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Money supply is the availability of money in the hands of the public (economy) that can be used to purchase goods, services and securities. In macroeconomics, the price of money is equivalent to the rate of interest. There's an inverse relationship between money supply and interest rates. As money supply increases, interest will decrease. On the other hand, interest will increases as money supply decreases. It is very important to understand that the economy works at market equilibrium. There are several factors affecting money supply; and these contributing factors will be the main focus of this paper. Understanding the basic principle on money supply is imperative to have a good grasp on the macroeconomic impact of money supply on business operations.
Here's the scenario: "Recent global developments have pushed the economy into a slump. Industrial production is sluggish and it has become difficult to stimulate demand. The Real GDP is slipping and though inflation looks to be under control, unemployment seems to be soaring. As the Chairman of the Federal Reserve appointed by the President of Oval Office, an effective control of the money supply has to be done.
Tools that Control Money Supply
The Federal Reserve use several tools like discount rate, federal funds rate, required reserve ratio and open market operations to control the money supply. In the simulation, the effect of controlling the money supply on the economy was presented. Typically, releasing money into the system results in higher Real GDP and lower unemployment. On the other hand, it also raises inflation.
Inflation and Real GDP work cross-purposes. As stated in the simulation, "striking the right balance between the two is very critical". In addition, "compounding this with the effects of domestic policies and international happenings, and macro-economic system will almost become unpredictable". Money-Multiplier is another thing that is unpredictable. This determines whether the base money that the Fed will release should decrease or increase. As stated in the simulation, the Fed also "tries to use the money supply as a lever to keep the economy on the rails". This is not an easy task for it requires very complicated analysis.
Influence on Money Supply
There are several factors affecting the money supply: spread between the discount rate and federal funds rate, required reserve ratio and open market operations. It is very important to understand that whenever the "DR charged by Fed is lower than the FFR charge by other banks; banks tend to borrow from the Fed.
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As defined in the simulation, "Required Reserve Ratio is the percentage of deposits that any bank holds as reserves". It is essential for businesses to understand that a decrease in RRR interprets a lesser bank reserves. Whenever RRR is low, banks can lend more; thus, increasing the money supply in the economy. On the other hand, an increase in RRR will decrease the money supply in the economy.
Open market operation is another thing that influences the money supply. It includes bonds, T- bills, and other investment tools. Sale of these investment tools decreases the money supply in the economy and buying these releases money.
Effect on Macroeconomic Factors
How money supply does affect the macro-economic factors? Why do businesses, leaders, economists and the like need understand the principles on money supply? The principles explained will provide indicators that are helpful in the decision making process. There are three macro-economic indicators: real gross domestic product (Real GDP), inflation rate and employment rate.
An increase in real GDP will increase the money supply. If there's more money in the system, there will be more investors; and this increase in investors will eventually lead to an increase in real GDP.
Another thing is inflation rate. Just like real GDP, an increase in money supply will also lead into an increase in inflation rate. Investopedia defines inflation as "the overall general upward movement of goods and services in the economy which is usually measured by the consumer price index and the producer price index". In the simulation, it is stated that "when the amount of money in the system is increased, the nominal value of money remains the same, but, as more money chases the same quantity of goods and services, the value of money is decreased". This will eventually lead to an increase in price which represents an increase in inflation rate.
Money supply also has an impact on unemployment rate; it is inversely related to Real GDP. As investment spending increases, there will be an increase in employment needs. The fact that there will be a need for an increase in production basically means that there will be a need for an increase in the labor force. This will eventually lead to a decrease in unemployment rate. Further, money supply in the system will decrease; thus, a decreased in Real GDP will eventually follow.
Money is a socially accepted medium of exchange for goods and services. It provides measurement of value and could be used as a measure of a nation's economic status. In the United States, the Federal Reserve is the one controlling the money supply in the economy. According to David Laidler, the creation of money is basically influenced by an economic theory called "monetarism". Laidler further explains that the management of money supply should be the primary means of regulating economic stability. With that said, there are several considerations in the creation of money. Money supply have a great impact on the economy and policies concerning money supply needs to be analyzed based on economic growth, inflation and unemployment.
The "Perfect Combinations"
The Federal Reserve Board defines monetary policy as a process where bank, government, or monetary authority manages the supply of money. The Fed can't simply make tons of money; it's not going to work! There are several factors to consider like inflation and unemployment (just to name a few). There are several combinations which can be beneficial on a country's economic status. The "perfect combinations" will present the major considerations in the creation of money.
Monetary Policy and Economic Growth
Quoted is part of an Australian governor during his talk to the Australian Institute of Company Directors: "Monetary policy should inevitably attract less attention. Price stability is a necessary condition for faster long-term growth, but there are many other policies which have to be got right". Further, he stated that "the heart of the long-term growth process is productivity enhancement through innovation, technological change and so on, and that to reap the benefits of those processes, we have to embrace the forces of competition and globalization, with all the discomforts and changes they bring".
Monetary policies vary from nation to nation. There is no clear evidence proving that a specific monetary policy will result to a definite economic growth. As quoted, price stability and economic productivity are very important considerations.
Monetary Policy and Low Inflation
Several economists believe that "as inflation recedes, inflationary expectations unwind,
and interest rates fall to low levels near zero, central banks can find themselves in circumstances
where they cannot lower interest rates and therefore monetary policy becomes impotent". Saxton, Vice Chairman of the Joint Economic Committee of US Congress, believes that "as long as the central bank adopts an appropriate policy apparatus, it can always pursue an easier policy stance and does not become impotent even if short-term rates fall to zero".
There are several problems associated with interest rate policy in low inflation. The Fed can always add reserves as long as there is an adequate supply of government debt. Monetary policy in low inflation requires changes on reserve operating instrument involving operating procedures modification. Low inflation do not paralyze the monetary policy. There are several alternatives to consider which can result to an increase in reserves when inflation is low.
Monetary Rate and Reasonable Rate of Unemployment
There's uncertainty on the "natural" rate of unemployment. According to Wieland, "the relationship between inflation and unemployment, a relationship that is central to the design of monetary policy, has been characterized by an active debate about the precision of relevant parameter estimates such as the estimated natural unemployment rate". A short-run unemployment-inflation tradeoff and the existing natural unemployment rate are the main considerations on this particular combination. The monetary rate is basically controlled by policy makers and wage setters.
Monetary policy has a great influence on a country's economic performance. It is associated with inflation, economic input and employment rate. It affects organizational economy-related decisions, as well as personal financial decisions made by people in a particular country buying a house, starting a company, and business expansion. Monetary policy has a direct influence on stock markets and rate of investors on a particular country. Monetary policies vary from nation to nation. There's no "perfect combination" or perfect monetary policy that can guarantee economic growth. It is a case to case basis; depending on a country's economic status and situation.
Brue, S.L., & McConnell, C.R. (2004). Economics: Principles, problems and policies. The
Federal Reserve Board. (2006). Monetary Policy. Retrieved on September 1, 2007 from
Saxton, J. (2003).Monetary Policy in Low Inflation. Retrieved on August 31, 2007 from
University of Phoenix. Monetary Policy Simulation.
Wieland, Volker.(1998). Monetary Policy and Uncertainty about the Natural Unemployment Rate. Retrieved on August 31, 2007 from h ttp://www.federalreserve.gov/pubs/feds/1998/199822/199822pap.pdf