causes of changes in the money supply in an open economy: commercial banks as sources of credit creation and the bank credit multiplier

Money and Banking 📈

1️⃣ Causes of Changes in the Money Supply in an Open Economy

Think of the money supply like a bathtub. The water level (money) can rise or fall depending on how much water is poured in or taken out. In an open economy, the main ways the “water level” changes are:

• Central bank actions – the Bank of England can inject money by buying government bonds (open‑market operations) or remove it by selling bonds.
• Reserve requirements – the minimum fraction of deposits banks must keep on hand. Lowering the requirement lets banks lend more, raising the money supply.
• Interest‑rate policy – lower rates make borrowing cheaper, encouraging spending and increasing money in circulation.
• Foreign exchange flows – when the pound weakens, foreign investors buy UK assets, bringing in foreign currency and expanding the domestic money supply.
• Capital flows – large inflows of foreign investment (e.g., a multinational setting up a factory) increase deposits in UK banks, boosting the money supply.

In short, the money supply rises when the central bank “pours in” more money or when banks lend more, and it falls when the opposite happens.

2️⃣ Commercial Banks as Sources of Credit Creation

Commercial banks are like money gardeners. When you deposit £1,000, the bank keeps a small portion as reserve (say 10%) and lends out the rest. The loaned money is spent, then re‑deposited somewhere else, and the cycle repeats. This process creates new money that did not exist before.

1. Deposit: £1,000 arrives at the bank.
2. Reserve: Bank keeps £100 (10%) and lends £900.
3. Loan: The £900 is spent, say to buy a bike.
4. Re‑deposit: The bike shop deposits the £900 into its own bank.
5. Repeat: The new bank again keeps 10% (£90) and lends £810, and so on.

Each round adds more money to the economy, even though the original deposit was only £1,000. That’s why banks are the main engines of credit creation.

3️⃣ Bank Credit Multiplier

The credit multiplier tells us how many times the initial deposit can be amplified through lending. It’s simply the reciprocal of the reserve ratio:

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

where r is the reserve ratio (expressed as a decimal).

Example: If the reserve ratio is 10 %, a £1,000 deposit can ultimately generate £10,000 in total money supply (1 000 × 10). The lower the reserve ratio, the higher the multiplier, and the faster the money supply grows.

In an open economy, foreign deposits and capital inflows feed into this multiplier mechanism, so changes in international confidence or exchange rates can have a big ripple effect on the domestic money supply.