Monetary policy | IGCSE Class 10 Economics Notes

This note covers the meaning of money supply and monetary policy, the main monetary policy measures a central bank uses (changes in interest rates, money supply and foreign exchange rates), and how these measures can help a government achieve its macroeconomic aims.

What is money supply?

Money supply is the total stock of money held by the public in an economy at a given point in time.

It is made up of currency (notes and coins) in circulation plus demand deposits held with commercial banks, since cheques and transfers drawn on these deposits are also used to settle transactions.

Money supply = Currency + Demand deposits

Definition: money supply. The total stock of currency and demand deposits held by the public, which can be used immediately to make payments.

Which institutions affect the money supply?

Only one body in an economy is normally authorised to issue the main currency: the central bank, which also carries out monetary policy.

Everyday lending and deposit taking is carried out by commercial banks, which accept deposits from savers and lend a portion of these funds to borrowers, charging a higher rate of interest on loans than they pay on deposits.

What is monetary policy?

Monetary policy refers to the actions taken by the central bank to control the money supply and the cost of borrowing (interest rates) in the economy, in order to influence spending, prices and output.

Definition: monetary policy. The use of changes in interest rates, money supply and related tools by the central bank to influence economic activity and prices.

There are three groups of monetary policy measures: changes in interest rates, changes in the money supply, and changes in the foreign exchange rate.

Each of these measures works through the banking system. A change in the interest rate alters the cost of borrowing, a change in the money supply alters the quantity of credit available, and a change in the foreign exchange rate alters the price of imports and exports.

Because all three act on the same economy, a central bank usually chooses a combination of them rather than relying on one alone, and it must judge how firms and households are likely to respond.

How does a change in interest rates work as a monetary policy measure?

The rate at which the central bank lends to commercial banks is called the interest rate set by the central bank. If commercial banks need extra funds to extend more credit, they can borrow from the central bank at this rate.

Definition: interest rate. The price of borrowing money, or the reward for saving, usually expressed as a percentage per year.

A rise in this interest rate makes it more expensive for commercial banks to borrow reserves.

This reduces the reserves commercial banks are willing to hold and lend against, so banks in turn raise the interest rates they charge their own customers.

Higher interest rates discourage borrowing for consumption and investment, reducing the quantity of money in active circulation.

A fall in these rates has the opposite effect: borrowing becomes cheaper, commercial banks extend more credit, and the money supply tends to rise.

Worked example 1. A central bank raises the interest rate at which it lends to commercial banks from 3% to 5%. A firm had planned to borrow $200,000 for one year at the old rate. Calculate the extra interest the firm would pay for the year at the new rate.

Answer: Interest at 3% = 0.03 × $200,000 = $6,000. Interest at 5% = 0.05 × $200,000 = $10,000. Extra interest = $10,000 − $6,000 = $4,000. The higher cost may persuade the firm to postpone the investment.

How does a change in money supply work as a monetary policy measure?

Besides working through interest rates, the central bank can act directly on the quantity of money using the reserve ratio and open market operations.

1. The central bank raises or lowers the required reserve ratio that commercial banks must hold against their deposits.
2. A higher reserve ratio leaves banks with less of each deposit available to lend, so total lending and deposits in the banking system contract.
3. A lower reserve ratio frees up more of each deposit for lending, expanding deposits and the money supply.
4. Separately, the central bank can buy or sell government bonds in the open market: buying bonds pays money into the economy and raises bank reserves, increasing the money supply, while selling bonds withdraws money from the economy and reduces reserves, decreasing the money supply.

Definition: reserve ratio. The minimum percentage of its total deposits that a commercial bank must keep as reserves rather than lend out.

Definition: open market operations. The buying and selling of government bonds by the central bank in order to increase or decrease the money supply.

Worked example 2. A commercial bank receives a new deposit of $1,000. The central bank's reserve ratio is 20%. Calculate the maximum amount of this deposit the bank can lend out.

Answer: Required reserve = 20% of $1,000 = $200. Amount available to lend = $1,000 − $200 = $800.

Worked example 3. A commercial bank has deposits of $500 million. The central bank raises the reserve ratio from 10% to 20%. Calculate the change in the amount of these deposits the bank can lend out.

