Money makes the world go round! But what controls Money? The short answer? Monetary policy! The long answer? Let’s find out together
Table of Contents
Fun Fact about Monetary policy!
Did you know that Venezuela‘s hyperinflation reached crazy high levels, with prices doubling every few days at its peak? This hyperinflation was fueled by the government’s excessive printing of money to finance its spending, leading to a dramatic devaluation of the currency, the bolivar. This phenomenon vividly illustrates how mismanaged monetary policy can have disastrous consequences for an economy.
So, that’s one way to not use monetary policy… lets find out more about monetary policy together!
Terms To remember!
- Demand side policies are policies focused on manipulating aggregate demand to achieve the macroeconomic objectives. The macroeconomic objectives include stable inflation, low levels of unemployment, economic growth, low levels of income inequality, and sustainable levels of government debt.
- Monetary policy is a set of actions the central bank does to control a nations overall money supply to manipulate aggregate demand and fulfill the macroeconomic objectives. It includes policies related to interest rates, and other methods to expand or contract money supply.
- Commercial bank: A financial institution that provides services like lending loans, providing bank overdrafts, savings, and certificates of deposits to the general public (Businesses and consumers). These institutes earn money from lending loans and earning interest on loans.
- Central bank is the government bank that has control over the supply of money in the country.
- Interest rates is the percentage paid on top of the money borrowed. It is also the percentage received when money is received.
How does Monetary Policy increase aggregate demand?
The answer to this is expansionary monetary policy! Expansionary monetary policy is the expansion of money supply via reduced interest rates and/ or quantitative easing. Quantitative easing is done when interest rates approach zero and can’t be reduced further. The central bank purchases government securities or other securities from the market in order to increase money supply and encourage investment and lending.
- Reducing interest rates reduces borrowing cost, and makes saving less attractive to consumers and spending more effective. The reduce borrowing cost incentivizes consumers to increase their expenditure, this increase in expenditure leads to an increase in aggregate demand.
- Reducing interest rates reduces borrowing cost, and makes saving less attractive to businesses and spending more effective. The reduce borrowing cost incentivizes businesses to increase their investments, this increase in investments leads to an increase in aggregate demand.
- Quantitative easing is injection to the economy as the central bank invest in the government (via government securities) and/or business, which gives businesses more money to spend and incur more investment expenditure which leads to the increase in aggregate demand.
How does Monetary policy reduce aggregate demand?
The answer to this is contractionary monetary policy! Contractionary Monetary Policy is the contraction of money supply via the increase in interest rates and/or reducing money circulation in the economy.
- The increase in interest rates, encourage savings and increases borrowing cost, thus discouraging consumers from borrowing money. The increased interest rates incentivizes consumers to save rather than incur consumer expenditure, hence consumer expenditure falls, leading to a fall in aggregate demand.
- The increase in interest rates, encourage savings and increases borrowing cost, thus discouraging businesses from borrowing money. The increased interest rates incentivizes businessto save rather than incur investment expenditure, hence investment expenditure falls, leading to a fall in aggregate demand.
Let’s evaluate monetary policies
| pros | cons |
| Interest rates can be changed quickly as there is no political influences that may be hesitant to raise interest rates. This means that central banks can quickly react to changes in inflation . | A decrease in interest rates may not reach the impoverish who are hesitant to borrow money due to existing debt. So monetary policy may be less effective in reducing poverty and income inequality. |
| There is no crowding out because there is no government expenditure that may monopolize the money supply when expansionary fiscal policy is done through increased government expenditure. This may make it easier to predict how much should the interest rate be set to achieve the wanted aggregate demand. | Expansionary monetary policy is less effective as it doesn’t directly effect a component of aggregate demand like an increase in government spending does. |
| Contractionary monetary policy is very effective in reducing inflation, as the central bank does inflation targeting, which is when the central bank creates a medium term inflation rate goal for the economy. | Consumers and businesses may not react to the reduction in interest rates or quantitative easing if they have no confidence in the economy, and thus a reduction in interest rates may not increase aggregate demand by a large extend if consumer and businesses refuse to spend money. |
| Every industry will feel the benefit of contractionary monetary policy, this means that industries that government would usually want to control can benefit from expansionary monetary policy. This may lead to an increase in market failure. |
Effect of monetary policy on Macroeconomic objectives
- Low and stable rates of inflation: Contractionary monetary policy is very effective in reducing inflation, as increasing interest rates increases borrowing cost for both businesses and consumer expenditure and incentives both to save rather than incur expenditure.
