Monetary Policy:
Monetary Policy: decisions made by the government regarding monetary variables such as
money supply, interest rates and the exchange rate to influence aggregate demand in the
economy.
Money Supply: the quantity of money in circulation in the economy
Money Supply:
Functions of Money:
● Medium of exchange allows transactions to take place
● Store of value that allows it to be used for future transactions
● Unit of account allows the value of goods, services and assets to be compared
● Standard of deferred payment: allows contracts for payment at a future date to be
agreed.
Narrow and Broad money - financial assets:
There are financial assets that come close to meeting the requirements to be regarded as
money, these assets are harder to observe which is why it is difficult to measure and monitor
the amount of money in the economy.
Liquidity: the extent to which an asset can be converted in the short term and without the
holder incurring a cost - the ease in which an asset can be converted into a form in which it
can be used to undertake a transaction. Cash and banknotes are the most liquid as they can
directly be used for transactions while government bonds or shares are much less liquid.
Narrow money (M0): a traditional way of measuring the money stock which was from the
monetary base comprising all notes and coins and circulation - the most liquid. It has
become less meaningful as a measure with the increased use of electronic means of
payment.
Broad money (M4): this includes notes and coins but also assets that are ‘near money’
including bank deposits, savings accounts, treasury bills, gilts - which can be used for
, transactions but may require a period of notice for withdrawal. This does not include
long-term dates, securities and shares as they fall in the category of assets rather than
money.
Credit Creation:
Credit multiplier: a process by which an increase in the money supply can have a
multiplied effect on the amount of credit in the economy.
How do banks make profit?: the interest charged on loans is greater than the interest
received on saving.
● Banks know that not all savers will want to simultaneously withdraw all their savings
so they lend out deposits in the form of loans
● The reserve ratio is the fraction of money deposits kept in the demand for reserve
and to meet withdrawal demands
● The US has a required reserve ratio of 10%
● Deposits into the bank are lent out again, these lendings fuel spending on the
economy and eventually the lended money returns to the bank in the form of
deposits, and again this money is lent out and a fraction is kept in reserve.
● The smaller the reserve ratio, the larger the credit multiplier.
● This is a sustainable practice unless bank run takes place, where a negative event
causes mass withdrawal causing a breakdown of the fractional reserve banking
system - the system relies upon strong consumer and business confidence in banks.
● If there is a situation where commercial banks are reluctant to lend, they will increase
their reserve ratios which leads to a fall in the money supply in the economy - for
example after the credit crunch of 2008 banks significantly reduced the amount of
their lending.
Money multiplier = 1 / reserve ratio - e.g if reserve ratio is 10% the money multiplier = 1/0.1 -
10
Initial deposits x Money multiplier = final money supply
Money creation through credit multiplier = final money supply - initial deposits.
The Fisher equation of exchange and the Quantity theory of Money:
This is an argument of classical economists that prices can only increase persistently if
money supply itself increases persistently, or if money supply grows more rapidly than real
output.
Velocity of circulation (V): the rate at which money changes hands - the volume of
transactions divided by money supply.
M = money supply, V = velocity of circulation, P = Average Price level, Q = Quantity of goods
and services sold (Q could alternatively be Y which is real income)
Fisher equation : MV = PQ
P = MV / Q
MV = nominal GDP, the total amount being spent in the economy (essentially the
expenditure method)
PQ = the value of what is sold in the economy - quantity x price (nominal GDP)
Monetary Policy: decisions made by the government regarding monetary variables such as
money supply, interest rates and the exchange rate to influence aggregate demand in the
economy.
Money Supply: the quantity of money in circulation in the economy
Money Supply:
Functions of Money:
● Medium of exchange allows transactions to take place
● Store of value that allows it to be used for future transactions
● Unit of account allows the value of goods, services and assets to be compared
● Standard of deferred payment: allows contracts for payment at a future date to be
agreed.
Narrow and Broad money - financial assets:
There are financial assets that come close to meeting the requirements to be regarded as
money, these assets are harder to observe which is why it is difficult to measure and monitor
the amount of money in the economy.
Liquidity: the extent to which an asset can be converted in the short term and without the
holder incurring a cost - the ease in which an asset can be converted into a form in which it
can be used to undertake a transaction. Cash and banknotes are the most liquid as they can
directly be used for transactions while government bonds or shares are much less liquid.
Narrow money (M0): a traditional way of measuring the money stock which was from the
monetary base comprising all notes and coins and circulation - the most liquid. It has
become less meaningful as a measure with the increased use of electronic means of
payment.
Broad money (M4): this includes notes and coins but also assets that are ‘near money’
including bank deposits, savings accounts, treasury bills, gilts - which can be used for
, transactions but may require a period of notice for withdrawal. This does not include
long-term dates, securities and shares as they fall in the category of assets rather than
money.
Credit Creation:
Credit multiplier: a process by which an increase in the money supply can have a
multiplied effect on the amount of credit in the economy.
How do banks make profit?: the interest charged on loans is greater than the interest
received on saving.
● Banks know that not all savers will want to simultaneously withdraw all their savings
so they lend out deposits in the form of loans
● The reserve ratio is the fraction of money deposits kept in the demand for reserve
and to meet withdrawal demands
● The US has a required reserve ratio of 10%
● Deposits into the bank are lent out again, these lendings fuel spending on the
economy and eventually the lended money returns to the bank in the form of
deposits, and again this money is lent out and a fraction is kept in reserve.
● The smaller the reserve ratio, the larger the credit multiplier.
● This is a sustainable practice unless bank run takes place, where a negative event
causes mass withdrawal causing a breakdown of the fractional reserve banking
system - the system relies upon strong consumer and business confidence in banks.
● If there is a situation where commercial banks are reluctant to lend, they will increase
their reserve ratios which leads to a fall in the money supply in the economy - for
example after the credit crunch of 2008 banks significantly reduced the amount of
their lending.
Money multiplier = 1 / reserve ratio - e.g if reserve ratio is 10% the money multiplier = 1/0.1 -
10
Initial deposits x Money multiplier = final money supply
Money creation through credit multiplier = final money supply - initial deposits.
The Fisher equation of exchange and the Quantity theory of Money:
This is an argument of classical economists that prices can only increase persistently if
money supply itself increases persistently, or if money supply grows more rapidly than real
output.
Velocity of circulation (V): the rate at which money changes hands - the volume of
transactions divided by money supply.
M = money supply, V = velocity of circulation, P = Average Price level, Q = Quantity of goods
and services sold (Q could alternatively be Y which is real income)
Fisher equation : MV = PQ
P = MV / Q
MV = nominal GDP, the total amount being spent in the economy (essentially the
expenditure method)
PQ = the value of what is sold in the economy - quantity x price (nominal GDP)
