Changing the money supply

Credit creation and the multiplier

1. Commercial banks are the main source of new money because they create credit whenever they lend.
2. A bank keeps only a fraction of each deposit as reserves and lends the rest to borrowers.
3. The sum lent is spent, received by someone else and re-deposited at another bank, which again keeps a fraction and lends the rest.
4. Repeated across the whole banking system, one initial deposit supports a much larger stock of deposits, so the money supply expands by a multiple of the original cash.

Bank credit multiplier:

$$\frac{1}{reserve\; ratio}$$

What limits credit creation

1. A higher reserve ratio or tougher capital requirement cuts the multiplier, so each £1 of reserves supports fewer new deposits.
2. Weak demand for loans limits lending: if households and firms will not borrow, banks cannot create credit however low rates are.
3. Cautious banks may hold excess reserves rather than lend, so reserves sit idle instead of multiplying.
4. The full multiplier is therefore a maximum, not a guarantee; how much money is actually created depends on confidence and loan demand.

The role of the central bank

1. A central bank can change the money supply both directly and indirectly.
2. It sets the policy interest rate: a cut lowers borrowing costs → more lending and credit creation → money supply rises; a rise does the reverse.
3. It can raise or lower reserve and capital requirements, tightening or loosening the multiplier.
4. As lender of last resort it supplies emergency liquidity, stopping a loss of confidence from shrinking deposits and the money supply.
5. It issues currency, acts as banker to the government and banks, and oversees financial stability.

Government deficit financing

1. A government running a budget deficit must finance the gap between its spending and tax revenue.
2. If it sells new bonds to the central bank, new money is created and the money supply rises.
3. If instead it borrows from the domestic private sector, existing money is transferred rather than created, so the money supply is broadly unchanged.
4. Financing a deficit through central-bank money creation is monetary financing, and it is inflationary if output cannot keep pace with the extra money.

Quantitative easing

1. QE is used when the policy interest rate is already close to zero and cannot be cut further.
2. The central bank creates new reserves and uses them to buy bonds → bond prices rise and yields fall → longer-term interest rates fall.
3. Cheaper credit and higher asset prices are meant to encourage borrowing, spending and investment, raising aggregate demand.
4. QE directly increases the money supply because it credits commercial banks with new reserves.
5. It risks higher inflation if overdone and can widen wealth inequality by pushing up asset prices held mainly by the rich, so its net benefit depends on how much slack there is in the economy.

Balance of payments flows

1. In an open economy, transactions with the rest of the world change the domestic money supply.
2. A balance of payments surplus brings a net inflow of foreign currency that is converted into domestic money → the money supply rises.
3. A balance of payments deficit causes a net outflow → the money supply falls.
4. When a central bank buys foreign currency to hold down its exchange rate, it creates domestic money and expands the supply.
5. Sterilisation offsets this: the central bank sells domestic bonds to mop up the extra money, keeping the money supply unchanged.