This section explores the fundamental concepts of money supply and monetary policy, crucial for understanding how governments influence macroeconomic stability.
Money Supply
Definition: Money supply refers to the total amount of money circulating in an economy at a given time. It's not just physical currency (notes and coins); it also includes various forms of liquid assets.
Types of Money Supply:
M0 (Currency in Circulation): This is the most liquid form of money, consisting of physical currency (banknotes and coins) held by the public.
M1 (Broad Money): Includes M0 plus demand deposits (checking accounts) and other checkable deposits. This represents money that is readily available for spending.
M2 (Narrow Money): Includes M1 plus savings deposits, money market deposits, and other less liquid assets.
Measuring Money Supply: Central banks track money supply using various measures to monitor economic activity and inflation.
Monetary Policy
Definition: Monetary policy refers to the actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity.
Objectives of Monetary Policy:
Price Stability: Keeping inflation at a low and stable level is a primary objective.
Economic Growth: Promoting sustainable economic growth and full employment.
Exchange Rate Stability: Maintaining a stable exchange rate (in some economies).
Tools of Monetary Policy:
Tool
Description
Open Market Operations (OMO)
Buying and selling government securities (bonds) in the open market.
Buying bonds increases the money supply (banks have more reserves to lend).
Selling bonds decreases the money supply (banks have fewer reserves to lend).
The Bank Rate (or Official Cash Rate)
The interest rate at which commercial banks can borrow money from the central bank.
Raising the bank rate increases borrowing costs for banks, which are then passed on to consumers and businesses, reducing spending and investment.
Lowering the bank rate decreases borrowing costs, encouraging spending and investment.
Reserve Requirements
The fraction of deposits that banks are required to hold in reserve (either as cash or at the central bank).
Increasing reserve requirements reduces the amount of money banks can lend, decreasing the money supply.
Decreasing reserve requirements increases the amount of money banks can lend, increasing the money supply.
Quantitative Easing (QE)
A more unconventional monetary policy tool used when interest rates are already near zero. It involves a central bank injecting liquidity into the economy by purchasing assets (like government bonds or other assets) to lower long-term interest rates and increase the money supply.
How Monetary Policy Works
Changes in the money supply and interest rates influence economic activity through various channels:
Interest Rate Channel: Changes in interest rates affect borrowing costs for consumers and businesses, influencing spending and investment.
Credit Channel: Monetary policy affects the availability of credit to businesses and consumers.
Exchange Rate Channel: Changes in interest rates can affect the demand for a country's currency, influencing the exchange rate.
Suggested diagram: A simple diagram illustrating how open market operations (OMO) can affect the money supply. Show a central bank buying bonds (money supply increases) and selling bonds (money supply decreases). Include arrows indicating the change in the money supply.