...Securities Liquid Money – Cash Page 230 230 231 231 B. Liquidity Preference and the Demand for Money 232 C. Implications of the Interest Sensitivity of the Demand for Money Interest Rates and Demand for Goods and Services Classical and Monetarist View The Keynesian View of Interest Rates and Expenditure Implications of the Differences 234 234 235 235 235 D. Changes in Liquidity Preference 237 E. The Quantity Theory of Money and the Importance of Money Supply The Money Equation Diagrammatic Representation of the Quantity Theory of Money 238 238 238 F. Methods of Controlling the Supply of Money Interest Rate Control Control over Banking Ratios Direct Controls over Banks Control of Government Borrowing 240 240 240 240 241 G. Monetary Policy and the Control of Inflation 241 © ABE and RRC 230 Monetary Policy Objectives The aim of this unit, in conjunction with Study Unit 12, is to explain and evaluate the effectiveness of monetary policy in a closed and open economy and discuss the possible impact of monetary policy on business decision-making. When you have completed this study unit and Study Unit 12 you will be able to: demonstrate an understanding of the relationship between the banking system and the creation of money identify the components of the high-powered money stock and explain why these have a magnified impact on the money supply explain the quantity theory of money and its role in explaining...
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...Introduction Monetary policies suggest greater attention over the world by renewed the interest in employing the central banks to control the money supply. Role of monetary policy is important to maintain a low and stable rate of inflation and price stability in the economy.(Rangarajan,1998) Imbalances of the import and export can cause the fluctuation of the exchange rate in the country. Different central bank used different monetary tools to control the money supply and maintain the economic stability of the country. Monetary Tools Used to Control the Money Supply 1. Bank of England (BoE) BoE used operational standing facilities (OSF) and interest rate (IR) to control the money supply in the countries. OSF is used to provide a security value for the market liquidity management and provides an arbitrage instruments in a standard market condition to make sure the IR will be in line with the Bank Rate. OSF gives bank resources to manage unexpected frictional payments shocks that could take the reserves accounting below zero.(Red Book-BoE,2010) IR is used to control the inflation rate by injecting money directly into the British economy by purchasing the government bonds and high quality corporate bonds. Reduction in bank IR cause borrowing more attractive and saving less attractive, this will affects the spending by companies and their customers over time the rate of inflation.(Niklov,2002) IR will cause the increase in exchange rates in Sterling relative to overseas...
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...Policy 4 Should the Central Bank control the Money Supply or Interest Rate 7 Uses of Monetary Policy 9 Drawbacks of Monetary Policy 11 The Effectiveness of Monetary Policy 12 Monetary Policy of Pakistan 13 What is Monetary Policy Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. The Need for Monetary Policy The government must regulate the money supply in order to maintain economic stability. If the government doesn’t intervene, the banks can lead to destruction in the economy. During a recession, profit-oriented banks would be prone to reduce the money supply by increasing their excess reserves...
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...Economics theories (Neo) Classical Theories 1. Introduction The term 'Classical' refers to work done by a group of economists in the 18th and 19th centuries. Much of this work was developing theories about the way markets and market economies work. Much of this work has subsequently been updated by modern economists and they are generally termed neo-classical economists, the word neo meaning 'new'. 2. Belief Classical economists were not renowned for being a happy, optimistic bunch of economists (in terms of their economic thinking!). Some believed that population growth would be too rapid for the resources available (Malthus was a particular exponent of this view). If this wasn't enough to depress the rate of long-term growth (and the rest of the population along with it!) then diminishing returns would cause further problems for growth. They believed that the government should not intervene to try to correct this as it would only make things worse and so the only way to encourage growth was to allow free trade and free markets. This approach is known as a 'laissez-faire' approach. Essentially this approach places total reliance on markets, and anything that prevent markets clearing properly should be done away with. Much of Adam Smith's early work was on this theme, and he introduced the notion of an invisible hand that guided economic activity and led to the optimum equilibrium. Many people see him as the founding father of modern economics. The Victorian period...
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...would remove coins from circulation and sell them for their metallic content. M2 = M1 + noncheckable savings deposits + money market deposit accounts + small time deposits + money market mutual fund balances. M3 = M2 + large time deposits (those of $100,000 or more). Near-monies are components of M2 and M3 not included in M1. M3 is distinguished from M2 by large time deposits (certificates of deposits). 5.) There is no concrete backing to the money supply in the United States. Paper money, which has no intrinsic value, has value only because people are willing to accept it in exchange for goods and services, including their labor services as employees. And people are willing to accept paper as money because they know that everyone else is also willing to do so. If the monetary authorities were issuing new banknotes at a rate far in excess of available output, the acceptability of paper money would diminish. People would start to worry about whether the banknotes would be worth much after they received them. Checks are part of the money supply and are not legal tender, but people accept them willingly from people believed trustworthy. The value or purchasing power of money is inversely related to the price level. The Board of Governors of the Federal Reserve System (the Fed) is responsible for managing the United States’ money supply so that money retains its value. 6.) In the first case, the value of the dollar (in year 2, relative to year 1) is $.80 (= 1/1.25);...
