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Monetary Policy

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Economics

You might have noticed a relatively recent post-pandemic price hike, which the Bank of England aimed to slow down by increasing interest rates to 0.5% in February 2022.1 This is an example of monetary policy: the Central Bank controls the interest rates to ultimately influence the rate of inflation in the whole economy. Want to learn more? Then read on.

Monetary policy: meaning

Monetary policy is a demand-side policy. It is a type of policy that allows the government to manipulate the interest rate and alter the money supply to change the level of aggregate demand and achieve its macroeconomic objectives.

Monetary policy is when the government uses interest rates and manipulation in the money supply to change the level of aggregate demand in the economy.

Before 1997, the Treasury Department in the government along with the Bank of England were responsible for setting monetary policy. However, since 1997 the Bank of England is in charge of the operational tasks and in charge of the nation’s monetary policy, and the Treasury only sets a ‘target’.

It is important to distinguish the Bank of England from other banks like Barclays or HSBC.

The Bank of England is a central bank that has the authority to change the interest rates and exchange rates and make changes to the money supply. Banks like Barclays or HSBC are commercial banks whose main operations are conducted to make a profit for their owners.

The Bank of England, a central bank, controls the banking system and implements the monetary policy on behalf of the government.

To better understand the functions of banks check our explanations on the Functions of Central Banks and Commercial Banks.

The instruments of monetary policy

A monetary policy instrument is a tool a central bank of a nation can use to control and influence the money supply, interest rates, and exchange rate to achieve a monetary objective.

The main monetary policy instrument that the Bank of England uses is the ‘Bank rate’. The Bank rate is the rate of interest the UK's central bank pays to other commercial banks like Barclays and HSBC on the deposit these commercial banks hold at the Bank of England.

The monetary policy committee (MPC) either raises or lowers the bank rate (by a quarter of 1%) every month while simultaneously leaving interest rates unchanged to keep inflation rate levels above 1% or below 1%.

The CPI target rate (the inflation rate that the UK aims to have) has remained at 2% since 2003.

To learn more about the different ways of measuring inflation check our explanation on Measures of Inflation.

The monetary policy committee (MPC) usually consists of 9 economists, headed by the Governor of the bank of England, who meet once a month to regularly set the bank rate as well as discuss and decide what aspects of the monetary policy need to change and be implemented.

The monetary policy concerning interest rates is usually based on the demand for credit and loans. When the central bank decides to increase interest rates, people will be less likely to borrow money as the cost of borrowing has increased.

Conversely, if the central bank decides to lower the interest rates, the cost of borrowing money decreases. Hence, more people will be likely to borrow. Ultimately, changes in interest rates will affect aggregate demand.

Monetary policy objectives

One central objective that the Bank of England has is to control inflation. This is the main monetary policy objective and the rate of interest is the principal monetary policy instrument they utilise.

Controlling inflation in the UK is seen as a means of creating ‘sound money’ that is deemed necessary for the economy. The end goal is creating and setting higher economic standards.

Expansionary monetary policy

Whereas fiscal policy can affect aggregate demand by using government spending, monetary policy can affect aggregate demand by changing interest rates, exchange, and money supply.

Let’s briefly look at the aggregate demand formulae:

As we said, fiscal policy can affect AD through government spending (G). Monetary policy can affect other components of the AD primarily the components of Consumption (C), Investments (I), and Net Exports (X-M) (changes in Net exports can happen due to exchange rate changes).

Refresh your knowledge on this topic in our explanation of Fiscal Policy.

In expansionary monetary policy, the central bank decreases interest rates to inject more income into the circular flow of income and to stimulate aggregate demand.

Here the central bank is encouraging consumption (C), borrowing, and investment(I) spending and discouraging savings as the cost of borrowing loans and credits has become cheaper. Exports (X-M) also increase as other countries find it cheaper to buy the country’s goods and services since interest rate reduction causes the exchange rate to depreciate relative to other currencies.

This exchange rate change makes exports more internationally price competitive as it is easier to buy your country's goods and services while simultaneously making imports less competitive.

We can use a graph to illustrate the effects of the enactment of expansionary monetary policy. Check Figure 1 below.

