Economics Assignment - Essay Example

Other ways to alter money supply in the economy may include altering discount rates, quantitative easing and Funding; however, the main emphasis of monetary policy is the “Open Market Operations” through which the government alters money supply in the economy. It is first important to understand how banks operate; banks lend out money to open public, this money when lend out in the economy is bound to come back to the banks as deposits by other people. Thus, the bank has more and more money to lend out.

However, the bank keeps certain amount of money as a safety measure to cater to demand of withdrawal of money by customers. The percentage of deposit kept safe by the bank is determined by the “Liquidity Ratio”. Example, if the liquidity ratio is 10%, and Mr. X comes and invests $100 in a bank, the bank would keep $10 as a reserve and would lend out the remaining $90 to customers. This increases money supply; the more money that flows in the bank, the more credit creation takes place. Open Market operations refer to buying and selling of bonds that happens between the Central bank and the commercial banks.

Commercial banks are very powerful when it comes to money creation or contractions. Thus, in case the government wants an expansionary monetary policy, the Central bank would ask the commercial banks to print fancy stamped papers with net amounts written (known as BONDS) and sell them to Central Bank. The central bank would buy the bond and pay the commercial bank money for the bond. Thus, this money is used by the commercial banks to make more credit as they give out this money to buyers. These people spend, Example, Mr.

X borrowed $90 and bought a Dell Computer, now Dell would deposit the $90 back in the bank and thus the bank would make a further loan of $81 (90% of $90) and this cycle goes on. This leads to money being multiplied and as a result, because of the Money Multiplier effect, $100 becomes approximately $1000 in the economy at a 10% liquidity ratio rate. This is an expansionary monetary policy that is used in times of recession to bring the economy back or close to the full employment level of output.

Money Multiplier = 1 / Liquidity Ratio Similarly, if the government wishes to contract the money supply, it does the opposite; the central bank prints and sells bonds to the commercial banks (taking out its reserves) thus the commercial banks have lesser funds to give out as loans in the economy and the overall economy contracts. This contracts the money supply and is used in times of inflation. This concept also has another vital aspect to it, the impact of interest rates as a result of money supply.

Money supply is directly linked to the interest rates, as shown below: Increases in money supply (via expansionary monetary policy) decreases interest rates (as shown above, from i1 to i2), this means people would be less willing to save and hence have a greater marginal propensity to consume*. Consumption will likely to go up as people would tend to spend more than they save, owing to low interest rates. Credit card purchases would be encouraged and investments would be made more attractive at lower interest rates.

Also, owing to the wealth effect, the people would be willing to spend