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...example, when demand is low in the economy, the government can step in and increase its spending to stimulate demand. Or it can lower taxes to increase disposable income for people as well as corporations. Monetary policy relates to the supply of money, which is controlled via factors such as interest rates and reserve requirements (CRR) for banks. For example, to control high inflation, policy-makers (usually an independent central bank) can raise interest rates thereby reducing money supply * Monetary policy involves changing the interest rate and influencing the money supply. * Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy. They are both used to pursue policies of higher economic growth or controlling inflation. Monetary Policy Monetary policy is usually carried out by the Central Bank / Monetary authorities and involves: * Setting base interest rates (e.g. Bank of England in UK and Federal Reserve in US) * Influencing the supply of money. E.g. Policy of quantitative easing to increase the supply of money. How Monetary Policy Works * The Central Bank may have an inflation target of 2%. If they feel inflation is going to go above the inflation target, due to economic growth being too quick, then they will increase interest rates. * Higher interest rates increase borrowing costs and reduce consumer spending and investment, leading to lower aggregate demand and lower...
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...affects the supply of money and decisions made by banks on borrowing. I will explain the Monetary Policy used by the Fed to control the supply of money and how these aim to avoid inflation. I will explain how the infusion of stimulus programs affects the supply of money. I will also describe the current indicators that show there is too little or too much money in the economy today and what steps are being taken to correct this. The current state of the economy and the demand for money are factors that influence the Federal Reserve to adjust the discount rate. Banks request additional money when their reserves get low. Changes in real estate become a factor when homeowners are unable to pay their mortgages and banks lose money. The Federal Reserve decreased interest rates for the real estate market, which made it less expensive for banks to borrow funds. “A change in the credit supply and demand influenced the Federal Reserve to increase the discount rate, discouraging banks from requesting money by making it more expensive for banks to borrow funds, (Colander, 2010)”. The Feds use the spread between the Discount Rate and the Federal Funds Rate to increase or decrease the supply of money. If the Discount Rate is lower than the Federal Funds Rate, banks will borrow from other bank which does not increase the supply of money. When the Federal Funds Rate is lower than the Discount Rate, banks will borrow from the Federal Funds which increases the supply of money. The...
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...given time, this is so as to avoid banking instability as attested to during the banking crisis of 2008. Commercial banks keep a tiny portion of their demand deposits as reserves, and this is informed by the assertion that depositors seldom withdraw all their demand deposits at a given time, unless there is a bank run of course. This system of fractional reserve aid banks in the creation of demand deposits, and this demand deposits are above what the bank has as reserves. How cash has evolved from commodity money to the current fiat money system. Under the commodity money system standard money had abstract value. The measurement of money was defined as the aggregate quantity of precious metals coins of a specific quality i.e. weight and design ,circulating within the borders of a country. Sources of money creation. 1).Minting of new coins can be facilitated by: -Recently extracted gold. -Melting existing from jewellery or ornaments. 2).The balance of payment surplus resulting from foreigners demand for local goods bring s in foreign gold. Countries are relatively not equally endowed in gold deposits, and thus countries with no gold deposits would rely on the melting of jewellery brought to the smelters by the rich of the country this proved inefficient during economic growth era. Countries had to stimulate demand of their exports and thus a surplus balance of payments account. This brought much needed gold coins or bullion in to the country. The very same way that...
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...currency falls. For example, if the inflation rate is 2%, then a pack of gum that costs $1 in a given year will cost $1.02 the next year. As goods and services require more money to purchase, the implicit value of that money falls. Monetarism theorizes that inflation is related to the money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies. Since the money supply had rapidly increased, prices spiked and the value of money fell, contributing to economic collapse What Causes Inflation? We can define inflation with relative ease, but the question of what causes inflation is significantly more complex. Although numerous theories exist, arguably the two most influential schools of thought on inflation are those of Keynesian and monetarist economics. ------------------------------------------------- Different Types of Inflation Inflation means a sustained increase in the general price level. However, this increase in the cost of living can be caused by different factors. The main two types of inflation are 1. Demand pull inflation – this occurs when the economy grows quickly and starts to ‘overheat’ – Aggregate demand (AD) will be increasing faster than aggregate supply (LRAS)....
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...emphasize keeping the growth rate of money steady, and using monetary policy to control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand). (ii) cash reserve ratio Second is the changes in the reserve requirements or cash reserve ratio. It is an instrument that. BNM controls the inflation by increasing the reserve ratio. Cash reserve ratio is a Central Bank regulation that sets the minimum reserves each commercial bank must hold to customer deposits and notes. manipulate the reserve ration in order to influence the ability of commercial banks to lend. When the economy is overheating and the threat of inflation is high, monetary policy will be tightened by withdrawing funds from the banking system and raising interest rates. The increase in bank rate increases the cost of borrowing which reduces commercial banks borrowing from the central bank. Consequently, the flow of money from the commercial banks to the public gets reduced. Therefore, inflation is controlled to the extent it is caused by the bank credit. Commercial bank will lost excess reserves >> diminishing their ability to creat money by lending >> commercial bank may...
