Causes of Money Supply to rise

Thomas Sim PEA2066

Q.

d) Discuss the causes of supply of money to rise in an economy. (8 marks)
(8 marks, 2012 Q7d)
What causes the money supply to rise?

A.

  1. Banks choose to hold a lower liquidity ratio.
  2. An inflow of funds from abroad. If the Bank of England has to buy the surplus pounds on the foreign exchange to build up foreign reserves. This sterling will be used by foreigners to buy UK exporters this will than be deposited in banks by the exporters, credit will be created leading to a multiplied increase in the money supply.

This will only occur when the Bank of England attempts to maintain an exchange rate below the equilibrium.

  1. A PSBR (Public Sector Borrowing Requirement), this depends on how the PSBR is financed:
  • if gov’t sells securities to the Bank of England, this will lead to an increase in the Money Supply, because bank’s deposits are seen as liquid assets. 
  • gov’t sells securities to oversees purchasers, this will lead to an increase in the Money Supply if the exchange rate does not increase.
  • Bank of England sells Treasury bills to the banking sector. These are seen as liquid assets and so they can be used as the liquidity base for additional loans to customers. Therefore there will be a multiplied increase in the Money Supply.
  • Gov’t sells bonds to the banking sector. Bonds are seen as illiquid and therefore there will be not used as a base for lending money.
  • Gov;t sells bonds or bills to the non banking sector. If the public buy anything from the gov’t they will reduce their deposits in banks, there will be no expansion in the Money Supply.
If there is a change in the way the PSBR is funded then there will be a change in the Money Supply this is known as funding.

The relationship between Money Supply and the rate of interest.

Some monetary theory assumes supply of money is totally independent of the interest rate. However Keynesian models assume that higher demand for credit will push up interest rate, making it more attractive for banks to supply credit higher interest rate may attract deposits from oversees.

Higher interest rate may encourage depositors to switch money from sight accounts to time accounts . Banks can then decrease liquidity ratio.
Ref:
What causes the money supply to rise? From Economics Help at
http://www.economicshelp.org/university/money-supply-increase/