Monetary Policy Basics

Interest Rates:

The interest rate determines the rate of interest at which borrowers pay lenders.  This can be on a consumer level or a business level and may or may not involve the central banks or private banks. When the base interest rate is lowered by the central bank of a country, it can be noted that borrowing is in a sense cheaper. When the base interest rate is increased the cost of borrowing is seen to become more expensive.

Money Supply:

Money supply is the total amount of monetary assets within the economy during a given period of time.  It consists of bonds, investments, other financial instruments, as well as cash. Traditionally an increase in money supply sees the price level of an economy increase, as there is “more money, chasing the same amount of product”. Whereas maintaining a specific money supply or reducing it leads to the price level of an economy decreasing, as there is “less money, chasing the same amount of product” meaning that there is no longer effective demand.

Expansionary Monetary Policy:

This would be pursued in order to achieve increased economic activity in the pursuit of growth. One manner of pursuing expansionary policy is to increase the money supply, while lowering interest rates. This will increase the output of the economy, but consequently an inflationary response.

This would be noted as a shift in aggregate demand outwards as you are increasing factors such as consumer spending, and investing. However, this does not directly affect government spending and the balance of trade may not change.

Contractionary Monetary Policy:

This would be pursued in order to achieve a lower price level in the economy, and to induce a cool-off period for the economy. One manner of pursuing contractionary policy is to decrease or maintain money supply, while increasing interest rates. This will reduce the output of the economy, while reducing the price level. This can be noted as a deflationary response.

This would be noted as shift in aggregate demand inwards as you are reducing factors such as consumer spending, and investing as you are making it more difficult to obtain credit, and establish effective demand.

Monetary Policy:

The most popular type of monetary policy to pursue is currently inflation targeting, whether to induce inflation or reduce it. There are however other factors that come into play in regards to monetary policy, which increase its complexity and its possible results. There is the issue of the velocity of money throughout the economy, and this considers how and where the money is moved and what economic activity it actually participates in.

It was Irving Fisher in 1911 who had established the clear relationship between money supply, velocity of money, and inflation. This can be noted as MV=PQ where M represents money supply, V represents velocity of money; P represents the price level of the economy, and Q the total quantity of goods available.

There is also one key issue that is often debated in regards to monetary policy, and that is the role of the gold standard. Traditionally, the value of a currency had been derived from gold which held actual value and was in existence at any one point. The reset of a currency back to the gold standard has often been used to combat high levels of inflation or hyperinflation as it has a “real value”. However the use of the gold standard restricts our ability to create money in order to manipulate currency, and a common use of monetary policy today has been to decrease/increase the value of a currency to achieve economic goals such as increased exports.

It can be noted that keeping the gold standard is difficult as economies tend to grow faster than the supply of gold, and this results in deflation. This is shown in the case where money supply is reduced, as there is no longer the effective demand at current market prices. The gold standard does to a degree have transparency as it is difficult to manipulate, but it restricts economies when there is a need for higher debt in order to fund war efforts, or revive the economy.

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