Most of the money in an economy was never printed. It was created by ordinary commercial banks making loans. Once you see how that works, the four tools a central bank uses to control the money supply stop being a list to memorise and start making sense.
📚 What you need to know
Commercial banks create money through fractional reserve banking: keep a fraction of each deposit, lend out the rest.
The money multiplier = 1 ÷ reserve ratio. A 20% ratio gives a multiplier of 5.
The four tools: open market operations, minimum reserve requirements, quantitative easing, and changes to the base rate.
Buying government bonds injects money; selling them withdraws money.
QE is different from ordinary open market operations because the central bank creates brand new electronic money to do it.
Monetary policy is fast and flexible but weak when confidence is low or rates are already near zero.
How banks create money
You deposit $1,000. The bank does not lock it in a vault. It knows you will not want all of it tomorrow, so it keeps a required fraction — say 20% — and lends $800 to someone else. That borrower pays a builder, the builder deposits the $800 in their own bank, which keeps $160 and lends $640. And on it goes.
No new notes were printed. But the total amount sitting in bank accounts across the economy has grown far beyond the original deposit. That is money creation.
The reserve ratio decides how quickly the bars shrink. A higher ratio means each bank lends less, the bars fall away faster, and far less money is created.
Money multiplier
money multiplier = 1 ÷ reserve ratio
WORKED EXAMPLE
Money creation from a new deposit
The central bank sets a reserve ratio of 10%. A customer deposits $2,000 of new money into the banking system. Calculate the maximum total deposits that could be created, and the maximum value of new loans.
Step 1: find the money multiplier1 ÷ 0.10 = 10Step 2: multiply the new deposit$2,000 × 10 = $20,000Step 3: loans are the total minus the original deposit$20,000 − $2,000 = $18,000Total deposits $20,000, new loans $18,000this is the MAXIMUM — it only happens if every dollar is redeposited and every bank lends fully
The four tools
All four end up doing the same job: changing how much money is available and how much it costs to borrow.
1. Open market operations
The central bank buys and sells government bonds on the open market, usually with commercial banks and insurance companies.
Buying bonds hands cash to the sellers. Bank reserves rise, banks can lend more, the money supply grows and interest rates tend to fall.
Selling bonds takes cash out. Reserves fall, lending capacity shrinks, and interest rates tend to rise.
2. Minimum reserve requirements
This is the legal fraction of deposits a bank must keep rather than lend. Its main purpose is safety — a buffer against a rush of withdrawals or a financial shock. But it also controls money creation.
Higher reserve ratio → smaller money multiplier → less lending → money supply grows more slowly
3. Changes to the base rate
The base rate, sometimes called the official rate, is what the central bank charges commercial banks to borrow. Every other interest rate in the economy is priced off it, so changing it moves mortgage rates, loan rates and savings rates together. This is the routine, everyday tool.
4. Quantitative easing
When rates are already close to zero there is nowhere left to cut. So the central bank creates new electronic reserves and uses them to buy large quantities of bonds from banks and financial institutions. Those institutions end up with cash instead of bonds, so they have more to lend, long-term interest rates fall, and borrowing picks up.
QE versus open market operations. They look almost identical, and examiners test the difference. Ordinary open market operations move existing money around. QE creates new electronic money and does it on a very large scale.
A neat way to remember QE: the central bank has run out of room to change the price of money, so it changes the quantity instead. That is literally what the name says.
How good is monetary policy?
Strengths
Independent of the political cycle, so it can take the long view.
Flexible — adjusted several times a year and reversed easily if it overshoots.
No direct cost to the government budget and no extra borrowing.
Very effective at cooling an economy with an inflationary gap.
Weaknesses
Cannot be targeted. One rate applies to every region and every industry.
Weak in a deep slump. If confidence is low, cheap loans go untaken.
The zero lower bound. Once rates are near zero, cuts have little room left.
Long, variable time lags — often a year or more before the full effect appears.
Cheap credit can inflate house and asset prices instead of output.
QE risks rapid inflation later, once the economy recovers.
💡 Exam tips
The money multiplier is 1 ÷ reserve ratio. Convert percentages to decimals first: 20% is 0.2, not 20.
Say “maximum” when you give a money creation answer. Leakages mean the full amount rarely appears.
Learn the QE versus open market operations distinction as a one-line definition.
Compare monetary with fiscal policy when evaluating: monetary is faster to change, fiscal is more predictable.
Use “loose” and “tight” as alternatives to expansionary and contractionary — both appear in exam papers.
Name the zero lower bound explicitly. It is a strong evaluation point.
⚠ Common mix-ups
Thinking banks lend out only what they hold. The lending itself creates new deposits, which is why the money supply is a multiple of the original deposit.
Reserve ratio and money multiplier confused. They are inverses: a bigger ratio means a smaller multiplier.
Saying QE prints banknotes. It creates electronic reserves, not physical cash.
Getting the bond direction backwards. The central bank buying bonds injects money.
Calling monetary policy a supply-side policy. It is demand-side.
Claiming a rate cut guarantees more borrowing. Only if households and firms are confident enough to borrow.
Up next: How Fiscal Policy Works — the other demand-side tool, run by the government through the budget rather than the central bank.
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