CLass 4 Monetary Policy

Class 4
Money Supply, Money Demand & Monetary policy

Money Supply
• Money supply is the supply of currency in an economy.
• In the previous class this money supply refers to M0 or monetary base.
• Money supply (Ms) is fixed by the Central Bank of a nation.
• Bangladesh Bank sets the money supply in our country.
• Thus, there is no causal relation between money supply and other
variables in the model.
Money demand
• According to the liquidity preference theory developed by John
Maynard Keynes, people demand or desire cash for three motives:
1. Transaction motive: People demand money for their daily
transactions. [Proportional to income] (Why?).
2. Precautionary motive: People demand money to tackle unexpected
life events. [Proportional to income] (Why?).
3. Speculative motive: People have the desire to save money. Thus,
they hold less money in cash when interest paid in bonds or from
banks increases. Thus, speculative demand is inversely proportional
to interest rate.
Demand for Real Balance:
Variables that influence the demand for real balance:
1. Income: If income increases, demand for holding money in cash
increases (because of transaction and precautionary motives).
2. Interest rate: If interest rate rises, demand for holding money (in
cash) decreases (because of speculative motive).
3. Inflation rate: If inflation rate rises, transactions will require more
cash but an increase in nominal interest rate reduces speculative
demand for cash. Thus, the effect is ambiguous.
• Thus, the function can be written as:
[r = interest rate, Y = income]
Inflation Rate and Money Demand
• Firstly, as price level rises in an economy, people will require more money
in their pockets to keep their daily consumption as before. Thus,
according to transactions motive, inflation rate will increase the demand
for money.
• Again, Nominal interest rate = Real interest rate + Inflation rate
• If inflation rate increases, people will soon realize that keeping money in
the bank is a loss. Therefore, nominal interest rate will have to be
increased by the banks. According to speculative motive, people keep
more money in the bank and less money in their pockets when interest
rates are high. Thus, the effect of inflation rate on money demand is
ambiguous.
The Financial Market: (Equilibrium)
r r
Here,
r = interest rate Equilibrium
Md = demand for cash
10% r*
5%
Md Md
1000 2000 Money Ms Money

In hand supply
The Financial Market: (Shifts)
r r Increase in demand
for money due to
increase in income
Surplus
of money
E2
r2 r2
A B
r1
r1 E1
Md1
Md Md2
Ms 2 Ms1 M Ms Money
asset
m u st b e in the
e d portion
The re d c o lor
T h e re st of it can
where.
Sample Question (5 marks) w e r s o m e examinee
ans ev e r th e
e org a n iz ed how
b
intends.
• Explain the consequences in the financial market of forcing the interest rate to be above the
equilibrium.
Answer: Let, the equilibrium be E1 where the equilibrium

interest rate is at r1. When the central bank forces the
interest rate to be above the equilibrium interest rate, it
increases from r1 to r2. At r2 interest rate, the supply of
money will be at point B and the demand for money will
be at point A. As the money supply is greater than the
money demand, there will be a surplus of money in the
economy. Therefore, the central bank will have to take
contractionary monetary policies to reduce the supply of
money in the economy so that the supply curve shifts to
the left and a new equilibrium is established at E2.
Monetary policy:
• Monetary policies are related to the change in money supply or
availability of credits or interest rate. Usually, the policies target to
change the monetary base.
• Target: To stimulate the economy when it is in a slump (expansionary)
and to cool down the economy when it is overheated (contractionary).
• There are three textbook instruments of monetary policy:
1. Discount window
2. Reserve requirement (rr)
3. Open market operations
Discount Window
• Discount window is simply a window of opportunity for commercial
banks to take loans from central banks at a very favorable rate of
interest called the discount rate.
• Look at how it may affect the money supply: (Expansionary)
Interest Interest
rate rate
r1 r1
r2
r2
shortage
Md Md
Money Money
M 1 MS 1 MS2
S
supply supply
Controlling Reserve Requirement
• The reserve requirement is the fraction of deposits that the commercial
banks are required by the central bank to keep as reserves in the central
bank or in their own vaults.
• The following tables show how changing required reserves changes the
money supply or monetary base: (Expansionary)
When, rr = 10% = 0.1 When, rr = 5% = 0.05

Assets Liabilities Assets Liabilities
Reserves 10 Reserves 5
Deposits 100 Deposits 100
Loans 90 Loans 95
• The greater the loans the greater the money in the hands of the public. Note
that monetary base did not change.
Open Market Operations:
• Open market operations are simply the sale and purchase of bonds by
the central bank.
• If the central bank sells its bonds to private banks or to the public
directly or via private banks, the buyer of the bonds will have less
money in hand for a certain period of time. Thus, money supply
decreases for that period of time.
• If the central bank purchases bonds from private banks or private
companies, the sellers of the bonds will acquire more money in hand
for a certain period of time. Thus, money supply increases for that
period of time.
Monetary Policy Summary Table
Monetary policy Changes M0? Expansionary policy Contractionary policy
Discount Window Yes Reduce discount rate Increase discount rate
Reduce reserve Reduce reserve

Reserve Requirement No
requirement requirement
Open Market Operations Yes Purchase bonds Sell bonds

CLass 4 Monetary Policy

Uploaded by

Copyright:

Available Formats

CLass 4 Monetary Policy

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CLass 4 Monetary Policy

Uploaded by

Copyright:

Available Formats

Class 4

Money Supply, Money Demand & Monetary policy

1000 2000 Money Ms Money

Answer: Let, the equilibrium be E1 where the equilibrium

When, rr = 10% = 0.1 When, rr = 5% = 0.05

Discount Window Yes Reduce discount rate Increase discount rate

Reduce reserve Reduce reserve

Open Market Operations Yes Purchase bonds Sell bonds

You might also like