Banks do not just store money. When they lend, they create it.
How one deposit grows
A deposit
Ana puts €1,000 in Bank A: its reserves rise.
Keep a part
Bank A must keep 10% (€100) and lends the other €900.
Spent and re-deposited
The €900 is spent and lands in Bank B, which lends €810.
Repeated
Deposits can grow to €1,000 × 1 ÷ 0.10 = €10,000.
Ana deposits €1,000; the reserve requirement is 10%
| Round | Deposited | Kept as reserves (10%) | Lent out |
|---|---|---|---|
| Bank A | €1,000 | €100 | €900 |
| Bank B | €900 | €90 | €810 |
| Bank C | €810 | €81 | €729 |
| … and so on | |||
| In total | €10,000 | €1,000 | €9,000 |
The points to remember
- Maximum deposits = first deposit × 1 ÷ reserve requirement (€1,000 ÷ 0.10 = €10,000).
- A lower reserve requirement means more money can be created.
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The central bank has four tools to change the money supply and interest rates.
Four tools of monetary policy
Open market operations
The central bank buys bonds from banks: their reserves rise, they lend more.
Minimum reserve requirement
A lower requirement lets banks lend more of each deposit.
Minimum lending rate
The rate the central bank charges banks: cut it and loans get cheaper.
Quantitative easing
Buying large amounts of bonds when the rate is already near zero.
The points to remember
- Write it like this: "QE is expansionary monetary policy: the central bank buys financial assets from commercial banks."
- The Bank of England and the US Federal Reserve both used QE from 2009, with rates near zero.
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The money market shows how the money supply sets the interest rate.
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The points to remember
- Axes: interest rate up, quantity of money across. Curves: MD and MS.
- Buy bonds or cut the reserve rule: MS right, rate down. Sell bonds: MS left, rate up.
Remember it as: More money, cheaper money.
Paper 1 asked this in the specimen paper, as part (a) for 10 marks.
Explain two tools open to a central bank to conduct expansionary monetary policy.
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How the 10 marks are given
| Marks | What your answer needs |
|---|---|
| 9–10 | Theory fully explained, terms used correctly all the way through, the diagram included and fully explained |
| 7–8 | Theory explained, terms mostly right, the diagram included and explained |
| 5–6 | Theory partly explained, some terms, the diagram included |
| 1–4 | Theory only described or stated; few relevant terms |