Monetary policy measures: changes in money supply

IGCSE Economics (0455) – Complete Syllabus Overview & Revision Notes

1. The Basic Economic Problem

1.1 Scarcity, Choice & the Three Fundamental Questions

• Scarcity: Resources (land, labour, capital, entrepreneurship) are limited.
• Choice: Society must decide how to allocate these scarce resources.
• Three basic economic questions:

  1. What goods and services should be produced?
  2. How should they be produced?
  3. For whom should they be produced?

1.2 Opportunity Cost

The value of the next best alternative that is foregone when a decision is made.

Example: Building a new hospital uses funds that could have been spent on a new school – the opportunity cost of the hospital is the school.

1.3 Economic Goods vs Free Goods

1.4 Factors of Production & Their Rewards

1.5 Production Possibility Curve (PPC)

• Shows the maximum possible output of two goods when all resources are fully and efficiently employed.
• Points on the curve = efficient; inside = under‑utilisation; outside = unattainable.
• Outward shift = economic growth (more resources or better technology).
• Inward shift = recession or loss of resources.

2. Allocation of Resources

2.1 Demand & Supply Basics

• Demand: Quantity buyers are willing & able to purchase at each price.
• Supply: Quantity sellers are willing & able to sell at each price.
• Market equilibrium: Intersection of the demand and supply curves.

2.2 Price Determination & Elasticities

2.3 Causes & Consequences of Price Changes

• Shift in demand → new equilibrium price & quantity (movement along supply curve).
• Shift in supply → new equilibrium price & quantity (movement along demand curve).
• Price change → changes in total revenue:

  • Elastic demand: price ↓ → TR ↑; price ↑ → TR ↓.
  • Inelastic demand: price ↓ → TR ↓; price ↑ → TR ↑.

2.4 Market Failure & Government Intervention

2.4.1 Types of Market Failure

• Public goods: Non‑rival & non‑excludable (e.g., street lighting).
• Merit goods: Under‑consumed if left to the market (e.g., education, vaccination).
• Demerit goods: Over‑consumed if left to the market (e.g., cigarettes, alcohol).
• Externalities:

  • Negative: Pollution – private cost < social cost.
  • Positive: Education – private benefit < social benefit.

• Information asymmetry: One party has better information (e.g., used‑car market).
• Monopoly power: Single seller can set price above marginal cost.

2.4.2 Government Tools to Correct Failure

2.4.3 Mixed Economy – Definition & Evaluation

• Definition: An economic system that combines market mechanisms with government intervention.
• Advantages: Balances efficiency with equity; can correct failures; provides public goods.
• Disadvantages: Potential for government failure; higher taxes; possible inefficiencies from over‑regulation.

3. Micro‑economic Decision‑makers

3.1 Households

• Consumers of goods & services; suppliers of labour.
• Decision‑making based on utility maximisation subject to a budget constraint.

3.2 Firms

• Producers of goods & services; aim to maximise profit.
• Key cost concepts:

  • Fixed Cost (FC)
  • Variable Cost (VC)
  • Total Cost (TC = FC + VC)
  • Average Cost (AC = TC/Q)
  • Marginal Cost (MC = ΔTC/ΔQ)

• Revenue concepts:

  • Total Revenue (TR = P × Q)
  • Average Revenue (AR = TR/Q = P)
  • Marginal Revenue (MR = ΔTR/ΔQ)

3.3 Markets for Factors of Production

• Labour market: Wages determined by supply of workers and demand for labour.
• Capital market: Interest rates set by supply of savings and demand for investment.
• Land market: Rent determined by scarcity and productivity of land.

3.4 Money & Banking (Micro‑level)

• Functions of money: Medium of exchange, store of value, unit of account.
• Types of money: Commodity, fiat, commercial‑bank deposits.
• Deposit (money) multiplier: Banks create money by lending a portion of deposits; see Section 4.4.

3.5 Market Structures

4. Government & the Macro‑economy

4.1 Macro‑economic Objectives

• Economic growth (real GDP ↑)
• Low & stable inflation
• Low unemployment (frictional, structural, cyclical)
• Equitable distribution of income
• External balance (stable balance of payments)

4.2 Fiscal Policy

• Expansionary fiscal policy: Increase government spending and/or cut taxes → AD ↑ → higher output & price level.
• Contractionary fiscal policy: Decrease spending and/or raise taxes → AD ↓ → lower output & price level.
• Key tools: government expenditure, direct taxes, indirect taxes (VAT), subsidies, public‑sector borrowing.

4.3 Supply‑side (Structural) Policy

• Improves productive capacity: investment in education, training, infrastructure, R&D, deregulation, tax incentives, competition policy.
• Long‑run effect: shifts LRAS (or potential output) right.

