Money and Banking

Commercial banks create credit — and therefore money — because they do not keep 100% of customers' deposits as cash. They keep only a fraction, the reserve ratio, to meet expected withdrawals, and lend out the rest.

The process works as follows. Suppose a customer deposits $1,000 and the reserve ratio is 10%. The bank keeps $100 as reserves and lends $900. The borrower spends the $900, and the recipient re-deposits it in the banking system. The bank again keeps 10% ($90) and lends $810, which is spent and re-deposited, and so on through successive rounds. Each round adds to total bank deposits, and since most money in a modern economy is bank deposits, the total money supply expands by a multiple of the initial deposit.

The total expansion is given by the bank credit multiplier = 1 ÷ reserve ratio. With a 10% reserve ratio, the multiplier is 10, so an initial $1,000 deposit can ultimately support $10,000 of bank deposits — the banks have created $9,000 of new money. A lower reserve ratio means banks lend more of each deposit, giving a larger credit multiplier and more money creation; a higher reserve ratio reduces it.

This shows that commercial banks are a major source of changes in the money supply: when banks lend more freely (e.g. in a confident, low-regulation environment), the money supply expands rapidly; when they restrict lending (e.g. in a crisis), it contracts. It also explains why the central bank can influence the money supply by changing reserve requirements or interest rates, which affect how much banks lend. Because money creation is largely in the hands of commercial banks, controlling the money supply precisely is difficult — an important limitation of monetarist policy.

Monetary policy uses interest rates, the money supply and credit conditions to influence the economy, with quantitative easing (QE) as an additional tool. Its effectiveness varies with the type of problem and the state of the economy.

Controlling inflation. For demand-pull inflation, monetary policy is well suited: raising interest rates reduces consumption and investment, lowering AD and inflation, and an independent central bank gives the policy credibility that anchors inflation expectations. The quantity theory (MV = PT) supports controlling the money supply/credit to control inflation: if V and T are stable, restraining money growth restrains the price level. However, this assumes V and T are stable (Keynesians disagree — V varies, and with spare capacity more money raises output not prices), the money supply is hard to control (banks create credit), and monetary policy is useless against cost-push inflation, where tightening AD merely raises unemployment.

Stabilising the economy / QE. In a recession, cutting interest rates stimulates AD. But when rates hit the zero lower bound, conventional policy is exhausted, and QE is used: the central bank creates money to buy bonds, raising the money supply, lowering long-term rates, and (via cheaper borrowing, more lending and a wealth effect) boosting AD. Strengths: QE can support demand when normal policy fails, as after 2008. Weaknesses: its effects are uncertain — banks may not lend the extra reserves, confidence may be too low, and it mainly inflates asset prices, which can worsen inequality without much real-economy effect.

General limitations of monetary policy. It is a blunt instrument (affects the whole economy, can't be targeted), has time lags (12–24 months), and depends on confidence and the responsiveness of borrowing/spending. It cannot directly tackle structural problems, the balance of payments or inequality.

Judgement. Monetary policy, including QE, is effective for its core purpose — controlling demand-pull inflation and managing AD in normal conditions — and is the main tool of most central banks for inflation targeting, owing to its flexibility and credibility. But its effectiveness is conditional and partial: it is weak in a deep recession (zero bound, low confidence), useless against cost-push inflation, hard to fine-tune (uncertain money control and lags), and QE has uncertain effects and side effects on asset prices and inequality. The most defensible conclusion is that monetary policy is a valuable but limited tool, most effective for demand-pull inflation and AD management, and best combined with fiscal and supply-side policy — with QE as an emergency measure when conventional rates are exhausted, rather than a reliable everyday tool.

The quantity theory of money states MV = PT, where M is the money supply, V the velocity of circulation, P the price level and T the number of transactions (output).

The simple monetarist prediction is that a 15% rise in M, with V and T stable, would cause a roughly 15% rise in P (inflation). But the data show the price level barely changed and output rose instead — so the simple prediction does not hold here.

This can be explained because, in a deep recession, the assumptions that V and T are stable do not hold:

• There is substantial spare capacity, so the extra money and spending can be met by higher output (T rises) rather than higher prices. Firms increase production to use idle resources, so P stays roughly constant while T increases.
• Velocity (V) often falls in a recession, as households and firms are cautious and hold onto money (or banks are reluctant to lend), so the rise in M is partly offset by lower V — dampening any effect on P.

So with rising T and possibly falling V absorbing the increase in M, the left-hand side (MV) translates into higher real output (T) rather than a higher price level (P). This illustrates the Keynesian critique of the quantity theory: when there is spare capacity, increasing the money supply can boost output with little inflation — which is exactly why expansionary monetary policy/QE is used in a recession.

Interest rates — the cost of borrowing and the reward for saving — can be explained by two theories, and they matter because they strongly influence aggregate demand.

Loanable funds theory. This views the interest rate as the 'price' that equates the supply of loanable funds (savings) with the demand for loanable funds (borrowing for investment and consumption). A higher interest rate increases the quantity of savings supplied and reduces the quantity borrowed; equilibrium is where the two are equal. An increase in saving (supply) lowers the rate; an increase in the demand to borrow raises it.

Keynesian (liquidity preference) theory. This views the interest rate as determined by the demand for money (liquidity preference) and the money supply. People hold money for transactions, precautionary and speculative motives; the speculative demand for money is inversely related to the interest rate. The equilibrium interest rate is where the demand for money equals the (central-bank-set) money supply. An increase in the money supply lowers the interest rate; an increase in money demand raises it. This theory is the basis for central banks influencing rates via the money supply.

Why interest rates matter. Interest rates are a key channel of monetary policy and affect AD through several routes: lower rates make borrowing cheaper, so consumption and investment rise; saving becomes less attractive, so spending rises; existing borrowers have more disposable income; and lower rates can depreciate the currency, raising net exports. Higher rates work in reverse, restraining AD and inflation. Interest rates therefore influence inflation, output, employment, the exchange rate and the current account, making them central to macroeconomic management.

Judgement. The two theories are complementary rather than contradictory: loanable funds emphasises the real market for savings and investment, while liquidity preference emphasises the monetary market and is the practical basis for central-bank policy. In practice, modern central banks set a key policy rate (consistent with liquidity preference) to influence the wider economy. Either way, interest rates matter enormously because they are a primary determinant of borrowing, spending and investment, and hence of aggregate demand, inflation and the wider economy.