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...Monetary policy is the process by which the monetary authority government controls the downturn economy through supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability in the world down turn. The official goals usually include relatively stable prices and low unemployment. Formulating a country's monetary and fiscal policy is extremely important when it comes to promoting sustainable economic growth. More specifically, monetary policy focuses on how a country determines the size and rate of growth of its money supply in order to control inflation within the country. In the United States, a committee within the Federal Reserve is responsible for implementing monetary policy. The Federal Open Market Committee (FOMC) is comprised of the Board of Governors and five reserve-bank presidents, and It meets eight times throughout the year to set key interest rate and to determine whether to increase or decrease the money supply within the economy. United States Government has adjust its monetary policy in response to the world down turns economy by increasing interest rates by fiat; reducing the monetary base, money supply and increasing reserve requirements. The United States central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. In the United States, the great depression began in...
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...economist’s fight to solve and bring down but still now no permanent solution to this burden on the economy. Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every rupee you own buys a smaller percentage of a good or service. Thus people loose purchasing power in short. However, there is a difference between “money inflation'' and “price inflation”. When the prices rise due to an expansion of the money supply, it is 'money inflation' but in the later phase more and more money supply has to be expanded an as such this is known as 'price inflation'. THEORIES OF INFLATION Two main theories of inflation mainly: 1. Demand Pull Inflation: This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies. Demand pull inflation occurs when the demand for goods and services exceeds their available supply at the existing prices. 2. Cost Push Inflation: When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports. COST OF INFLATION Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affects different people in different ways. It also depends on whether inflation is anticipated...
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...increase in general price level. It can also refer to the condition of “too much money chasing too few goods.” Inflation is an indication of the value of money. A rise in general price means a drop in the value of money held by the society. Inflation is measured using a price index. A weighted consumer price index (CPI) measures the change in the average prices of a ’market basket’ of goods and services purchased by a typical urban household, taking into account importance of certain goods relatively to others. An increase in the CPI reflects inflation in the economy. TYPES OF INFLATION a) DEMAND-PULL INFLATION This happens when there is an excess of aggregate demand for goods and services over aggregate supply or the maximum available outputs in the economy. A high aggregate demand may be the result of an increase in government spending, a drop in taxes or a shock (sudden increase) in investment due to a drop in interest rate. The problem arises when there is an excessive money supply and the economy is moving towards or is already at full employment. The following diagram shows demand-pull inflation. Increase in the price level from P1 to P2 shows the result of an increase in aggregate demand towards full employment income. Output price rises because demand is causing high input price. Further increase in price to P2 shows an increase in aggregate demand above full employment. Here, real output has reached maximum limit. Further increase...
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...that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks, which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). During the past two decades, maintenance of low inflation, price stability has become the principal focus of central banks around the world. At the same time, the view has emerged that monetary policy is better suited than fiscal policy for short-run stabilization purposes. Monetary decisions take into account a wider range of factors, such as: * Short-term interest rates; * Long-term interest rates; * Velocity of money through the economy; * Exchange rates; * Credit quality; * Bonds and equities (corporate ownership and debt); * Government versus private sector spending/savings; * International capital flows of money on large scales; * Financial derivatives such as options, swaps, futures contracts, etc. Monetary Policy Tools Monetary policy uses three main tactical approaches to maintain monetary stability: 1. Money Supply The first tactic manages the money supply. This mainly involves buying...
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...The Federal Reserve controls the economy of the United States through a variety of tools. They use these tools to shape the monetary policy of the United States in order to promote economic growth and reduce the rate of inflation and the unemployment rate. By adjusting these tools, the Fed is able to control the amount of money in the supply. By controlling the amount of money, the Fed can affect the macro-economic indicators and steer the economy away from runaway inflation or a recession. The Federal Reserve uses three main tools in order to control the money supply. The first tool is open-market operations. These operations consist of the buying and selling of government bonds to commercial banks and the public. Open-market operations are the most important tool that the Fed can use to influence the money supply (Brue). By buying bonds from the open market, the Federal Reserve increases the reserves of commercial banks which in turn will increase the overall money supply in the country. The opposite is true if the Fed sells bonds on the open market. By doing so, the Fed reduces the reserves of banks and, in turn, takes money out of the system. By being able to control how much money the commercial banks can lend, the Fed has a very powerful tool to adjust the economy. The second tool the Federal Reserve uses is the adjustment of the reserve ratio. The reserve ratio is the ratio of the required reserves the commercial bank must keep to the bank’s own outstanding checkable-deposit...
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