Answer: At a reserve ratio of 10%, required reserves = 10% of $500 million = $50 million, so the bank can lend $450 million. At a reserve ratio of 20%, required reserves = 20% of $500 million = $100 million, so the bank can lend $400 million. The amount the bank can lend falls by $50 million.

Worked example 4. A central bank sells $50 million of government bonds to commercial banks through open market operations. The reserve ratio is 10%. Calculate the fall in the maximum total deposits the banking system can support.

Answer: The sale withdraws $50 million of reserves from the banks. Maximum fall in deposits = $50 million ÷ 0.10 = $500 million. The money supply therefore falls by up to $500 million.

How does a change in the foreign exchange rate work as a monetary policy measure?

The foreign exchange rate is the price of one currency in terms of another. It is determined in the foreign exchange market, where the participants include commercial banks, foreign exchange brokers, other authorised dealers and the central bank.

Definition: foreign exchange rate. The price of one country's currency expressed in terms of another country's currency.

A central bank can influence the exchange rate of its currency. It can buy or sell its own currency in the foreign exchange market, using its reserves of foreign currency, and its interest rate decisions also matter: a higher interest rate tends to attract funds from abroad, raising demand for the currency and its exchange rate, while a lower interest rate tends to reduce it.

A fall in the exchange rate makes the country's exports cheaper to foreign buyers and its imports dearer for domestic buyers, which tends to increase exports and reduce imports. A rise in the exchange rate does the opposite: exports become dearer and imports cheaper, and cheaper imported goods and raw materials can help to reduce inflation.

Worked example 5. A country's exchange rate is 1 unit = $0.50. Its currency is then lowered to 1 unit = $0.40. A good made in the country costs 100 units. Calculate its price in dollars before and after the devaluation, and state the effect on foreign buyers.

Answer: Before, price = 100 × $0.50 = $50. After, price = 100 × $0.40 = $40. The good is $10 cheaper for foreign buyers, so exports should rise.

What are the macroeconomic aims of a government?

Governments generally aim for price stability (keeping inflation low and steady), economic growth (a rising level of output over time), full employment (as many workers in work as possible), and a satisfactory balance on the balance of payments (avoiding a persistent deficit where a country spends more abroad than it earns).

Governments may also seek a fairer distribution of income. Monetary policy is one of the main sets of tools used to pursue these aims, alongside fiscal and supply-side policy.

Definition: macroeconomic aims. The broad economic objectives a government pursues for the whole economy, usually including price stability, economic growth, full employment and balance of payments equilibrium.

These aims often pull in different directions. A policy that raises output and employment quickly may also push prices up, while a policy that slows inflation may temporarily raise unemployment.

A government therefore has to decide which aim matters most at a particular time, and it uses monetary policy together with other policies to try to reach several aims at once.

How can monetary policy help a government achieve its macroeconomic aims?

If inflation is too high, the central bank can raise the interest rate at which it lends to commercial banks, raise the reserve ratio, or sell government bonds through open market operations.

Each of these reduces the money supply and raises the cost of borrowing, discouraging spending and so helping to bring price stability.

If growth is too slow or unemployment is too high, the central bank can lower the interest rate, lower the reserve ratio, or buy government bonds.

Cheaper and more plentiful credit encourages firms to invest and consumers to spend, which can raise output and employment, although it risks adding to inflation if demand rises faster than supply.

If a country has a persistent current account deficit on its balance of payments (importing more than it exports), the central bank can lower the exchange rate, making exports cheaper and imports dearer, which should help exports rise and imports fall, improving the balance of payments.

A country with high inflation could instead allow its exchange rate to rise, so that imported goods and raw materials become cheaper.

In practice, these measures interact and can conflict. For example, raising interest rates to control inflation can also attract foreign funds seeking higher returns, causing the currency to appreciate, which then makes exports dearer and can worsen the balance of payments.

A government therefore has to weigh several aims together when using monetary policy.

Why might monetary policy fail to achieve the macroeconomic aims?

Monetary policy works mainly by changing the cost and availability of borrowing, so it depends on firms and households actually responding to cheaper or dearer credit; if confidence is very low, even a large fall in interest rates may not persuade firms to invest.

Raising interest rates to control inflation can slow growth and raise unemployment, so monetary policy aims can conflict with each other.

