marks) (b) Find the interest cost and the profit, in ten thousand dollars. (3 marks) (c) If 2% of the loans become bad debts and are written off, find the profit, in ten thousand dollars. (2 marks) (d) How would a rise in bad debts affect the bank’s lending rate? (1 mark)	(a) Interest income = loan interest + return on reserves = 8 billion × 4% + 2 billion × 0.5% = 3200 + 100 = 3300 ten thousand dollars (3 marks). (b) Interest cost = 10 billion × 1% = 1000 ten thousand dollars (1 mark); profit = 3300 − 1000 = 2300 ten thousand dollars (2 marks). (c) Bad debts = 8 billion × 2% = 1600 ten thousand dollars; profit = 2300 − 1600 = 700 ten thousand dollars (2 marks). (d) The bank would raise lending rates to cover expected bad debts and risk, or tighten its lending terms (1 mark).
7	In an economy the nominal interest rate is 5% and the inflation rate is 3%. (a) Use the approximate method to find the real interest rate. (2 marks) (b) Use the exact method to find the real interest rate, correct to two decimal places. (3 marks) (c) If inflation rises to 6% while the nominal interest rate is unchanged, how does the saver’s real return change? (2 marks) (d) How does this affect a person who holds a large amount of cash? (1 mark)	(a) Approximate real rate = nominal rate − inflation rate = 5% − 3% = 2% (2 marks). (b) Exact real rate = (1 + 0.05) ÷ (1 + 0.03) − 1 = 0.019417, about 1.94% (3 marks). (c) The real rate becomes 5% − 6% = −1%, so the saver’s real return turns negative and purchasing power falls by about 1% a year (2 marks). (d) Cash earns no nominal interest, so inflation reduces its purchasing power and raises the opportunity cost of holding cash; the holder suffers a real loss (1 mark).
8	A good made in Hong Kong sells for 78 Hong Kong dollars. The exchange rate moves from 7.80 to 7.50 Hong Kong dollars per US dollar. (a) Find the US dollar price of the good at each exchange rate. (3 marks) (b) Find the percentage change in the US dollar price. (2 marks) (c) For an American buyer, has the Hong Kong good become cheaper or more expensive? (1 mark) (d) If Hong Kong prices rise by 10% while US prices are unchanged and the exchange rate stays at 7.80, what happens to Hong Kong’s export competitiveness? (2 marks)	(a) At 7.80 the price is 78 ÷ 7.80 = 10.0 US dollars; at 7.50 it is 78 ÷ 7.50 = 10.4 US dollars (3 marks). (b) Percentage change = (10.4 − 10.0) ÷ 10.0 × 100% = 4% (2 marks). (c) As the Hong Kong dollar depreciates with the US dollar, the US dollar price of the same good rises, so the good becomes more expensive for American buyers (1 mark). (d) Hong Kong prices rise by 10% while the exchange rate is unchanged, so dollar prices rise in step, exports become relatively more expensive and competitiveness falls (2 marks).

Section C　Interest Rates, Inflation and Regulation

Section C: Give percentages to two decimal places and money amounts to the nearest dollar.

#	Question	Answer and marking notes
9	The HKMA’s base rate is the higher of the US federal funds target upper bound plus 50 basis points and the average of the overnight and one-month HIBOR plus 50 basis points. Suppose the US upper bound is 4.00% and average HIBOR is 3.20%. (a) Find the base rate. (3 marks) (b) Explain why Hong Kong interest rates broadly follow US interest rates. (2 marks) (c) If funds flow out of the Hong Kong dollar on a large scale, will HIBOR rise or fall? (1 mark) (d) Under the linked exchange rate system, how does a rise in interest rates help stabilise the exchange rate? (2 marks)	(a) US upper bound plus 50 basis points = 4.00% + 0.50% = 4.50%; HIBOR plus 50 basis points = 3.20% + 0.50% = 3.70%; taking the higher gives a base rate of 4.50% (3 marks). (b) Under the linked exchange rate the Hong Kong dollar is tied to the US dollar, and a large interest gap would drive funds towards the higher-yielding currency, so arbitrage keeps Hong Kong rates moving with US rates (2 marks). (c) An outflow of funds reduces the supply of Hong Kong dollars and pushes HIBOR up (1 mark). (d) Higher interest rates raise the return on holding Hong Kong dollars, attract inflows and dampen borrowing and spending, easing depreciation pressure so that the rate returns within the guarantee band (2 marks).
10	A person has 1,000,000 dollars on deposit in a bank that pays no interest, and the price level rises by 4% in a year. (a) Find the real purchasing power of the deposit after one year, to the nearest dollar. (3 marks) (b) Find the loss in purchasing power. (2 marks) (c) State two social costs of inflation. (2 marks) (d) Who is hurt more by unanticipated inflation? (1 mark)	(a) Real purchasing power = 1,000,000 ÷ (1 + 4%) = 961,538.46 dollars, that is 961,538 dollars to the nearest dollar (3 marks). (b) Loss = 1,000,000 − 961,538 = 38,462 dollars (2 marks). (c) Any two: menu costs of changing prices frequently, shoe-leather costs of holding less cash, distortions to taxes and wealth distribution, and misallocation of resources as relative prices become unclear (2 marks). (d) People on fixed nominal incomes, such as holders of long-term fixed deposits, recipients of fixed pensions, and those holding large amounts of cash (1 mark).
11	A small shop has monthly sales of 400,000 dollars. When all payments are in cash, the cost of counting, transporting and giving change is about 0.6% of sales. After switching to electronic payment the fee is 1.5% of sales, while the cash handling cost disappears completely. (a) Find the monthly cost of cash handling. (2 marks) (b) Find the monthly electronic payment fee. (2 marks) (c) Find the net increase in monthly cost after the switch. (2 marks) (d) State two non-monetary benefits of electronic payment. (2 marks)	(a) Cash handling cost = 400,000 × 0.6% = 2,400 dollars (2 marks). (b) Electronic payment fee = 400,000 × 1.5% = 6,000 dollars (2 marks). (c) Net increase = 6,000 − 2,400 = 3,600 dollars (2 marks). (d) Any two: automatic transaction records that simplify auditing and tax filing, lower risk of cash loss or theft, faster checkout, and easier online sales and loyalty schemes (2 marks).
12	The Hong Kong Deposit Protection Scheme protects eligible deposits up to 500,000 dollars per depositor per bank. A person has 1,200,000 dollars on deposit with one bank. (a) Find the protected and unprotected amounts. (3 marks) (b) What can the person do to protect all of the deposit? (2 marks) (c) State the main areas supervised by the HKMA, the SFC and the Insurance Authority respectively. (3 marks)	(a) Protected amount = 500,000 dollars; unprotected amount = 1,200,000 − 500,000 = 700,000 dollars (3 marks). (b) Spread the deposits over different banks so that each bank holds no more than the protection limit, or hold part of the funds in other assets (2 marks). (c) The HKMA supervises the banking system and monetary stability; the SFC supervises the securities and futures markets, listed companies and intermediaries; the Insurance Authority supervises insurers and insurance intermediaries (3 marks).

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