Monetary policy measures: changes in money supply

Published by Patrick Mutisya · 14 days ago

IGCSE Economics 0455 – Government and the Macro‑economy: Monetary Policy (Changes in Money Supply)

Monetary Policy – Changes in the Money Supply

1. What is Monetary Policy?

Monetary policy is the set of actions undertaken by a country’s central bank (e.g., the Bank of England, the Federal Reserve) to control the amount of money circulating in the economy. The main aim is to influence macro‑economic objectives such as price stability, economic growth, and employment.

2. Objectives of Monetary Policy

  • Control inflation (price stability)

  • Support sustainable economic growth

  • Maintain low and stable unemployment

  • Stabilise the exchange rate (in some countries)

3. Main Instruments that Change the Money Supply

InstrumentTypical ActionEffect on Money SupplyEffect on Interest RatesLikely Impact on Aggregate Demand (AD)
Open Market Operations (OMO)Buy or sell government securitiesBuying securities ↑ money supply; selling securities ↓ money supplyBuying → lower rates; selling → higher ratesBuying → AD ↑; selling → AD ↓
Reserve Ratio (RR)Change the proportion of deposits banks must hold as reservesLower RR ↑ money supply; higher RR ↓ money supplyLower RR → lower rates; higher RR → higher ratesLower RR → AD ↑; higher RR → AD ↓
Discount (Policy) RateChange the rate at which banks can borrow from the central bankLower discount rate ↑ money supply; higher discount rate ↓ money supplyLower rate → lower market rates; higher rate → higher market ratesLower rate → AD ↑; higher rate → AD ↓
Quantitative Easing (QE)Large‑scale purchase of longer‑term securitiesIncreases money supply directlyPushes long‑term interest rates downAD ↑ (especially investment and housing)

4. How the Instruments Work – The Transmission Mechanism

  1. Central bank changes the money supply using one of the instruments above.

  2. The change alters the interbank market interest rate (e.g., the policy rate).

  3. Commercial banks adjust their lending rates (e.g., mortgage, business loan rates).

  4. Changes in borrowing costs affect consumer spending and business investment.

  5. Aggregate demand shifts, influencing output and price levels.

5. The Money Multiplier

The relationship between the reserve ratio and the total amount of money that can be created is expressed by the money multiplier:

\$m = \frac{1}{rr}\$

where rr is the reserve ratio (expressed as a decimal). A lower reserve ratio increases the multiplier, allowing a larger expansion of the money supply for a given amount of base money.

6. Example Calculation

Suppose the central bank injects £10 million into the banking system and the reserve ratio is 5 % (0.05). The potential increase in the money supply is:

\$\Delta M = m \times \Delta B = \frac{1}{0.05} \times £10\text{m} = 20 \times £10\text{m} = £200\text{m}\$

This illustrates how a small change in base money can lead to a much larger change in the total money supply.

7. Policy Stance and Economic Context

  • Expansionary monetary policy (increase money supply) is used when the economy is in recession or when inflation is below target.

  • Contractionary monetary policy (decrease money supply) is used to cool an overheating economy or curb high inflation.

8. Potential Limitations

  • Liquidity trap: When interest rates are already very low, further cuts may not stimulate borrowing.

  • Time lags: The impact on output and inflation can take months or years to materialise.

  • Exchange‑rate effects: Changes in interest rates can affect the currency value, influencing net exports.

  • Financial stability concerns: Excessive money creation may fuel asset‑price bubbles.

9. Suggested Diagram

Suggested diagram: LM curve shift illustrating the effect of an expansionary monetary policy on interest rates and output.

10. Quick Revision Checklist

  • Know the three main tools: OMO, reserve ratio, discount rate (plus QE as a modern tool).

  • Be able to state the direction of change in money supply, interest rates, and AD for each tool.

  • Understand the money multiplier formula and how reserve ratio changes affect it.

  • Recall the transmission mechanism steps from central bank action to macro‑economic outcome.

  • Identify situations where expansionary or contractionary policy is appropriate.