Changes in the Money Supply in an Open Economy (Cambridge International A-Level Economics)

Factors that change the money supply

• The money supply changes when the stock of cash and deposits in the economy rises or falls

• In an open economy, five main forces cause this:

  • commercial bank credit creation
  • the actions of the central bank
  • government deficit financing
  • quantitative easing
  • changes in the balance of payments

Commercial banks and credit creation

• When a commercial bank makes a loan, it does not simply lend out existing deposits — it creates new deposits, expanding the money supply
• This happens because banks hold only a fraction of deposits as reserves (see reserve ratio in 9.4.4) and lend the rest
• The borrower spends the loan; the funds are deposited at another bank; that bank keeps a fraction as reserves and lends the rest; and so on

The bank credit multiplier

• The bank credit multiplier is the factor by which an initial deposit at a commercial bank expands the total money supply through successive rounds of lending and re-depositing.

$\mathrm{Bank} \mathrm{credit} \mathrm{multiplier}=\frac{1}{\mathrm{reserve} \mathrm{ratio}}$

Worked Example If the reserve ratio is 10%, calculate by how much an initial £100 deposit can expand the money supply

Step 1: substitute the values into the formula

$\mathrm{Bank} \mathrm{credit} \mathrm{multiplier}=\frac{1}{\mathrm{reserve} \mathrm{ratio}}\,\,\mathrm{Bank} \mathrm{credit} \mathrm{multiplier}=\frac{1}{0.1}=10\,$

Step 2:multiply the initial deposit by the multiplier

£100 x 10 = £1,000

Note:

• The lower the reserve ratio, the larger the multiplier - and the greater commercial banks' capacity to expand the money supply
• In practice the multiplier is rarely at its theoretical maximum because households hold some funds as cash (reducing re-deposits) and banks may hold excess reserves

The role of a central bank

• The central bank influences the money supply through four main channels

  • Monetary policy — setting the base interest rate affects commercial bank lending rates, which influences how much borrowing (and therefore deposit creation) takes place; raising rates contracts the money supply, lowering rates expands it
  • Lender of last resort — the central bank provides emergency liquidity to commercial banks facing short-term funding pressures, preventing bank failures that would contract the money supply
  • Banker to the government — the central bank holds government accounts and manages government debt issuance, the mechanism through which deficit financing feeds into the money supply (see below)
  • Regulating the banking industry — setting minimum reserve and capital ratios constrains how much commercial banks can lend, directly affecting the bank credit multiplier

Worked Example Central banks can control the money supply. An increase in the money supply will cause inflation, therefore central banks can control inflation. Evaluate this statement. [20 marks]

Indicative answer structure

• AO1 Knowledge: Define money supply and inflation; identify the five causes of money supply changes (credit creation, central bank actions, deficit financing, QE, BoP); state the QTM link between M and P
• AO2 Analysis: Explain the mechanisms through which central banks influence the money supply (interest rates, reserve requirements, QE, sterilisation of BoP flows); explain the QTM prediction that rising M causes rising P under stable V and T
• AO3 Evaluation: Central banks have partial control - commercial bank credit creation, government deficit financing, and BoP flows all change the money supply outside direct central bank control. The link from money supply to inflation is also conditional - V and T are not constant, and post-2008 QE showed that large money supply expansion did not immediately cause inflation because V fell.

Strong answers conclude that central banks can influence both money supply and inflation, but not fully control either

Government deficit financing

• Government deficit financing is the process by which a government funds spending that exceeds its tax revenue, usually by borrowing through the issue of government bonds
• When the government runs a budget deficit, it sells bonds to raise funds
• If bonds are bought by the central bank or commercial banks using newly created reserves, the money supply expands — this is sometimes called "monetising the deficit"
• If bonds are bought by the non-bank private sector (households, pension funds), the money supply does not expand — existing money is simply transferred from savers to the government and then back to the economy as government spending
• The inflationary impact of deficit financing, therefore, depends on who buys the bonds

Quantitative easing (QE)

• Quantitative easing is a monetary policy tool in which the central bank creates new reserves electronically and uses them to buy financial assets (typically government bonds) from commercial banks and other financial institutions, expanding the money supply.

• QE is used when conventional monetary policy has reached its limits — typically when interest rates are already near zero

• The mechanism

  • The central bank creates new reserves and credits commercial banks' accounts
  • Commercial banks' balance sheets now hold more liquid reserves in place of bonds
  • With more reserves, banks have greater capacity to lend, further expanding the money supply via the bank credit multiplier

• QE was used extensively by the Bank of England, US Federal Reserve and European Central Bank after the 2008 financial crisis and during the COVID-19 pandemic

Changes in the balance of payments

• In an open economy, flows of money across borders also change the money supply

  • Current account surplus - exports exceed imports, so foreign buyers' payments for domestic goods increase domestic bank deposits, expanding the money supply
  • Current account deficit - imports exceed exports, so payments flowing abroad reduce domestic bank deposits, contracting the money supply
  • Capital inflows (foreign investment into the country) increase the money supply; capital outflows reduce it

• Central banks can offset these effects through sterilisation - buying or selling domestic bonds to neutralise the money supply impact of BoP flows, maintaining monetary policy independence

Exam Hint The five causes listed in the syllabus are not independent - they interact:

• Quantitative easing works through the bank credit multiplier
• Deficit financing may or may not expand the money supply depending on who buys the bonds
• BoP flows can be sterilised by central bank action

Strong answers trace these connections rather than listing the causes in isolation.

For evaluation, the key insight is that no single actor fully controls the money supply in an open economy. Commercial banks, central banks, governments and international flows all contribute. This framing directly contradicts simplistic "the central bank controls money supply" claims that examiners regularly flag.