The Traditional Models of Money Supply - Coursework Example

Introduction Money plays critical role in an economy and its exact measuring and understanding the dynamics behind its demand and supply are crucial. The most important implications for understanding the role of money is based on the fact that effective determination of money supply and demand effectively allow to determine prices, output and unemployment level. Money supply is effectively determined as the total amount of money available in the economy at a given point in time. As such there are different scales or measures which determine the money supply in an economy. The most standard measures which determine the money supply in economy are M1 and M2 which consists of different instruments which form the overall monetary base of any given economy. It is critical to note that the monetary base of an economy is determined both by the central bank as well as the commercial banks of the country and such the level of money supply change with the changes in the ability of commercial banks to create deposits. The traditional methods of determining the money supply has long been in demand and were wisely exercised by the central banks. However, with the current credit crunch has resulted into the dynamic changes in the way monetary policy as a whole has been exercised. These changes include more aggressive cuts in the interest rates, use of the quantitative easing as well as innovation into the types of assets that are now accepted for repo transactions. The first part of this paper will discuss the traditional models of money supply whereas the second part of this paper will be discussing the practical application of these models and how things have changed specially after the current credit crunch. How Central Bank controls Monetary Base? The monetary base of an economy comprises of M1 and M2 measures of money supply. M1 comprises of currency in circulation, checkable deposits as well as travelers’’ cheques. M2 consist of M, saving and time deposits as well as funds held by money market mutual funds.(Dornbusch, Fischer & Startz.,2003) The central bank controls the monetary base of the economy by exercising following tools: Reserve Requirements Central bank often requires the commercial banks to keep certain portion of their deposits as reserves with the central bank. This is often done in order to control the money supply as by altering the reserve requirements, central banks basically aim to change the bank lending. As will be discussed in following sections, commercial banks often create money through lending therefore by increasing the reserve requirements, central bank can curb the ability of the banks to lend excessively thus restricting the growth of money supply. Similarly, by relaxing the reserve requirements, central bank can basically increase the money supply by allowing commercial banks to lend at lower rates.(Gwatney et.al,2003). Open market Operations Open market operations is another important too through which central bank controls the monetary base. Open market operations involve buying and selling of government securities in the open market by the central bank of the country. When a central bank purchase the government securities it basically injects the money into the system hence the overall money supply increases in addition to the currency in circulation and deposits with the commercial banks. Similarly, if central bank purchases the government securities, it is basically aiming at reducing the money supply in the system. Changing Discount Rate Discount rate is the rate which central bank charges to the banks when they borrow the funds from central bank. When a central bank intends to discourage the banks from excessive borrowing, it can increase the discount rate and as such banks tend to restrict their lending in order to ensure that they maintain enough funds to pay off their liabilities. This restriction on the lending therefore affects the overall money supply in the economy. Impact of Balance Sheet of Central Bank When central bank reduces the discount rate, the overall demand for discount loans will increase and Banks will start to borrow from Central Bank. As a result, the asset side of the central bank’s balance sheet will increase whereas currency under the liabilities head will decline. However, there will be an increase in the Bank reserve which is shown on the liabilities side of the balance sheet. The increase in the discount rate will have vice versa impact on the balance sheet of the central bank. Similarly, by increasing the reserve requirements, the liabilities of the central bank will increase as well as the currency at hand will also increase with the increase in the reserve requirements. Credit Creation by Commercial Banks The exercise of various money supply tools also allow commercial banks to contribute towards creation of money through lending. When a bank extends a loan it basically deposits money into a separate checking account of the borrower which create extra deposits for the bank itself. Commercial banks are required to maintain a certain portion of their deposits with the central bank. The percentage of such deposits is called the required reserve ratio and every bank is required to maintain that portion of its deposits as reserves with the central bank. However, the excess reserves- actual reserves held by the bank that exceed its regulator required reserve ratio are therefore lent by the banks to their borrowers.