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Money Supply Case Study

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According to Wright & Quadrini, (2009), the money supply is determined by interactions between four economic forces: depository institutions, depositors, borrowers and central banks. Central banks manipulate money supply in the economy by controlling its money liability called the monetary base (MB). MB, in fact, equals to the total currency in circulation (C) plus Reserves (R) which are cash in banks’ vaults and commercial banks’ deposits with the Fed. When the Fed engaged in Open Market Operation (OMO), they are controlling the MB by selling and buying any securities but in most cases, Fed prefers government bonds over other assets. If the Fed wants to increase MB, it buys securities from the banks or other primary dealers. For instance,…show more content…
In the long run, both the goal of money supply growth and interest rates is perfectly compatible but in the short run, central banks face trade-off between money growth and price stability because shift in demand for money will affect interest rate if the money supply is fixed (Wright & Quadrini, 2009). Therefore, explicit inflation targeting (keeping increases in price level within the certain range) leads to lower employment and output in short run. Likewise, monetary aggregate targeting can boost employment and economic growth but can result in higher inflation. Further, time lag which is long lags between policy implementation and real-world effects made it difficult for policy makers to determine what degree of policy is…show more content…
Under a managed float regime, the foreign exchange rate is determined by demand and supply forces in the market but the central bank intervenes when their domestic currency grow too weak or strong. Under unsterilized foreign exchange intervention, the central bank influences the foreign exchange rate by adjusting MB to instigate changes in MS. Increasing MS by buying international reserves induces depreciation of domestic currency whereas decreasing MS by selling international reserves induces appreciation of domestic currency by influencing both nominal domestic interest rate and expectation about future exchange rate. Central banks also engage in a sterilized foreign exchange interventions “when they offset the purchase or sale of international reserves with a domestic sale or purchase. For example, the purchase of $10000 million of international currency by central bank might be sterilized by selling $10000 million worth of domestic government bonds. When engaging in sterilized intervention, there is no net change in MB, therefore long-term effect does not exist on the exchange rate. In addition, the central banks may choose to participate in wide currency intervention where a country tries to anchor its currency fixed to
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