Monetary Policy: Changes in Money Supply

This section explores how governments use monetary policy to influence the macroeconomic environment, specifically focusing on measures that affect the money supply.

What is Monetary Policy?

Monetary policy refers to actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity.

The primary goal of monetary policy is typically to achieve macroeconomic stability, often targeting low and stable inflation and full employment.

The Role of the Central Bank

In most economies, a central bank (e.g., the Bank of England, the Federal Reserve) is responsible for implementing monetary policy. It has tools at its disposal to manage the money supply.

Key Instruments of Monetary Policy: Changes in Money Supply

The central bank can influence the money supply through several key instruments:

• Open Market Operations (OMO): This is the most frequently used tool. It involves the buying and selling of government securities (bonds) in the open market.
• The Official Bank Rate (or Policy Rate): This is the interest rate at which commercial banks can borrow money from the central bank.
• Reserve Requirements: This is the fraction of deposits that banks are required to hold in reserve.

1. Open Market Operations (OMO)

Buying Government Securities: When the central bank buys government securities from commercial banks and the public, it injects money into the economy. Banks have more reserves, leading to an increase in their lending capacity and thus the money supply.

Selling Government Securities: When the central bank sells government securities, it withdraws money from the economy. Banks have fewer reserves, leading to a decrease in their lending capacity and a reduction in the money supply.

2. The Official Bank Rate (Policy Rate)

Lowering the Official Bank Rate: This makes it cheaper for commercial banks to borrow money from the central bank. Banks are likely to pass on these lower costs to their customers in the form of lower interest rates on loans. This encourages borrowing and spending, increasing the money supply.

Raising the Official Bank Rate: This makes it more expensive for commercial banks to borrow money from the central bank. Banks are likely to pass on these higher costs to their customers in the form of higher interest rates on loans. This discourages borrowing and spending, decreasing the money supply.

3. Reserve Requirements

Lowering Reserve Requirements: This allows banks to lend out a larger proportion of their deposits. With lower reserves, banks can create more money through lending, increasing the money supply.

Raising Reserve Requirements: This forces banks to hold a larger proportion of their deposits in reserve, leaving them with less money to lend. This reduces the amount of money banks can create, decreasing the money supply.

Table: Summary of Monetary Policy Instruments

Instrument	Action	Effect on Money Supply
Open Market Operations	Buying Government Securities	Increases
Open Market Operations	Selling Government Securities	Decreases
Official Bank Rate	Lowering	Increases
Official Bank Rate	Raising	Decreases
Reserve Requirements	Lowering	Increases
Reserve Requirements	Raising	Decreases

Impact of Changes in Money Supply on the Macroeconomy

Changes in the money supply can have significant impacts on the macroeconomic environment:

• Inflation: An increase in the money supply can lead to inflation if the economy is operating at or near full capacity. More money chasing the same amount of goods and services pushes prices up.
• Economic Growth: An increase in the money supply can stimulate economic growth by encouraging borrowing and investment.
• Unemployment: Increased economic activity resulting from a higher money supply can lead to lower unemployment.

Figure: Suggested diagram: A simple graph showing the relationship between the money supply and inflation. The money supply curve would typically be upward sloping. An increase in the money supply leads to a corresponding increase in inflation.

Limitations of Monetary Policy

Monetary policy is not always effective and has some limitations:

• Time Lags: It can take time for changes in monetary policy to have a noticeable impact on the economy.
• Liquidity Trap: If interest rates are already very low, further reductions in the official bank rate may not stimulate borrowing and spending (a liquidity trap).
• Global Factors: Economic conditions in other countries can influence the effectiveness of domestic monetary policy.