Core Concepts of Money, Supply, and Monetary Policy

Posted on Mar 28, 2025 in Economy

Understanding Money and Its Functions

  • Store of value: Money allows transferring purchasing power into the future. However, it’s an imperfect store due to inflation eroding its value.
  • Unit of account: Money provides the common terms for quoting prices and recording debts.
  • Medium of exchange: Money is used to facilitate transactions for goods and services.

Money Classifications (Aggregates)

Money supply is often categorized into different aggregates:

  • M0/MB (Monetary Base): Currency in circulation plus bank reserves held at the central bank.
  • M1: M0 plus demand deposits (checking accounts) and other highly liquid deposits.
  • M2: M1 plus savings accounts, money market accounts, and small-denomination time deposits (CDs).
  • M3: M2 plus large-denomination time deposits and institutional money market funds.
  • M4 (and higher): Broader measures including M3 plus other less liquid assets like certain bonds. (Note: Definitions can vary by country).

Factors Influencing Money Supply

  • The Central Bank: Through monetary policy tools.
  • The Banking Sector: Through lending and deposit creation (money multiplier effect).
  • Household Behavior: Public preferences for holding cash versus deposits.

Key Monetary Concepts

  • Monetary Base (B): Currency in circulation (C) plus bank reserves (R). Formula: B = C + R.
  • Bank Reserves (R): The portion of deposits that banks hold either as vault cash or at the central bank, and do not lend out.
  • Reserve Ratio (rr): The fraction of deposits that banks are required or choose to hold as reserves.
  • Currency-Deposit Ratio (cr): Reflects the public’s preference for holding currency (cash) relative to demand deposits.
  • Discount Rate: The interest rate at which the central bank lends reserves to commercial banks.
  • Financial Intermediation: The process of channeling funds from savers (lenders) to borrowers (spenders).
  • Banking Sector: Financial intermediaries legally authorized to accept deposits and make loans, playing a key role in money creation.

Money Creation Process

  • Primary Emission (Monetary Base Creation): Controlled by the central bank, primarily through open market operations and lending to banks.
  • Secondary Emission (Deposit Creation): Occurs as the banking sector lends out a portion of deposits, creating new deposits and thus expanding the money supply beyond the initial monetary base (the money multiplier effect).

Money Supply Model and Policy

Purpose of the Model

A simplified money supply model helps analyze how central bank policies, banking sector behavior (reserve holding), and household preferences (currency holding) interact to determine the overall money supply.

Monetary Policy

Monetary policy refers to the central bank’s actions to manage the money supply and credit conditions to foster price stability and maximum employment. Key tools include:

  • Open Market Operations: Buying or selling government securities to inject or withdraw reserves from the banking system.
  • Reserve Requirements: Setting the minimum reserve ratio banks must hold.
  • The Discount Rate: Adjusting the interest rate for loans to commercial banks.

Theories of Money Demand

Portfolio Theories

These theories emphasize money’s role as a store of value within a broader portfolio of assets. People demand money because it offers liquidity and safety, balancing the risk and return characteristics of other assets like bonds or stocks.

Transactions Theories

These theories focus on money’s role as a medium of exchange. People demand money primarily to facilitate everyday transactions – buying goods and services. The level of economic activity influences this demand.

Money and Inflation Dynamics

Quantity Theory of Money

The quantity equation of money (MV = PY) provides a fundamental framework linking the money supply (M), the velocity of money (V – the rate at which money changes hands), the overall price level (P), and the real output of goods and services (Y). It suggests that, if velocity (V) and real output (Y) are relatively stable or predictable, changes in the money supply (M) will directly impact the price level (P), thus driving inflation.

Inflation and Seigniorage

Governments can finance public spending through:

  1. Taxes
  2. Borrowing (issuing debt)
  3. Printing Money (Seigniorage)

Seigniorage is the profit derived from creating money. When a government finances its spending by instructing the central bank to print excessive amounts of money, it increases the money supply rapidly. This often leads to high inflation. Inflation acts as an inflation tax, eroding the purchasing power of money held by the public.

Economic Modeling Insights

Equilibrium Conditions

Macroeconomic models often analyze the conditions under which different markets reach equilibrium. For example, the IS-LM model identifies the combination of interest rate (r) and national income (Y) where both the goods market (represented by the IS curve) and the money market (represented by the LM curve) are simultaneously in balance.

Policy Impact Assessment

Mathematical models allow economists to assess the potential impact of policy changes. Using techniques like partial derivatives, they analyze how shifts in policy parameters (e.g., government spending, tax rates, money supply) affect key economic variables (like output, employment, inflation, and interest rates). Graphing these results, often using diagrams like the IS-LM framework, helps visualize and understand these complex interactions.