Changing the exchange rate to help the balance of payments can also work against the aim of price stability, because a weaker currency makes imported goods dearer.

Finally, under a fixed or managed exchange rate, defending a chosen rate requires the central bank to hold large reserves of foreign currency, which can run out if used continuously.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it.

What are fiat money and legal tender?

Currency notes and coins are called fiat money because their value comes from the guarantee of the issuing authority rather than from the value of the paper or metal itself.

They are also legal tender, meaning they cannot legally be refused in payment of a debt.

Demand deposits, by contrast, are not legal tender because a cheque can be refused as a method of payment, even though in practice they circulate almost as freely as cash.

What else does a central bank do?

The central bank also acts as banker to the government, holds the country's foreign exchange reserves, and acts as the lender of last resort, standing ready to lend to commercial banks when they are short of funds.

The central bank limits how far commercial banks can expand deposits by setting a required minimum proportion of deposits that banks must hold as reserves, known as the Cash Reserve Ratio (CRR), sometimes called the reserve ratio.

CRR = Reserves ÷ Deposits

Definition: Cash Reserve Ratio. The minimum percentage of its total deposits that a commercial bank must keep as reserves rather than lend out.

How do exchange rate systems differ?

Under a flexible exchange rate, the rate is set by the demand for and supply of foreign currency, and the central bank does not normally intervene.

Under a fixed exchange rate, the government sets the rate at a chosen level, and the central bank must buy or sell foreign currency to keep the rate there.

Many countries now use a managed floating exchange rate, where the rate mostly floats but the central bank intervenes from time to time to moderate large movements.

When a government, under a fixed exchange rate, deliberately lowers the value of its currency (so more units of domestic currency are needed to buy one unit of foreign currency), this is called devaluation, and it makes the domestic currency cheaper for foreigners.

When a government deliberately raises the fixed value of its currency, making the domestic currency more expensive for foreigners, this is called revaluation.

Under a flexible exchange rate, the equivalent market-driven movements are called depreciation (a fall in the value of the domestic currency) and appreciation (a rise in its value).

Definition: devaluation. A deliberate fall in the value of a currency against other currencies by the government, under a fixed exchange rate system.

Draw the price of foreign currency in terms of domestic currency on the vertical axis and the quantity of foreign currency on the horizontal axis.

An upward-sloping supply curve and a downward-sloping demand curve for foreign currency cross at the original equilibrium exchange rate.

If residents demand more foreign goods, the demand curve for foreign currency shifts to the right, and the new equilibrium exchange rate is higher, meaning more units of domestic currency are needed to buy one unit of foreign currency. This shows a depreciation of the domestic currency.

What are the merits of monetary policy?

Monetary policy can usually be changed quickly by the central bank, without needing lengthy legislation, so it can respond faster to a sudden problem such as rising inflation than many other policies.

Changes in the interest rate or reserve ratio affect the whole banking system at once, giving the central bank a broad tool for managing the overall level of spending in the economy.

Because the central bank, rather than elected politicians, usually sets these measures, decisions can be taken on economic grounds with less short-term political pressure.

The measures are also reversible. If a rise in interest rates turns out to be too severe, the central bank can lower them again at short notice, which makes monetary policy a flexible instrument for fine tuning demand.

Finally, open market operations can be carried out in small steps, so the central bank can adjust the money supply gradually rather than in one large change.

How do commercial banks create money?

Commercial banks do not expect every depositor to withdraw their money at the same time. This allows a bank to keep only part of its deposits as reserves and lend out the rest.

When a loan is made, the borrower typically redeposits the money (directly or after spending it), which becomes a new deposit in the banking system. Total deposits therefore rise above the original cash paid in, and the money supply expands.

Starting with a given amount of reserves, successive rounds of deposits and loans allow the banking system as a whole to support a multiple of the original reserves. This multiple is the money multiplier.

Money multiplier = 1 ÷ CRR

Worked example 6. The Cash Reserve Ratio is 20%. Calculate the money multiplier, and the total deposits that an initial reserve of $100 can eventually support across the banking system.

Answer: Money multiplier = 1 ÷ 0.20 = 5. Total deposits supported = $100 × 5 = $500.

