9.18 - Changes in Money Supply
Causes of an increase in the money supply
In an open economy, the money supply can expand due to various factors involving banks, government actions, and international flows. These increases typically occur when new money enters circulation or existing money multiplies through lending.
Main factors leading to money supply growth
- Increase in commercial bank lending - Banks create new money by extending loans, which appear as deposits in borrowers' accounts.
- Government spending financed by borrowing from commercial banks - When governments borrow from banks to fund expenditure, this injects new money into the economy.
- Government spending financed by borrowing from the central bank - Direct borrowing from the central bank similarly boosts the money supply by creating new funds.
- Sale of government bonds to private sector financial institutions - Through quantitative easing, the central bank buys bonds, increasing liquidity and encouraging lending.
- Net inflow of money from abroad - When more money enters the country (e.g., from exports) than leaves (e.g., for imports), the domestic money supply rises.
How commercial banks create credit
Commercial banks play a key role in expanding the money supply by creating credit through their lending activities. This process relies on the fact that not all deposits are withdrawn immediately, allowing banks to lend out a portion while maintaining liquidity.
The process of credit creation by banks
Banks can generate more deposits than the cash and liquid assets they hold because only a small fraction of deposits are typically withdrawn in cash. Modern payment systems, such as credit cards, debit cards, and online transfers, facilitate this by moving funds between accounts without physical cash.
Key aspects of credit creation:
- Deposit and lending cycle - When a customer deposits money, the bank keeps a portion as reserves and lends the rest, creating new deposits in borrowers' accounts. These new deposits can then be lent further, multiplying the initial amount.
- Role of confidence - The system depends on customer trust that deposits are safe. If confidence erodes, it can lead to a 'run on the bank', where mass withdrawals force banks to liquidate assets, as seen in the 2008 financial crisis.
This credit creation amplifies the money supply but requires careful management to avoid liquidity shortages.
Liquidity ratios and the bank credit multiplier
Liquidity ratios help banks manage the balance between lending and maintaining sufficient liquid assets to meet withdrawal demands. These ratios influence how much credit banks can create.
Understanding liquidity ratios
The liquidity ratio (also known as the reserve ratio) is the proportion of a bank's total liabilities held as liquid assets, such as cash or easily convertible securities. Central banks may mandate a minimum ratio to ensure stability. A lower ratio allows banks to lend more, expanding credit creation, but it heightens the risk of insolvency if withdrawals surge. A higher ratio limits lending but enhances safety.
Formula for the bank credit multiplier
The bank credit multiplier measures how much new credit can be generated from an initial change in liquid assets.
Where:
- Liquidity ratio (reserve ratio) = Percentage of liabilities held as liquid assets (%)
Formula for the potential increase in total liabilities
Where:
- Change in liquid assets = Initial increase in reserves (£)
- Bank credit multiplier = Value calculated from the formula above
Formula for the change in loans
Where:
- Change in liabilities = Total new deposits created (£)
- Change in liquid assets = Initial increase in reserves (£)
Worked example - Calculating the bank credit multiplier and credit creation
A bank has a reserve ratio of 10% and receives a new deposit of £20,000, increasing its liquid assets by this amount. Calculate the bank credit multiplier, the potential increase in total liabilities, and the change in loans.
Step 1: Identify the values
- Reserve ratio = 10%
- Change in liquid assets = £20,000
Step 2: Calculate the bank credit multiplier
Step 3: Calculate the potential increase in total liabilities
Step 4: Calculate the change in loans
Limitations on credit creation and capital ratios
While banks can theoretically multiply credit extensively, practical constraints limit this process. Additionally, capital ratios provide a safeguard against losses from risky lending.
Practical limitations on bank lending
- Demand for loans - If households and firms are unwilling to borrow (e.g., during economic downturns), credit creation stalls.
- Availability of credit-worthy borrowers - Banks avoid lending to those with poor credit histories to minimise default risks, as evidenced by the US sub-prime mortgage crisis.
- Regulatory and risk factors - Excessive lending without sufficient reserves can lead to instability, prompting central bank interventions.
Understanding capital ratios
The capital ratio measures a commercial bank's available financial capital (including retained profits and newly issued shares) as a percentage of its riskier assets. For example, a 12% capital ratio means 12% of riskier assets are backed by capital, allowing banks to absorb unexpected losses. Higher ratios promote stability, protect depositors, and discourage reckless lending.
Functions of the central bank
Central banks oversee the financial system and influence the money supply through various roles, ensuring economic stability and implementing policy.
Key functions performed by central banks
- Issuing currency - Produces banknotes and authorises coin minting to maintain a reliable money supply.
- Banker to commercial banks - Holds reserves, facilitates inter-bank payments, and acts as a lender of last resort during liquidity crises.
- Banker to the government - Manages government accounts and finances deficits through borrowing or bond sales.
- Monetary policy implementation - Adjusts interest rates, reserve requirements, and other tools to control inflation and growth.
Government deficit financing and its effects
Governments finance deficits (when spending exceeds revenue) in ways that can either use existing money or expand the money supply.
Methods of financing government deficits
- Selling securities to the non-bank private sector - This absorbs existing money without increasing the supply.
- Borrowing from commercial banks - Creates new money as banks lend funds they generate through credit creation.
- Borrowing from the central bank - Directly increases the money supply by injecting new funds into circulation.
These methods influence liquidity and economic activity, with borrowing from banks or the central bank typically stimulating growth but risking inflation.
Quantitative easing and balance of payments effects
When traditional monetary tools are ineffective, central banks use quantitative easing to boost the money supply. International trade also affects domestic money through balance of payments flows.
How quantitative easing works
Quantitative easing involves the central bank purchasing government or private securities from financial institutions, often when interest rates are already very low or negative. This increases banks' liquid assets, encouraging more lending, lowering long-term interest rates, and stimulating activity. It was first implemented in Japan in the 1990s and later in the UK and USA after the 2008 recession.
Balance of payments impact on money supply
The balance of payments records international transactions, and net inflows can expand the domestic money supply.
Effects of net money inflows:
- When export revenues exceed import costs, foreign earnings are deposited in domestic banks, creating reserves that enable multiple credit expansion.
- This leads to a compounded increase in the money supply as banks lend based on the new deposits.