Supply of Money in an Economy - Essay Example

1. Introduction Supply of money in an economy needs to be controlled so as to ensure a stable rate of inflation and economic growth. Monetary policyis one of the tools of Central bank to control the various macroeconomic factors, in particular, inflation, level of unemployment and price stability. To implement a monetary policy, a Central bank takes certain steps to influence the supply of money in the economy mainly through varying the interest rates. These steps go a long way to keep the rate of inflation at a controlled rate and curtail the supply of money in the economy. However, the effectiveness of monetary in controlling the economy is real terms remains to be a debatable issue. If Central bank attempts to control economy by implementing monetary policy through varying interest rates, it can have some indirect impacts on the overall economic activities that might lead to problems. This paper illuminates the theoretical foundations upon which the monetary policy rests. It discusses the various methods utilised to determine and implement the monetary policy in an economy on the part of Central banks. The paper also elaborates the effectiveness of monetary policy in controlling economy and critically discusses its effectuality in meeting the intended economic ends such as controlling inflation and maintaining price stability. 2. Theoretical Foundations and Effectiveness of Monetary Policy 2.1. Theoretical Foundations of Monetary Policy Developing and implementing monetary policy happens to be the most crucial responsibility of a Central Bank. Monetary policy refers to the strategies of Central Banks implemented for the purpose of controlling various economic factors such as inflation and employment etc. Bofinger, Schchter and Reischle propound that "the main aim of monetary policy is a control of final targets of the economic process (price stability, real growth, full employment), which have been set in such a way as to maximise the ultimate goal of social welfare."1 Theoretically, there are four equations that are used to evaluate the impact of money or monetary policy on the overall economy. The aggregate demand function emphasises the impact of total demand on interest rates which consequently affects inflation. The 'Philip-Lucas supply curve' or the supply function relates the total output in an economy to the rate of inflation. The third equation relates the demand of money in an economy to total expenditure as well as the interest rates. The fourth equation of monetary policy relates it to the supply of money in the economy on the part of Central Bank.2 The theoretical foundations of monetary policy rest on the fact that money plays a great role in the economy of a country. Therefore, various economic factors, in particular, the inflation rate and employment level can be controlled by an effective monetary policy. King also propounds that "money growth is higher, the higher is the inflation rate".3 The growth of money or credit in an economy goes a long way in determining the prevailing inflation rate and employment level in the long run. Monetary policy helps Central banks to achieve the goal of economic stability and inflationary targets. Mahadeva says that "Central banks have always been in the forefront of those that promote low inflation or price stability as a or the goal of monetary policy."4 It is because of the fact that controlling inflation or maintaining a desired level of prices is considered to be the important functions of monetary policy and crucial aims of a Central bank. Central banks influence the supply and growth of money in the economy by changing interest rates in order to affect the aggregate demand. Arestis and Sawyer delineate the rate of interest as, "the Central Bank rate can be viewed as the key rate on which all other interest rates are based-often explicitly so as in the case of the interest rates charged by banks on loans and paid by banks on deposits" (2004, p443). Hence the Central bank influences the supply of money in the market through the rates at which the commercial banks offer loans and accept deposits. Increasing this rate of interest causes the money supply to fall down by means of affecting the borrowing capacity of individuals and businesses. Thus the supply of money in the economy is curtailed and inflation is controlled. Another strategy that is utilised by the Central banks is to make changes to the exchange rate so as to affect different economic variables such as prices, income and output level etc. Changes in interest rates on the part of Central bank put a great impact on the level of saving and expenditure by households as well as investment by business people in the economy. The changes in saving, expenditure and investment level in the economy control the flow of credit and money growth which put a great impact on the inflationary pressures prevailing in the economy. There are several ways through which Central banks achieve the objective of monetary policy. Open market operation as well as through setting reserve requirements are generally used by most Central banks to control the creation of credit in the economy. 2.2. Effectiveness of Monetary Policy in Controlling Economy Monetary policy is considered to be one of the pre-eminent steps taken by a Central Bank to control certain macroeconomic factors mainly through interest rate variations. Interest rate variations on the part of Central Bank go a long way in influencing major economic indicators such as inflation, price stability, level of employment, exchange rate and level of saving and investment. When Central Bank increases the rate of interest offered to the commercial banks, it affects the lending capacity of these banks. This consequently has an impact on the money or credit being circulated in the economy. This is said to have a significant impact on inflation level and price stability in the economy. Furthermore, the level of saving and investment varies significantly with the lending capacity of banks. However there have also been certain arguments criticising the role of monetary policy in controlling economy. These are mostly concerned with the effectiveness of monetary policy in influencing the macro economic factors such as inflation in real terms and within a certain time period. Monetary policy through variations in interest rate on the part of a Central bank leads to beneficial impact in economic terms only when the level of aggregate demand in the economy is resistant to change. Arestis and Sawyer elaborate this point as, "when the level of