Draw a cycle of boxes: an initial deposit enters a bank; the bank keeps the required reserve and lends the remainder to a borrower; the borrower spends the loan, and the recipient redeposits it as a new deposit in the banking system; the cycle repeats, each round adding a smaller amount, until total reserves held equal the required ratio of total deposits.

What are outright and repo operations?

Open market operations are described as outright operations when there is no promise to reverse the transaction later, and the resulting change in money supply is permanent in nature.

Where there is an agreed date and price for reversing the transaction, the change in money supply is only temporary.

Under a repurchase agreement (repo), the central bank buys securities from a bank with an agreement to resell them later at an agreed price; the interest rate charged on this transaction is the repo rate.

The opposite transaction, where the central bank borrows money from banks by selling securities with an agreement to buy them back later, is conducted at the reverse repo rate.

Repo and reverse repo operations at different maturities (overnight, seven day, fourteen day) have become the main tool for changing short-term interest rates.

What are qualitative tools?

A central bank's tools are often grouped as quantitative tools, which change the overall quantity of money or credit (the reserve ratio, its lending rate, buying and selling bonds), and qualitative tools. Alongside the quantitative tools, a central bank can also use qualitative tools, such as moral suasion (persuading commercial banks to lend more or less to particular sectors) and margin requirements (changing how much collateral a borrower must provide relative to a loan).

These work through persuasion and selective rules rather than through a direct, economy-wide change in the money supply, and so are usually treated as a supplementary set of tools alongside the main quantitative measures.

Glossary

• Money supply: the total stock of currency and demand deposits held by the public at a given time.
• Monetary policy: the central bank's use of interest rates, money supply and related tools to influence economic activity.
• Central bank: the institution responsible for issuing currency and controlling the money supply of a country.
• Commercial bank: a bank that accepts deposits from the public and lends part of these funds to borrowers.
• Reserve ratio: the minimum percentage of deposits a commercial bank must keep as reserves rather than lend out.
• Interest rate: the price of borrowing money, or the reward for saving, usually expressed as a percentage per year.
• Open market operations: the buying and selling of government bonds by the central bank to change the money supply.
• Foreign exchange rate: the price of one currency expressed in terms of another currency.
• Devaluation: a deliberate fall in the value of a currency by the government under a fixed exchange rate system.
• Revaluation: a deliberate increase in the value of a currency by the government under a fixed exchange rate system.
• Depreciation: a fall in the value of a currency against other currencies under a flexible exchange rate system.
• Appreciation: a rise in the value of a currency against other currencies under a flexible exchange rate system.

Common errors and misconceptions

• Misconception: money supply is only the physical cash printed by the government. Correct: money supply also includes demand deposits held with commercial banks, which can be spent by cheque or transfer.
• Misconception: a central bank cannot influence the exchange rate. Correct: it can buy or sell its own currency using its foreign currency reserves, and its interest rate decisions also change the demand for the currency.
• Misconception: raising the reserve ratio increases the money supply because banks hold more money. Correct: raising the reserve ratio reduces the amount banks can lend, so it decreases the money supply.
• Misconception: only interest rates count as monetary policy. Correct: monetary policy also includes direct changes to the money supply, such as the reserve ratio and open market operations, and changes in the foreign exchange rate.
• Misconception: a weaker currency only brings benefits for a country's trade position. Correct: a weaker currency helps exports and imports but also makes imported goods dearer, which can raise inflation.
• Misconception: commercial banks can lend out all of the deposits they receive. Correct: commercial banks must keep back a required reserve, set by the reserve ratio, and can only lend the remainder.
• Misconception: lowering interest rates always leads to faster economic growth with no drawbacks. Correct: lower interest rates can encourage spending but also risk higher inflation if demand grows faster than supply.

Exam-style questions with model answers

Q1. Define 'money supply'. [2 marks]

1. Money supply is the total stock of money held by the public in an economy at a point in time.
2. It consists of currency (notes and coins) plus demand deposits held with commercial banks.

Q2. Identify two monetary policy measures a central bank can use to reduce the money supply. [2 marks]

1. Raise the interest rate at which it lends to commercial banks.
2. Raise the reserve ratio that commercial banks must hold against their deposits.