(Abel, Bernanke & Croushore, 2006). The relationship which can effectively determine how much money and credit a bank can create is shown with the help of money multiplier. Money multiplier shows the inverse relationship between the money creation and the reserve requirement. (Froyen,2008). Higher the reserve requirements lower will be the money creation and is derived in following manner: Money Multiplier = 1 / R Where R is the required reserve ratio For example, if required reserve ratio is 10% than M =1/0.1 M= $10 This means that with a $1 increase in the deposits, the banking system can effectively create $10 more dollars through its ability to create money. The above equation also indicates that the money multiplier is affected by the required reserve ratio. Recent Changes The current credit crunch brought forward many important changes in the way monetary policy was actually conducted. The tools and methods described above were historically used by the Central banks. Some of the actions that were undertaken by the Federal Reserve system include aggressive changes in the interest rates, the use of quantitative easing, relaxation in some of the inflation as well as interest rate targets. This section will discuss some of the changes in the monetary policy that took place during recent credit crisis: Quantitative Easing Quantitative easing is a form of monetary policy in which a central bank basically attempt to reduce the interest rates to the close of zero or at zero level. The overall purpose of undertaking such actions is when a central bank no longer can further reduce the discount rate or regulatory reserve requirements. Quantitative easing is mostly done by purchasing the government bonds as well as the corporate bonds by the central bank so that the overall money supply in the economy increases. Quantitative easing is also referred as the printing of new money however central bank does so through electronically creating new money. During the current financial crisis, FED has undertaken the process of quantitative easing successfully by creating artificial money in order to provide the boost to the overall money supply. Same was also done by the Bank of England with greater degree of success however, in case of Japan; quantitative easing could not provide the desired results as Bank of Japan failed to curb the deflation. Bank of England has put on halt its quantitative easing efforts too because its results are often hard to assess.(Seager,2010). Changes in interest rates Another associated action with the quantitative easing was the drastic reduction of the interest rates to the very low or almost zero level.(Lewis,2008). This was basically aimed at stimulating the consumption activity within the economy to boost the aggregate demand. FED took very aggressive approach in cutting down the interest rates to a very low level as compared to the previous recessions. During 2008, FED reduced its interest rates to almost 1% which was further reduced during the subsequent period in order to ease up the economy. The overall aim of FED was to keep the interest rates within the range of 0 to 0.25% in order to further stimulate the economy.(npr.org, 2008). This interest rate cut was more aggressive as compared to the earlier efforts of various central banks because it was aimed at stimulating the economy and bringing in change in the consumption by extending cheap credit to the consumers. The more aggressive rate cuts was also the result of the fact that gradual cut into the interest rates did created the required degree of stimulus necessary for obtaining the desired objectives. It was because of this reason that the interest rate cuts were more aggressive during this period as compared to earlier recessions. Relaxation in different targets Economic theory suggest that the by reducing the interest rates, inflation in the economy will creep up. This inverse relationship between the interest rates and inflation indicates that increasing the money supply will increase the general price level. However, FED undertook a unique approach by further relaxing the inflation and interest rate targets in order to ensure that the aggregate demand for goods and services increase. This was an extra ordinary step because FED basically attempted to make a tradeoff between the low interest rates and inflation targets. Further, lowering of interest rates also result into increase in the fair value of the assets which ultimately increase the prices of the assets hence capital markets get a boost also if interest rates are declined to an acceptable range. Similarly, FED also attempted to change the security structure of the repo transactions by allowing securities such as MBS as alternative securities to be given under the repo transaction. This was potentially done in order to improve the marketability of potentially illiquid securities. Conclusion Monetary policy is one of the most effective tools for achieving the various important economic targets such as output, employment as well as controlling of inflation. Central banks often use different tools and methods which are used to control the money supply in the economy. Some of the methods include open market operations, changing the discount rates as well as open market operations. However, due to current credit crisis, Federal Reserve System has undertaken many different monetary policy actions to stimulate the economy. Some of the actions that include are quantitative easing, changes in the interest rates and inflation targets as well as the aggressive reduction in the interest rates. References 1. Abel, A, Bernanke, B (2007). Macroeconomics. 6th. ed. New York: Prentice Hall. 2. Dornbusch, R, Fischer, S (2003). Macroeconomics. 8th. ed. New York: McGraw- Hill. 3. Froyen, R (2008). Macroeconomics: Theories and Policies. 8th. ed. London: Pearson Education. 4. Gwatney, J, Stroup, R, Sobel, R (2003). Economics: Private. 10th. ed. London: Thomson. 5. Lewis, K (2009) U.S. Federal Reserve Cuts Interest Rates to Historic Low America.gov, Available: http://www.america.gov/st/econ-english/2008/December/20081216153402berehellek0.1642267.html Last accessed 13th April, 2010 6. Npr.org,(2009) Fed Cuts Interest Rate By Half Point to 1 Percent NPR, Available: http://www.npr.org/templates/story/story.php?storyId=96271322 Last accessed 13th April, 2010 7. Seager, A (2010). Bank of England halts quantitative easing [online]. [Accessed 14 April 2010]. Available from: . Read More