4.4 Monetary Policy – Changing the Money Supply

4.4.1 What is Monetary Policy?

Actions taken by a country’s central bank (e.g., Bank of England, Federal Reserve, Reserve Bank of India) to control the amount of money in the economy and the cost of borrowing. Primary aims: price stability, sustainable growth and low unemployment.

4.4.2 Main Instruments (Changes in Money Supply)

4.4.3 The Transmission Mechanism

1. Central bank changes the money supply using one of the instruments above.
2. The change alters the inter‑bank (policy) interest rate.
3. Commercial banks adjust their lending and deposit rates.
4. Borrowing costs for households and firms change.
5. Consumer spending, business investment and net exports respond.
6. Aggregate demand shifts, influencing real GDP and the price level.

4.4.4 Money (Deposit) Multiplier

Shows how a change in base money is magnified through the banking system:

m = 1 ÷ rr  where rr = reserve ratio (expressed as a decimal).

Example: Base money injected = £10 million; reserve ratio = 5 % (0.05).

Money multiplier = 1 / 0.05 = 20.

Potential increase in total money supply = 20 × £10 million = £200 million.

4.4.5 Policy Stance & Economic Context

• Expansionary monetary policy: Used in recession or when inflation is below target.
• Contractionary monetary policy: Used to cool an overheating economy or curb high inflation.

4.4.6 Limitations & Evaluation

• Liquidity trap: When rates are already near zero, further cuts may not stimulate borrowing.
• Time lags: Recognition, implementation and impact lags can span months to years.
• Exchange‑rate effects: Lower rates may depreciate the currency, boosting exports but raising import prices.
• Financial‑stability risks: Prolonged easy money can fuel asset‑price bubbles (e.g., housing).
• Policy coordination: Monetary policy is less effective if fiscal policy is contractionary.

4.4.7 Diagrammatic Requirement

4.5 Key Macroeconomic Diagrams to Master

• AD‑AS (short‑run & long‑run)
• IS‑LM (interaction of goods & money markets)
• Phillips curve (inflation ↔ unemployment)
• Budget‑deficit & government‑spending multiplier
• LRAS shift (supply‑side policy)
• External balance diagram (BP curve)

5. Economic Development

5.1 Measuring Development

5.2 Causes of Development Differences

• Physical & human capital (schools, hospitals, infrastructure)
• Technology & innovation
• Institutional quality (property rights, rule of law, governance)
• Geography & natural resources (climate, mineral endowments)
• Trade openness & foreign direct investment (FDI)
• Macroeconomic stability (low inflation, credible fiscal policy)

5.3 Policies to Promote Development

• Education & health investment: Improves labour productivity.
• Infrastructure development: Roads, electricity, broadband reduce transaction costs.
• Stable macro‑economic environment: Low inflation, sustainable public finances.
• Trade liberalisation & FDI attraction: Access to larger markets and technology.
• Good governance & institutions: Reduces corruption, secures property rights.
• Targeted poverty‑reduction programmes: Conditional cash transfers, micro‑credit.

6. International Trade & Globalisation

6.1 Benefits & Costs of Trade

• Benefits: Comparative advantage, larger markets, economies of scale, lower prices, technology transfer.
• Costs: Domestic industries may shrink, job losses in certain sectors, dependence on external shocks.

6.2 Trade Protection Instruments

6.3 Balance of Payments (BoP) Overview

• Current account: Trade in goods & services, income, transfers.
• Capital & financial account: Direct investment, portfolio investment, loans.
• Official reserves: Central‑bank holdings of foreign currency, gold.
• Surplus → net inflow of foreign currency; Deficit → net outflow (may be financed by borrowing or reserve depletion).

6.4 Exchange‑Rate Regimes

• Floating (flexible) rate: Determined by market forces.
• Fixed (pegged) rate: Government/central bank maintains a set rate, using reserves or OMO.
• Managed float (dirty float): Authorities intervene occasionally to smooth volatility.

6.5 Globalisation – Evaluation

• Positive aspects: Faster technology diffusion, cultural exchange, poverty reduction in many developing countries.
• Negative aspects: Environmental degradation, cultural homogenisation, widening income inequality.

Key Revision Tips

• Master the definitions – many exam questions ask for precise terminology.
• Practice drawing all required diagrams from memory; label axes, curves and shifts.
• Use the “cause‑effect‑evaluation” structure for essay questions (e.g., explain how a change in the reserve ratio affects AD, then evaluate its effectiveness).
• Memorise the formulae:

  • Money multiplier = 1 ÷ reserve ratio
  • GDP = C + I + G + (X – M)
  • Real GDP per capita = Real GDP ÷ Population

• Link case‑study examples (e.g., UK quantitative easing 2020, China’s export‑led growth, Brazil’s inflation targeting) to the relevant theory.