- Reduce unemployment: By reducing interest rates, borrowing cost reduces for businesses, hence their cost of production reduces which incentivizes business to employ more people thus increasing employment in the country.
- Low income inequality: A reduction in interest rates may make it easier for the poor to borrow money and start a business thus earning income. Lower interest rates also incentivizes business to hire more people, which means more people are earning income. However, its unlikely that a reduction in interest rates would reach the impoverish if they are burdened by existing debt and are hesitant to borrow money.
- Economic growth: Expansionary monetary policy can be used to increase economic growth as with the increase in aggregate demand, real gross domestic product will increase, as an increase in aggregate demand will incentivize producers to produce more. However, economic growth may not occur even with expansionary monetary policy as consumers and business may not react to the reduction of interest rates if they have no fate in the economy hence aggregate demand may not increase and real gross domestic product won’t either.
- Sustainable debt: A decrease in interest rates makes it easier (cheaper) for the government to repay any debt to the central bank.
How does Monetary policy resolve inflationary gap?
Before any government intervention the economy’s aggregate demand was at SRAD1 and the economy’s short run aggregate supply is denoted by SRAS. They intersect to give the equilibrium price level P1 and equilibrium real gross domestic product at Y1 which is unfortunately greater than the optimum output of Y0.
To fix that the government imposes contractionary monetary policy via increasing the interest rates, which makes saving more attractive and borrowing less attractive, as the borrowing cost increases. When borrowing cost increases it discourages investment expenditure and consumer expenditure (which are components of aggregate demand), thus aggregate demand decreases denoted by the SRAD curve shifting to the left (SRAD1 to SRAD0). The decrease in aggregate demand resulted in a decrease in price level from P1 to P0 and a decrease in real gross domestic product from Y1 to Y0 thus eliminating the inflationary gap.
How does Monetary policy remove deflationary gap?
Before any government intervention the economy’s aggregate demand was at SRAD1 and the economy’s short run aggregate supply is denoted by SRAS. They intersect to give the equilibrium price level P1 and equilibrium real gross domestic product at Y1 which is unfortunately less than the optimum output of Y0.
To fix that the government imposes expansionary monetary policy via decreasing the interest rates, which makes saving less attractive and borrowing more attractive, as the borrowing cost decreases. When borrowing cost increases it encourages investment expenditure and consumer expenditure (which are components of aggregate demand), thus aggregate demand increases denoted by the SRAD curve shifting to the right (SRAD1 to SRAD0). The increase in aggregate demand resulted in a increase in price level from P1 to P0 and a increase in real gross domestic product from Y1 to Y0 thus eliminating the deflationary gap.
OR
To fix that the government imposes expansionary monetary policy via quantitative easing, when the central bank invest in businesses, it encourages investment expenditure as businesses have more money to spend (which is a components of aggregate demand), thus aggregate demand increases denoted by the SRAD curve shifting to the right (SRAD1 to SRAD0). The increase in aggregate demand resulted in a increase in price level from P1 to P0 and a increase in real gross domestic product from Y1 to Y0 thus eliminating the deflationary gap.
Higher level Economics: How do commercial banks create money?
terms to remember:
- Credit creation: refers to expanding the availability of money through the advancement of loans and credit by banks and financial institution. These institutions use their demand deposits to provide loans to their customers. In the process of credit creation banks keep some shares of their money as a minimum reserve requirement to meet the demand of the depositors.
- credit multiplier: refers to the ratio between the change in demand deposits and change in cash reserves of the commercial banks with the central banks. The formula for this is 1/ reserve ratio
- Cash Reserve ratios: The commercial banks have to hold a certain amount of deposit as reserves with the central bank. The percentage of cash required to be kept in reserves as against the bank’s total deposits.
- Statutory liquidity ratio: is a minimum percentage of deposits that a commercial bank has to maintain in the form of gold, liquid cash, or other securities.
- reserve ratio/minimum reserve requirement= Cash reserve ratio+ Statutory liquidity ratio
To understand this lets take a worked example.