Monetary policy Expansionary monetary policy graph StudySmarter

Figure 1. Expansionary Monetary Policy - StudySmarter.

Let’s suppose the Bank of England with the MPC committee has decided to reduce interest rates to encourage more borrowings, investment, and consumption as the cost of borrowing money has become cheaper and more attractive for households and firms.

There is also a need to find new markets to export British-made goods and services ever since the advent of Brexit. Hence, the intention is to increase overall exports and remain competitive in the global economy.

With these changes in mind, considering that consumption, investments, and net exports, components of aggregate demand will increase, it will then shift the AD curve outward (to the right) from AD1 to AD2. The size of the shift depends on the size of the multiplier effect.

To learn how to calculate the multiplier check our explanation on the Aggregate Demand Curve.

As the economy sees an increase in aggregate demand, shown by the movement from point A to point B, real output increases from Y1 to Y2 and we also see a price level increase of P1 to P2. The extent to which both price level and real GDP increase depend on the slope of the long-run aggregate supply curve (LRAS).

To learn more about the different types of supply curves check our explanation on the Aggregate Supply.

In this scenario, the implementation of expansionary monetary policy will increase the overall real output (real GDP) and increase the availability of jobs which will simultaneously results in increased employment levels.

Contractionary monetary policy

When using a contractionary monetary policy, the government increases interest rates to decrease the level of aggregate demand in the economy. The implementation of contractionary monetary policy can be a result if the economy sees too strong growth that ends up causing high inflation levels.

When the central bank increases its interest rates, the cost of borrowing loans and credits for households and firms increases. This will in short term discourage consumption; borrowings, investments, and imports are likely to increase. Imports will rise as the exchange rate will appreciate which will, in turn, discourage other countries to buy goods and services as the currency has become more expensive. This change will make exports less competitive and imports more competitive.

Let’s assume the Bank of England has decided to increase interest rates. This, in turn, increased the cost of borrowing loans and credits which will discourage households’ consumption and firms’ investment as well as increase imports (that will likely result in a budget deficit). All of these components of aggregate demand will decrease and we can illustrate a representation of this change below in Figure 2.

Figure 2. Contractionary monetary policy - StudySmarter.

A decrease in these components, which are some of the key components of aggregate demand, will cause the aggregate demand curve to shift inward (to the left) from AD1 to AD2. This also causes real output to decrease from Y1 to Y2 and general price levels fall from P1 to P2.

A decrease in real output and a decrease in price levels due to a contractionary monetary policy can cause recessions in the long run, as the main goal initially was to control inflation. The likelihood of the recession occurring can increase due to the multiplier effect as well. This in the end causes the economy to move from point A at an operating level to point B.

Examples of monetary policy

One example of monetary policy implementations includes interest rate changes. The Bank of England can either increase or decrease them to achieve its macroeconomic objective of keeping inflation in check.

An additional example is exchange rate changes. Here, the Bank can cause the currency to appreciate or depreciate in order to control the balance of payment budgets.

A final recent example was when the US federal reserve (the policymakers responsible for interest rate policy in the USA) sold government bonds and other securities through market operations.

Monetary policy vs fiscal policy

Monetary Policy involves using interest rates and other monetary tools to influence the level of consumer spending and aggregate demand. Monetary policy aims to stabilize the economic cycle: keeping inflation low and avoiding recessions.

Fiscal policy, often associated with Keynesian economic theory, is a section of the government's overall economic policy which aims to achieve its economic objectives through the use of fiscal instruments such as taxation, public spending, and a budgetary position.

Check out our explanation to learn more about Fiscal Policy.

Monetary Policy - Key takeaways

  • Monetary policy is when the government uses interest rates and manipulation in the money supply to change the level of aggregate demand in the economy.
  • A monetary policy instrument is a tool that a central bank of a nation can use to control and influence the money supply, interest rates, and exchange rate to achieve a monetary objective.
  • The main monetary policy instrument that the Bank of England uses is the Bank Rate.
  • In expansionary monetary policy, the central bank decreases interest rates to inject more income into the circular flow of income and increase the level of aggregate demand in the economy.
  • In contractionary monetary policy, interest rates are increased with the intention of decreasing the level of aggregate demand in the economy.

