Understanding Money Supply, Central Banks, and Monetary Policy

Posted on Jan 11, 2025 in Economy

What is Money?

  • Medium of Exchange: It is acceptable by all for transaction purposes.
  • Store of Value: It can be held for future purchases.
  • Standard of Value: It serves as a yardstick for measuring the prices of goods.

What is Money Supply?

  • M1 (Narrow Money): Includes currency held by the public (non-bank) plus balances in transaction accounts.
  • M2 (Broader Money): M1 plus balances in savings accounts and money market mutual funds.

Required Reserves Ratio

It is the portion of the deposits that commercial banks are required to keep in the reserves account.

Excess Reserves

Excess Reserves = Actual balance in the reserves account – Required Reserves

Example:

  • Deposits = $100,000
  • Required Reserves Ratio (RRR) = 5%
  • Actual Balance in Reserves A/C = $8,000
  • Excess Reserves = 8000 – (5% of 100,000) = 8000 – 5000 = $3,000

Functions of Central Banks

  1. Issue Currency
  2. Regulate or Control Money Supply
  3. Control Inflation/Recession
  4. Regulate Interest Rates
  5. Supervise the Financial System
  6. Charter Banks and Financial Institutions
  7. Regulate the Domestic Currency’s Exchange Rate

Monetary System Tools and Their Uses

  • Required Reserve Ratio (RRR)

    Central banks set the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves.

    • If RRR Increases, the amount available for loans by commercial banks decreases, and the money supply decreases.
    • Example: Deposit = 100, RRR 10% -> $90 Amount Available
    • If RRR decreases, the lendable amount by commercial banks increases, and the money supply increases.

  • Discount Rate (DR)

    The rate of interest at which the central bank lends money to commercial banks (as a lender of last resort).

    • If DR increases, commercial bank borrowing from the central bank decreases.
    • Loans by commercial banks decrease, and the money supply decreases.

  • Open Market Operations

    The sales and purchase of government securities.

    • When government securities are sold by the central bank, corporate households, commercial banks, etc., will pay money and receive government securities. Less money will be available for loans, and the money supply decreases.
    • When government securities are bought by the central bank, corporate households, etc., commercial banks, etc., will sell government securities and receive money. More loans will be given, and the money supply increases.

Monetary Stimulus Effects

It intends to increase aggregate demand. It helps in coming out of a recessionary situation in an economy.

  • The central bank would increase the money supply.
  • The interest rate would decline.
  • Households, industries, businesses, and the government would borrow more.
  • Investment and government spending would increase, and aggregate demand will increase.

Monetary Restraint on the Economy

It aims at restricting aggregate demand in an economy. This is used to control inflation.

  • The central bank reduces the money supply.
  • The interest rate would increase.
  • Households, industries, businesses, and the government would borrow less.
  • Consumption, investment, and government spending would decrease, and aggregate demand will decrease.

Demand for Money

  • Transaction Motive/Demand (MT)

    It is the requirement of money to meet transaction needs. (MT) = F(y)

    • If y increases, MT increases. If y decreases, MT decreases.
    • Money for transaction purposes is positively related to the level of income.

  • Precautionary Motive/Demand (MP)

    The demand for money for meeting unforeseen or unexpected expenses. (MP) = F(y)

    • If y increases, MP increases. If y decreases, MP decreases.
    • Precautionary demand is positively related to the level of income.

  • Speculative Motive/Demand (MS)

    The money held for speculative purposes for later financial opportunities. It indicates cash holding. (MS) = F(y)

    • If the interest rate increases, cash decreases.
    • Speculative demand is negatively related to the level of income.

Why is the Demand for Money Graph Downward Sloping?

The demand for money graph is downward sloping due to the negative relationship between interest rates and cash holdings.

Why is the Money Supply Curve Vertical?

The money supply curve is vertical because the central bank’s decision to change the money supply is independent of the market interest rate.

The Equation of Exchange and its Implication

M.V = P.Q

  • M = Money Supply
  • V = Velocity of Circulation of Money
  • P = Price Level
  • Q = Output of the Economy
  • Implication: There is a positive relationship between changes in the money supply and changes in the price level.