December 11, 2011

Money and Monetary Policy


Money is anything that serves as a commonly as accepted medium of exchange or means of payment.

We now use paper money and bank money (cheques and drafts).

People value money for what it buys.

Money supply definition at the economy level include M1 and M2. M1 is called transactions money and is equal to currency in the economy plus deposits in checking accounts of banks. M2 is M1 plus highly liquid savings accounts.

Demand for money arises out of need for transactions and precautionary needs. Speculative motive also could be there when people hold money to buy something later instead of buying it now.

Economic theory predicts that demand for money is sensitive to interest rates. Higher interest rates lead to less demand for money.

Effect of money on output

An increase in money will lower interest enough to persuade people to hold all the new money.

Lower interest rate increase investment.

Due to the multiplier effect, increase in investment leads to increase in output.

Even though put in the three steps, the actual monetary mechanism is complex in its effects on output and prices.

A school or thought in economics known as monetarism argued that macroeconomic fluctuations are caused by erratic growth in money supply.

Federal Reserve of USA conducted a full-scale monetarist experiment from 1979 to 1982.

It rejected the monetarist approach after 1982.


Inflation occurs when the general level of prices is rising.

The rate of inflation is measured as the rate of change of the economy wide price levels (say consumer price index, or CPI).

The most widely used measure of inflation in USA is the consumer price index (CPI).

In general unanticipated inflation redistributes wealth from creditors to debtors.

when society takes steps to lower inflation, the real costs of such steps in terms of lower output nad employment can be painful.

Monetary Policy

Monetary policy deals with money supply, interest rates and exchange rates of an economy.

Central banks are given the responsibility for monetary policy in many countries.

In USA Federal Reserve System (or FED) was created in 1913 and it was given the responsibility ofr nation's money and credit.

Fed has the major instruments to implement its policy:

1. Open market operations
2. The discount rate on bank borrowing
3. Reserve requirements on depository institutions.

Fed has the responsibility of backstopping the domestic international financial system in crisis.

That is what now (October 2008) Fed and Secretary of Treasury are doing in USA. To support the financial system as there is a crisis in the system.

Sterilization:if foreigners want more domestic currency, the money supply in an economy will increase. Fed can decrease money supply in the economy by selling bonds. If foreigners take away their currency, money supply will fall. Fed has to buy bonds and increase the domestic money supply. These processes of Fed in response to the behavior of foreigners is called sterilization.

Knol - 218 and 219

UC Berkeley Lecture


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