Definitions of money supply and monetary policy

Government and the Macro‑economy

Monetary Policy

Key definitions (AO1)

Money supply (M) – the total amount of money that is available for households and firms to spend or invest at a given point in time. It includes:

• Cash (notes and coins) held by the public.
• Balances in bank accounts that can be used for transactions (e.g., current accounts, checking deposits).

The IGCSE syllabus requires only a single, general definition; detailed aggregates such as M₀, M₁ or M₂ are optional examples.

Monetary policy – the set of actions carried out by a country’s central bank to influence the quantity of money, the level of interest rates and, where relevant, the exchange rate. The ultimate aim is to achieve the government’s macro‑economic objectives of price stability, sustainable economic growth, full employment and exchange‑rate stability.

Objectives of monetary policy (AO2)

• Maintain low and stable inflation (price stability).
• Support steady economic growth.
• Promote high employment (full employment).
• Stabilise the national currency and manage exchange‑rate pressures.
• Contribute to overall financial‑sector stability.

Monetary‑policy measures (required by the syllabus) (AO1)

Measure	How it works	Typical effect on the economy	Macro‑aim(s) targeted	Evaluation – main pros & cons (AO3)
Interest‑rate changes (policy/discount rate)	The central bank raises or lowers the rate at which commercial banks can borrow short‑term funds from it (the policy or discount rate). This influences the market interest rate that banks charge households and firms.	Lower rates → cheaper borrowing → higher investment and consumer spending (expansionary). Higher rates → more expensive borrowing → reduced spending (contractionary).	Price stability, economic growth, full employment.	Pros: Quick to implement; directly affects borrowing costs. Cons: Time‑lag before changes affect consumption/investment; may fuel asset‑price bubbles; limited when rates are already very low (liquidity trap).
Open‑market operations (OMOs)	The central bank buys (injects) or sells (withdraws) government securities in the open market. Buying adds reserves to commercial banks; selling removes reserves.	Purchasing securities increases bank reserves, expands the money supply and pushes interest rates down. Selling securities does the opposite.	Price stability, economic growth, full employment.	Pros: Precise control of the amount of reserves; can be adjusted daily. Cons: Effect depends on banks’ willingness to lend; may be less effective if confidence is low; can affect government debt markets.
Reserve‑requirement changes	The proportion of deposits that banks must keep as cash or as balances with the central bank (the reserve ratio) is altered.	Lower reserve ratio → banks can lend a larger fraction of deposits → money supply rises. Higher reserve ratio → lending falls → money supply contracts.	Price stability, economic growth, full employment.	Pros: Large impact on the money multiplier; can be a powerful tool. Cons: Used infrequently because it can cause sudden shifts in credit availability; banks may hold excess reserves, reducing the intended effect.
Foreign‑exchange‑rate interventions	The central bank buys or sells its own currency in the foreign‑exchange market, usually using its foreign‑exchange reserves.	Buying foreign currency (selling domestic currency) weakens the exchange rate, making exports more competitive and stimulating demand. Selling foreign currency (buying domestic currency) strengthens the exchange rate, helping to curb inflationary pressure from import prices.	Exchange‑rate stability, price stability, economic growth (via export competitiveness).	Pros: Direct influence on exchange rate; can support export‑oriented growth. Cons: May deplete reserves; can trigger retaliation from trading partners; limited impact if market expectations dominate.

Quantitative illustration – reserve‑ratio and the money multiplier

The money multiplier (k) shows how a change in the reserve ratio (r) affects the potential size of the money supply:

\[ k = \frac{1}{r} \]

Example:

• If the reserve ratio is 20 % (r = 0.20), the multiplier is k = 1/0.20 = 5.
• When the central bank lowers the ratio to 16 % (r = 0.16), the multiplier rises to k = 1/0.16 ≈ 6.25.
• With an initial excess‑reserve injection of £10 million, the potential increase in the money supply is:
  • At 20 %: £10 m × 5 = £50 m.
  • At 16 %: £10 m × 6.25 = £62.5 m.
• Thus, a 4‑percentage‑point fall in the reserve ratio can raise the money supply by about £12.5 million in this simplified illustration.

How monetary policy affects the economy (AO2)

When the central bank adopts an expansionary stance (e.g., lowers the policy rate, buys securities, reduces reserve ratios or weakens the exchange rate) the typical chain of events is:

1. More reserves become available for commercial banks.
2. Market interest rates fall, making borrowing cheaper.
3. Businesses increase investment; households increase consumption, especially on durable goods and housing.
4. Aggregate demand (AD) rises, leading to higher output (real GDP) and lower unemployment.
5. Higher demand can put upward pressure on the price level, so inflation risk must be monitored.

A contractionary stance (raising the policy rate, selling securities, increasing reserve requirements or strengthening the exchange rate) works in the opposite direction, helping to reduce inflation by slowing demand.

Link to the Quantity Theory of Money (optional but useful) (AO2)

The relationship between the money supply and the price level is expressed by the Quantity Theory of Money:

\[ M \times V = P \times Y \]

• M = money supply
• V = velocity of money (average number of times a unit of money is spent in a period)
• P = overall price level
• Y = real output (real GDP)

In the short‑run, if V and Y are relatively stable, an increase in M tends to raise P (inflation). If Y is also growing, the same increase in M can boost output with a smaller impact on prices. In the long‑run, V is assumed constant, so changes in M affect only P.

Suggested diagram (AO2)

Evaluation of monetary policy (AO3)

• Time‑lags – Recognition, implementation and effect lags mean that policy actions may only affect the economy months or years later, reducing precision in targeting inflation.
• Conflicts between aims – A policy that supports growth and employment (low rates) can conflict with price‑stability objectives if it generates excess demand.
• Liquidity trap – When interest rates are already near zero, further cuts have little effect; the central bank may have to resort to unconventional tools (e.g., quantitative easing), illustrating the limits of conventional monetary policy.
• Interaction with fiscal policy – Expansionary monetary policy can be undermined by contractionary fiscal policy (higher taxes, reduced spending), and vice‑versa.
• Impact on exchange rates – Interest‑rate changes affect capital flows and the exchange rate, which feed back into inflation and export competitiveness.
• Banking‑sector response – Even if the central bank provides extra reserves, banks may hold excess reserves rather than increase lending, especially when confidence is low.

Real‑world example (AO2)

In 2022 the Reserve Bank of Country X cut its policy rate from 5 % to 3 % to combat a recession caused by a sharp fall in global demand. Expected effects were:

• Market interest rates fell, reducing mortgage and business‑loan costs.
• Household consumption and business investment were projected to rise, shifting AD to the right.
• Unemployment was expected to fall as firms increased production.
• Because the economy still had spare capacity, the central bank anticipated only a modest rise in inflation, keeping price‑stability within its target range.

Summary checklist for exam (AO1‑AO3)

• Define money supply and monetary policy (AO1).
• List and explain the four monetary‑policy measures, linking each to the macro‑economic aims (AO2).
• Show the chain of cause‑and‑effect for expansionary and contractionary policies.
• Write the Quantity Theory of Money equation and explain its short‑run/long‑run implications.
• Draw and label a money‑market diagram showing a shift in the money‑supply curve.
• Provide at least two evaluation points for each measure (time‑lag, effectiveness, conflicts, etc.) (AO3).