aggregate demand is stable and only affected by random shocks and the rate of interest, then monetary policy (in the form of varying the rate of interest) may be an effective way of offsetting those shocks".5 When the economy is only confronting random shocks rather than instability and fluctuations, the monetary policy can play a role in correcting the economic shocks. This shows that the interest rate variation as a part of monetary policy would not reap benefits or would not control the economic indicators if the economy itself is suffering from instability. Interest rates variations on the part of Central banks take a long period of time to slightly affect saving and investment. Therefore, varying the rate of interest solely for the purpose of controlling the level of saving and investment in the economy would not be effective in exhibiting the desired results. Arestis and Sawyer put forward that "interest rates may have very little effect on the levels of investment and savings and hence variations in the rate of interest would be ineffectual in reconciling intended savings and investment"6 This shows that target of monetary policy also has a significant impact on its effectiveness and ineffectiveness. If monetary policy is solely intended for controlling the economic variables like inflation and employment level, it can prove to be an effective means to achieve this goal. However, implementation of monetary policy for the purpose of influencing saving and investment level in the economy could lead to ineffectuality. Monetary policy is deemed effective in controlling economy through its influence on the inflation rate. George et al. say that "in the long run, monetary policy determines the nominal or money values of goods and services- that is, the general price level."7 The fact that Central bank's interest rates play an effective role in determining the supply of money in the economy, leads one to conclude that high interest rates decrease the price of goods and services whereas low interest rates increase it. Monetary policy is also said to be effective in maintaining and preserving price stability in the economy. However, the point that should be considered that variation in interest rates has various direct and indirect economic effects. An attempt to control economy by increasing interest rate might lead to rising price level. For instance, high interest rates make borrowing difficult for businesses and lead to incremental production costs. Tylecote asserts that "high interest rates raise production costs; through costs, prices. They also raise the cost of living through the cost of mortgage interest payments."8 Not only high interest rates negatively affect the price level in economy but also impact upon the prevailing wage rates of labour. Because of inflation, the purchasing power of labour is affected and the labour demands increase in his wages. Increase in wages would also lead to further increase in production costs. Monetary policy, by means of high interest rates, on one hand increases the price of consumer goods through high production cost and on the other hand increases the wage level in the economy. This suggests that an economy becomes highly vulnerable to rise in prices if the interest rate is increased too significantly. Producers would always transfer the increase in cost of production to the consumers increasing the price of consumer goods, which will in turn reduce the consumption level in the economy. The point here is that using interest rates as a means to control economy might instigate adverse effects in the economy. Increase in wage level as well as interest rate, serving to be the variable production costs, might also induce producers to produce less than their capacity to produce. This would also have adverse consequences for the economy as it would lead to a reduction in the level of output produced in the economy. This reduction in the level of output could also affect the country's balance of payment through a decline in the economy's self-sufficiency and a slump in exports. 3. Conclusion This paper elaborates the monetary policy theory as a tool available to the Central banks for the purpose of achieving the end of economic control. It also critically elaborates the effectiveness of monetary policy in delivering these ends. Central banks mostly utilise the tool of monetary policy in order to control the supply of money in the economy, maintain price stability, curtail the level of unemployment and curb inflation. To meet these ends, the Central bank mostly uses the interest rate variability. Generally the main purpose of economic policy is to assure the stable economic growth which is sustainable for the long time. By implementing a predictable and credible monetary policy the central bank holds interest rate down. This is common between economic theory and the international practice of central banking that the tools of monetary policy are ineffectual in maintaining a long lasting effect on both the rate of economic growth and level of employment. The fact however cannot be denied that there may be an irregular impact which can not be rejected in the short term. Inflation and nominal interest rate are the only tokenish variables which can be affected by monetary policy in long term. It is evident from the above discussion that intending monetary policy only to control inflationary pressure and maintain the price stability might not be effective because of the impact of interest rates on production costs. Furthermore, monetary policy has a very slight impact on the levels of saving and investment as elaborated in the paper. The monetary policy also tends to work only within stable economies. It affects the inflation, level of saving and investment in the long run. These are important considerations for economic stability and growth. Reference List Arestis, P. and Sawyer, M. (2004), "On the Effectiveness of Monetary Policy and of Fiscal Policy", Review Of Social Economy, 62(4), pp. 441-464 Bofinger, P., Schchter, A. and Reischle, J. (2001), "Monetary Policy: Goals, Institutions, Strategies, and Instruments", Oxford University Press: UK George, E. et al. (1999), "The transmission mechanism of monetary policy," The Monetary Policy Committee, Bank of England, UK King, M. (2002), "No Money, No Inflation- The Role of Money in the Economy", Bank of England: Quarterly Bulletin, Summer, 42(2), pp. 162-177 Mahadeva, L. (ed.) (2005), "How monetary policy works", Routledge: UK Tylecote, A.B. (1975), "The Effect of Monetary Policy on Wage Inflation." Oxford Economic Papers, 27(2), pp. 240-244 Read More