Q3. A commercial bank has deposits of $500 million. The central bank raises the reserve ratio from 10% to 20%. Calculate the change in the amount of these deposits the bank can lend out. Show your working. [4 marks]

1. At a reserve ratio of 10%, required reserves = 10% of $500 million = $50 million.
2. The bank can lend $500 million − $50 million = $450 million.
3. At a reserve ratio of 20%, required reserves = 20% of $500 million = $100 million, so the bank can lend $400 million.
4. The amount the bank can lend falls by $50 million ($450 million to $400 million).

Q4. Explain how a central bank can use interest rates to reduce inflation. [4 marks]

1. The central bank raises the interest rate at which it lends to commercial banks.
2. This raises the cost to commercial banks of borrowing reserves from the central bank.
3. Commercial banks respond by raising the interest rates they charge their own borrowers.
4. Higher borrowing costs discourage consumer spending and business investment, reducing total demand and so helping to slow inflation.

Q5. Explain how a fall in the foreign exchange rate of a country's currency may help it to reduce a deficit on its current account. [4 marks]

1. A fall in the exchange rate means the currency is worth less against other currencies.
2. Exports become cheaper for foreign buyers, so the quantity exported is likely to rise.
3. Imports become dearer for domestic buyers, so the quantity imported is likely to fall.
4. With exports rising and imports falling, the current account deficit should narrow.

Q6. Analyse how a central bank can use open market operations to reduce inflation. [6 marks]

1. Open market operations are the buying and selling of government bonds by the central bank.
2. To reduce inflation, the central bank sells government bonds to commercial banks and other buyers.
3. Buyers pay for the bonds, so money is withdrawn from the banking system and bank reserves fall.
4. With fewer reserves, banks can lend less, so the money supply contracts.
5. A smaller money supply and less lending raise interest rates and reduce spending.
6. Lower total demand eases pressure on prices, helping to bring inflation down.

Q7. Discuss whether or not a government should use monetary policy to reduce unemployment. [8 marks]

1. Monetary policy can lower the interest rate at which the central bank lends, making borrowing cheaper.
2. Cheaper credit encourages firms to invest and expand output, so they take on more workers.
3. Lower interest rates also encourage consumers to spend, raising demand and output and so employment.
4. The central bank could also lower the reserve ratio or buy government bonds, increasing the money supply and lending.
5. However, if demand rises faster than supply, the result may be inflation rather than more jobs.
6. If confidence is low, firms may not borrow and invest even when interest rates fall, so unemployment may stay high.
7. Lower interest rates may cause the currency to depreciate, making imports dearer and adding to inflation.
8. On balance, monetary policy can help reduce unemployment, but it works best alongside other policies and carries risks.

Key takeaways

• Money supply is the total stock of currency and demand deposits held by the public at a given time.
• Monetary policy uses interest rates, money supply and foreign exchange rate changes to influence spending and prices.
• Raising the interest rate or the reserve ratio reduces the money supply and discourages spending.
• Open market operations change the money supply by the central bank buying or selling government bonds.
• Devaluation or depreciation makes exports cheaper and imports dearer, helping a balance of payments deficit.
• Revaluation or appreciation makes exports dearer and imports cheaper.
• Macroeconomic aims usually include price stability, economic growth, full employment and balance of payments equilibrium.
• Monetary policy measures can conflict, so achieving one aim may make another harder to reach.

Test yourself

What two main components make up money supply?

Currency (notes and coins) in circulation and demand deposits held by the public with commercial banks.

What happens to the money supply if the central bank raises the reserve ratio?

The money supply falls, because banks must keep back a larger share of deposits as reserves and can lend out less.

What is the interest rate set by the central bank?

The rate of interest at which the central bank lends funds to commercial banks.

What is the difference between devaluation and revaluation?

Devaluation is a deliberate lowering of a currency's fixed value by the government; revaluation is a deliberate raising of it.

How does selling government bonds through open market operations affect the money supply?

It withdraws money from the banking system and reduces bank reserves, decreasing the money supply.

Why might a government devalue its currency?

To make its exports cheaper and imports dearer, helping to correct a deficit on the balance of payments.

Name two macroeconomic aims a government might pursue.

Any two of: price stability, economic growth, full employment, balance of payments equilibrium.