The starting deposit is $100 and there is a reserve ratio of 10%, let see how much credit can this $100 create
| Bank | Bank’s deposits | Reserve ratio: 10% | Amount Bank can loan out |
| A | 100 | 10 | 90 |
| B | 90 | 9 | 81 |
| C | 81 | 8.1 | 72.9 |
| D | 72.9 | 7.29 | 65.61 |
| E | 65.61 | 6.561 | 59.046 |
Explanation: A person deposits $100 in bank A, but due to the reserve ratio of 10% the bank has to keep $10 and can loan out 90%. Another’s bank loan can be another bank’s deposit as a consumer may deposit that $90 to bank B and once again bank B has to keep $9 because of the reserve ratio and can loan out $81. From these 6 transactions the amount of credit created is 90+81+72.9+ 65.61+59.046= $368.57.
However rather than creating a large table to find out how much credit can be made, we can use a formula 1/reserve ratio, which is the credit multiplier. To find out how much money is created we multiply the credit multiplier with the initial deposit
So in the case of the example above the total money created is…
$100*(1/0.1)
=$100*10
=$1000
So if the central bank wants to increase the aggregate demand (expansionary monetary policy) they simply lower the reserve ratio. For example now the reserve ratio is 5%, hence with the same 100 dollars, $2000 can be created, rather than the initial $1000.
If the central bank wants to reduce aggregate demand (contractionary monetary policy) they will increase the reserve ratio. If the bank were to increase the reserve ratio to 20%, the same $100 will only create $500, rather than the initial $1000.
Higher level Economics: What are tools available to governments to control the money supply?
Its important for the governments to control money supply because that will be how interest rates are set. The more money there is in the economy, the lower the interest rates (expansionary monetary policy). The less money there is in the economy, the higher the interest rates (contractionary monetary policy).
- Minimum reserve requirement: As explained above if the central bank wants to do a contractionary monetary policy they will increase the minimum reserve requirement and vice versa should be done if they want to do expansionary monetary policy.
- Open Market Operations: involves the buying a selling of securities in the open market by the central bank. If the central banks wishes to reduce the money supply, they will sell more government securities to institutions which will reduce the money they will have to lend. If the vice versa should happen then the central bank will buy back the securities, essentially the central banks injecting money in to the economy, and this will give institutions more money to lend.
- base rate: The base rate is the rate of interest in which the central bank charges loans on the commercial bank. The commercial bank sets its interest rates a little higher than the base rate to earn profit. If the central bank increases the base rate, it is passed on to the consumers in the form of increased interest rates which is a contractionary monetary policy. If the central bank decreases the base rate, it is passed on to the consumers in the form of decreased interest rates which is a expansionary monetary policy
- Quantitative easing (expansionary monetary policy): In quantitative easing the central bank injects new money directly into the economy by purchasing assets, mostly securities from other financial institution with newly create electronic cash. This is usually done when interest rates are near 0% yet the central bank still wants to apply an expansionary monetary policy.
Higher Level Economics: What determines the equilibrium nominal interest rates?
- The nominal interest rate are interest rates that aren’t adjusted for inflation.
- Real interest rates are interest rates that are adjusted for inflation.
The Y axis of the money market diagram is the nominal interest rates, and the x- axis is the quantity of money. The demand curve for money is a downward sloping curve. It can be explained by the law of demand that is when price falls, quantity demanded rises. If the nominal interest rate rises people will be less likely to borrow money hence the quantity demanded for money will fall.
The supply of money in an economy is controlled by the by the central bank through it’s monetary policy, and is generally considered to be fixed at any give time. Thus its usually shown as a perfectly inelastic supply curve.
The money market is determined at where the demand and supply for money intersect to determine the equilibrium nominal interest rate.
In the case of the graph above the equilibrium nominal interest rate is at ie, where the Sm is equal to Dm. If the central bank adopted contractionary monetary policy, then the supply for money would shift left from Sm to Sm1 and the nominal interest rates would increase from ie to i1.
On the other hand if the central bank adopted an expansionary monetary policy, then the supply for money would shift right from Sm to Sm2 and the nominal interest rates would decrease from ie to i1.
Sources:
Oxford IB diploma Economics course book 2020 edition
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