Sources

1. Bank of England - Monetary Policy Summary, February 2022.

Monetary Policy

Monetary policy is a policy the government uses that consists of manipulating interest rates and altering the money supply in an economy to change the level of aggregate demand and achieve its overall macroeconomic objectives.

The monetary policy enables governments to control inflation in times of high levels of economic growth but also promote consumption when the economy enters a recession 

Expansionary and contractionary Monetary Policies enable the governments to influence components of aggregate demand and the overall economy. For example, increasing economic growth through low interest rates or controlling inflation levels through high interest rates.

Interest rates, open market operations, and reserve requirements are some examples. 

The Central Bank buying or selling government securities.

Final Monetary Policy Quiz

Question

What is the lender of last resort?

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Answer

It is typically characterised as the central bank’s willingness to offer loans to solvent banks with short-term liquidity issues.

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Question

List the three classic tools a central bank uses to manage the money supply.

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  • Altering reserve requirements.
  • Adjusting the discount rate.
  • Open market operations.

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Question

Describe how an open market operation may be used to control the money supply.

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Answer

The central bank buys or sells government assets in the open financial market to control the size of the monetary base.

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Question

Describe how the discount rate may be used to increase the money supply.

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Answer

The central bank uses a discount rate to charge commercial banks when they acquire reserves from the central bank. It compels banks to retain more reserves due to less money available to lend. 

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Question

Central banks were founded as for-profit organisations with the goal of promoting financial market stability. True or false?

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Answer

True.

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What are the main functions of the central bank?

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Answer

The main functions of the central bank are to assist the government in maintaining macroeconomic stability and to ensure financial stability in the monetary system.

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What is a central bank?

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Central banks can then be defined as state-owned entities tasked with formulating monetary policy, acting as Bank to the government and other bankers, serving as the lender of last resort, and overseeing the domestic banking system with financial supply and rate of interest.

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What are the secondary functions of the central bank?

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Bank to the government.

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Independent central banks get their own separate rights, allowing them to join international accords without the permission of the government. True or false?

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True.

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Question

What is macroeconomic stability?

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Answer

The characteristics of macroeconomic stability are stable growth, employment, a stable price level, and consistency in the current balance of payments account.

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Name two indicators of macroeconomic stability.

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Answer

Stable growth.

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Question

Define what a bank is.

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Answer

A business that makes its profit by paying interest to people who keep money there and charging a higher rate of interest to borrowers who borrow money from the bank.

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What are the two types of banks?

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Commercial and investment banks.

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What are bank reserves?

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Answer

Money and liquid assets (such as securities that can be sold quickly) held by banks in order to meet withdrawals by customers

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Question

What do you understand by private equity?

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Investments in private companies, buyouts of private shares for the purpose of funding new technology, make acquisitions, expand working capital, adn to bolster and solidify a balance sheet.

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What are commercial banks?

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Answer

Commercial banks are one of the most important types of financial institutions in an economy. They work by accepting deposits from customers and using those deposits to make loans.

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How do commercial banks get their money?

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Commercial banks get their money from customer deposits.

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How do commercial banks make profit?

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Banks make profits buy providing lower interest rates on deposits and charging higher interest rate on loans.

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What are the main functions of commercial banks?

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  • Guaranteeing safe deposits.
  • Providing interest on deposits.
  • Offering loans.
  • Other financial services.

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Why deposits on commercial banks are considered to be safe?

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Answer

The central bank of a country serves as a lender of last resort for commercial banks. In case, anything would happen the Bank of England would step in and guarantee you get your money back.

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Why is interest earned on deposits important during times of inflation?

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To keep the actual worth of your money intact.

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When does commercial banking become more profitable?

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Commercial banking becomes more profitable when banks lend money to businesses and individuals and there’s a wide difference between the interest charges on loans and deposits.

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Mention some of the other financial services a commercial bank offers.

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-Enabling clients to access cash in a matter of seconds, by just going to an ATM. 

-Allowing and facilitating international payments to pay for goods and services you might want to receive from other countries. 

-Offer financial advice for your retirement fund or any other financial matter you might need advice on.

