DSE Economics | Monetary Policy Tutor Prep Guide

DSE Economics | Monetary Policy Tutor Prep Guide | Money Multiplier and Limits

2026-11-01

Tutor lesson-prep guides · Secondary Economics

Students say that cutting rates stimulates the economy, then treat the money multiplier as one, subtract inflation from the nominal rate and stop, and cannot explain why Hong Kong cannot cut rates on its own. All three gaps come from mixing up tools with transmission.

Objectives — Students can: (1) compute the money multiplier and total deposits from a reserve ratio; (2) state the transmission chain from rates to consumption, investment and net exports; (3) apply the Fisher effect to get a real rate; (4) explain the limits imposed by a linked exchange rate.

01 Prerequisites (3-minute check)

If any of these fails, fix it before the lesson starts.

Skill	Quick check	Pass mark
Functions of money	medium of exchange, store of value	notes are legal tender
Supply and demand	price and quantity	the interest rate is the price of money
Inflation	real versus nominal	nominal rates must be adjusted

02 Lesson flow (60 minutes)

Time	Stage	Tutor does	Student does
0-10 min	Money supply	M1 against M3	base money 800 hundred million
10-22 min	Money multiplier	reciprocal of the reserve ratio	1 over 0.20 is 5
22-34 min	Transmission	three chains	consumption, investment, net exports
34-46 min	Real rate	Fisher effect	5.25% less 2.4%
46-56 min	Exchange rate and limits	linked rate	the 7.75 to 7.85 band
56-60 min	Exit check	collect and mark	independent

03 Teaching script (read it out)

Scene 1: First move: separate tools, intermediate targets and final targets

Tools are what the central bank controls directly: the discount rate, reserve requirements and open market operations. Intermediate targets are money supply and short-term rates. Final targets are price stability, full employment and growth. Students who treat a tool as an outcome write that a rate cut lowers unemployment, skipping investment and output. With a reserve ratio of 20% the multiplier is 1 over 0.20, which is 5, so base money of 800 hundred million supports deposits of 4000 hundred million. Ask: why is the multiplier not infinite? (Each loan leaves part of the deposit as reserves.)

Task: write the three layers on one line and join them with arrows.

Scene 2: Transmission: three chains, each with conditions

A rate cut lowers borrowing costs so investment rises; it also lowers the return on saving so consumption rises; and it pushes funds abroad so the currency weakens and net exports rise. Together these raise aggregate demand. With a nominal rate of 5.25% and inflation of 2.4% the real rate is about 2.85%, and the Fisher form gives 2.78%. Marks come from the chain, not the conclusion, so the answer must show the intermediate steps. Reminder: a cut helps borrowers on floating rates at once and does nothing for fixed-rate borrowers. Compute: nominal 6% with inflation 4% gives a real rate of about 1.92%.

Scene 3: The exchange rate regime sets the policy space

Hong Kong runs a linked exchange rate, promising to hold the currency between 7.75 and 7.85 against the US dollar, so policy broadly follows the United States. When the US raises rates Hong Kong must follow even if the local economy is slowing, which is the loss of monetary autonomy. A floating regime can cut independently but pays with depreciation and imported inflation. Asked whether Hong Kong can cut rates to fight a recession, the correct answer is that the space is constrained and fiscal policy must take over. Ask: if the US cuts 25 basis points, what is Hong Kong most likely to do? (Follow, because of arbitrage.)

Task: list two advantages and two drawbacks of each regime.

04 Question types and worked steps

Type	Example	Steps	Answer
Money multiplier	reserve ratio given	one divided by the ratio	5
Total deposits	base money times multiplier	watch the unit	4000 hundred million
Real interest rate	nominal rate and inflation	Fisher effect	2.78%
Policy comment	effectiveness or limits	tool, intermediate, final	linked rate limits autonomy

Sanity check (teach this): The multiplier is at least one, so an answer below one means the ratio was inverted. Deposits cannot be smaller than base money: 4000 against 800. Real rates can be negative when inflation exceeds the nominal rate, though nominal rates rarely are. Use basis points for changes: 25 basis points is 0.25 of a percentage point, so 5.25% becomes 5.00%. Under a linked rate the two interest rates cannot drift apart for long without arbitrage.

05 Independent practice (3 questions)

Question	Answer	What to watch
Multiplier with a 20% reserve ratio	5	one divided by 0.20
Deposits supported by 800 hundred million	4000 hundred million	800 times 5
Real rate for 5.25% nominal and 2.4% inflation	about 2.78%	Fisher effect

06 Common mistakes and what to say

Mistake	Student writes	Say this
Inverting the multiplier	answers 0.2	The multiplier is one divided by the reserve ratio, not the ratio itself.
Giving only the outcome	writes that a rate cut helps the economy	Show the chain: rate cut, investment up, demand up.
Plain subtraction for the real rate	stops at 2.85%	When inflation is high, use the Fisher form.
Ignoring the linked rate	says Hong Kong can cut freely	Hong Kong follows US rates, so the space is constrained.

07 Homework (paper, section and question numbers)

Secondary Economics chapter index — questions 4 and 7 are the same type
All prep guides — other chapters in this subject
DSE Economics practice papers — monetary policy set, questions 2 to 9

08 Exit check (last 5 minutes)

Question	Answer	Decision
Multiplier with a 20% reserve ratio	5	three correct allows trade next
Three layers of monetary policy	tools, intermediate, final	one wrong means reteach
Limit under a linked rate	no independent rate cuts	two or more wrong means restart

09 Tutor FAQ

Does more money always mean inflation?

It depends on spare capacity and velocity; with idle capacity, extra money may mostly raise output.

Why use basis points?

Rate moves are small, so basis points avoid decimal confusion; 100 basis points is one percentage point.

Does Hong Kong have its own policy rate?

It has a discount window base rate, but its direction follows the US federal funds rate.

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A TutorZone lesson-prep guide. Written by the TutorZone team; questions and lesson flow are original and are not taken from any school or publisher material.