Core-023 Money Supply and Monetary Policy
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About Core-023 Money Supply and Monetary Policy
About the Teacher
Jay Moulton
Jay Moulton is a business veteran. In short:
- Corporate finance and turnaround expert in U.S. and Canada
- CEO or operator of numerous companies in many industries
- 30 years of actually applying business economics principles
- Successfully led and invested in several leveraged buyouts
- Director or advisor to 30+ different companies
- Experience in both for-profit and not-for-profit sectors
- Producer of 700 professional videos and several TV shows
- Author of six economics and business strategy books
- Graduate of Harvard Business School MBA program
- Graduate of The Royal Military College of Canada
- Professional electrical engineer
- Governor of the Harvard Club of British Columbia
Money Supply and Monetary Policy
MODULE 1
The total stock of money circulating in a nation's economy is its money supply. "Monetary policy" refers to the actions that a nation's central bank takes to influence the amount of money and credit in that nation's economy, usually with the objective of improving the economy's performance.
Money Demand
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Interest-bearing assets and money interact to affect money demand. The decision to hold money results from a decision that allocates wealth between interest-earning bonds and cash. Shifts in the money demand curve depend on several factors.
The money demand curve plots the relationship between interest rates and the quantity of money we use or hold as cash. In this case, money means currency, checking accounts and travelers' checks. This is money that people generally use for transaction purposes.
People choose how they want to divide their wealth between bonds and money. Bonds earn an interest rate, money does not.
The money demand curve plots the relationship between the price of money and the amount of money in your pocket or in your checking account. The interest rate on a bond is a measure of the opportunity cost of holding money. The higher the interest rate is, the higher the opportunity cost of holding money.
Why don't people just hold bonds and sell their bonds when they need money? One reason is that there is a cost of converting one asset into the other asset.
What causes the money demand curve to shift? Income causes the money demand curve to shift. People's future expectations also affect how much money they hold.
Money demand is the inverse relationship between an interest-bearing asset, like a bond or savings account, and money which is used for transaction purposes. Income and future expectations also affect money demand.
Fractional Reserve Banking
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This video shows how money is created, beginning with an initial deposit of 50 cents in a bank. The bank reserves a fraction of the deposit based on the required reserve ratio, then loans out the rest at a higher rate of interest. The loan cycles through the system.
The T-account has two sides. The right side of the account includes liabilities - amounts that the bank owes. The left side of the T-account details the bank's assets. The two sides balance.
A detailed example of money creation through fractional reserve banking.
This assessment will test your knowledge of Public Goods.
Money Supply
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The Central Bank manages the money supply in the economy through open market operations. Open market operations are the Central Bank's open market purchases of bonds from banks and sales of bonds to banks.
The supply of money is determined by the Central Bank. The Central Bank sets goals for the amount of money it wants in circulation at any given time. Money supply in this context means money which is used for transaction purposes. In most countries, this type of money is called M1.
The Central Bank has holdings of cash and holdings of bonds and it has relationships with large security dealers, which also hold cash and bonds. If the Central Bank wants to increase the amount of money in circulation, and increase money supply, it buys bonds, from the security dealers.
The Central Bank has holdings of cash and holdings of bonds. If the Central Bank wants to reduce the amount of money in circulation, the Central Bank sells bonds to the security dealers and receives money in payment from their banks.
Money Supply and the Money Multiplier
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The video demonstrates how the banking system creates additional money in circulation, using as a tool, the choice between keeping money as reserves or lending the amount.
Let’s assume that the Federal Reserve Bank injects $1,000 in cash into the banking system. The banks that form the banking system have a choice. Should the bank lend the money or put that money in reserve?
A detailed explanation of the money multiplier process.
A simple money multiplier equals one divided by the reserve requirement. In our example, the reserve requirement was 10%. One divided by .10 equals ten. The simple money multiplier, for our example, is ten. $1,000 of new money injected into the banking system grew to $10,000.
This example assumes there are no reserve leakages in the process -- the bank lends the full 90% and does not maintain excess reserves. The example also assumes that every loan leads to an equal amount being deposited in another bank.
In the real world, the money multiplier is quite a bit different. This video reviews the U.S. money multiplier from 2008 to 2011.
This assessment will test your knowledge of Public Goods.
Monetary Policy
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In this video, we review how the Federal Reserve can implement monetary policy in three ways: 1) through open market operations, 2) by changing the discount rate, and; 3) by changing the required reserve ratio.
The Federal Reserve, or “Fed”, controls money supply in the economy using three tools.
A review of how quantitative easing is implement.
How does monetary policy affect the economy? Let’s look at the demand and supply of money in the economy.
An expansion in money supply reduces interest rates. Lower real interest rates make investment and consumption cheaper. At lower interest rates, entrepreneurs undertake some investment projects they otherwise would not have. Spending, by firms, increases. Similarly, consumers buy more.
Lower interest rates tend to cause financial capital to move abroad. As funds move out of the country, the dollar depreciates in value and net exports expand. As domestic interest rates fall, investors move money to countries where interest rates are higher.
Lower interest rates tend to cause the prices of assets such as stocks, houses, and other investment properties to rise. Why does this happen?
This assessment will test your knowledge of Public Goods.
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