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What is a balance sheet of a commercial bank?

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The balance sheet of a commercial bank provides an overall overview of how well the bank is operating.

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What does a balance sheet of a commercial bank contain?

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Assets and liabilities.

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How are assets and liabilities displayed on a commercial bank's balance sheet?

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In a balance sheet, assets and liabilities are displayed on the right-hand side and left-hand side, respectively.

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What are the assets of a commercial bank?

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A commercial bank generates revenue and profit through its assets.

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What are liabilities for a commercial bank?

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Liabilities are those items that the bank owes to other parties.

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Why are commercial banks required to keep a portion of their customer deposits?

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To ensure that the bank has enough money in case a client wants to withdraw their funds.

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What's one of the most important liabilities on a bank's balance sheet?

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Interested owed to customer deposits.

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Mention some examples of the largest commercial banks in the UK.

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HSBC, Barclays, Lloyds Banking group, and NatWest groups.

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What role do commercial banks play in the economy?

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Providing financing to businesses and individuals which enables them to perform activities such as opening up a startup or buying a house.

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What are other financial institutions?

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While commercial banks concentrate on providing services to the broad public, other financial institutions are more likely to serve only a certain group of customers with more specialised products and services.

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How is financing of other financial institutions done?

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There are various ways how other financial institutions receive financing. Main ones include gathering funds and investing those funds on different securities.

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How are commercial banks different from other financial institutions?


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Answer

The main difference between a commercial bank and other financial institutions is that commercial banks can take deposits from their customers.

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What are the aims and objectives of other financial institutions?


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Answer

Providing: 

  • Services in the banking industry
  • Insurance services
  • Capital formation
  • Investing tips and advice
  • Brokerage services
  • Pension fund administration
  • Trust fund services

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Question

Why are financial institutions important for economies all over the world?

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Answer

Financial institutions are crucial to all economies all over the world as individuals and businesses depend on these institutions for transactions and funding. 

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Question

How do financial institutions such as the Central Bank keep the money supply under control?

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To control liquidity in the economy, the central bank employs a variety of tools known as monetary policies.

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Explain insurance services provided by other financial institutions.

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Financial institutions, such as insurance firms, provide individuals protection against the loss of their lives or the loss of a specific asset in the event of a catastrophe.

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Explain capital formation provided by other financial institutions.

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This includes helping companies grow their capital stock like plant, machinery, tools, and equipment, structures, modes of transportation, and communication, among other things. 

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Explain the brokerage services offered by other financial institutions.

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Brokerage services help investors buy stocks, invest in private equity, and facilitate other types of investment transactions.

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Question

Explain how credit unions work.

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Credit unions serve specific groups of people such as teachers. They have a similar function to the traditional banking system. However, these types of financial institutions are created and owned by individuals participating in them. They create a pool where funds are poured into and then use this pool to generate loans to each other at low-interest rates.

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Explain the difference between investment banks and commercial banks.

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Investment banking organisations operate differently from banks because they do not take deposits or lend money. In exchange for providing services, investment banking corporations charge substantial fees on behalf of their clients for executing trades on behalf of those clients.

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Explain how other financial institutions administrate pension funds.

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Answer

Individuals usually prepare for their retirement with the assistance of financial institutions, which provide a variety of different types of investment programs.

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What are trust fund services?

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Answer

Other financial institutions manage the assets of their clients, invest them in the most advantageous options accessible in the market, and ensure that the funds are kept secure.

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What are the most common types of financial institutions?

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Answer

One of the most common types of financial institutions that everyone knows about are commercial banks and central banks. 

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What is credit creation?

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Answer

Credit creation is a process where a bank uses a part of deposits made from their customer, to offer loans to individuals and businesses; resulting in more money created in an economy.

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What is the process of credit creation?

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Answer

By expanding their deposits, banks create credit in an economy. They do this by loaning a part of the deposits they have, therefore, generating money and funds for other people. 

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What is the credit creation multiplier formula?

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Answer

Total credit creation = original deposit x money multiplier

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Question

What does credit creation theory states?

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Answer

Credit creation theory states that as a result of bank lending activities, the bank produces deposits which then creates new purchasing power.

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