The document discusses various aspects of monetary policy and monetary aggregates. It defines narrow money (M1) as comprising currency in circulation and demand deposits, while broad money (M2) includes M1 plus long-term deposits and other savings accounts. It describes the monetary transmission mechanism by which an increase in the money supply leads to a fall in interest rates and rise in output and employment. It also discusses currency substitution, the motives for holding money, and various monetary policy tools used by central banks.

1. June 2009 Unit 2 Paper 2 - Question 3 Answers<br />3a i<br />Narrow money, also called M1, covers money which is immediately available for spending. That is, it comprises the monetary base and all short term deposits. This measure of money fulfils the medium of exchange function.<br />3a ii<br />Broad money, also known as M2, measures the total amount of money in the economy. Broad money is therefore narrow money plus long term deposits held at financial institutions. This monetary aggregate fulfils the store of value function. <br />3a iii<br />The stages involved from the implementation of expansionary monetary policy to an increase in output and employment is called the monetary transmission mechanism. As the money supply increases, a surplus of money is created in the money market. In order for the money market to clear, the rate of interest must fall to entice individuals to hold larger money balances. Following a reduction in the rate of interest, monetarist classify two independent effects:<br />Direct effects – This accounts for the effect of a fall in the interest rate which leads to an increase in consumer spending on goods and services. This increase in consumer expenditure when the interest rates changes is also known as the wealth effect.<br />Indirect effects – This refers to the impact of the fall in the interest rate on investments which is assumed to be quite elastic, since monetarist believe that the rate of interest plays an important role in determining investments. <br />3a iv<br />V is referred to as the velocity of circulation which gives the number of times per year each dollar is spent on goods and services. The product between the money supply and the velocity of circulation gives the total level of expenditure in the economy for the entire year.<br />3a v<br />Currency substitution - In a large number of emerging and developing economies, local currencies do not adequately fulfil the functions of money and as a consequence individuals partially switch to foreign currencies. This is referred to as currency substitutions. One of the prime factors responsible for currency substitution is high domestic inflation. When this occurs, holding domestic money becomes quite costly, as the purchasing power or real value is eroded. In an attempt to avoid such losses, individuals react by switching to foreign currencies as a store of value. Here, the foreign currency, such as the US dollar, is used as a medium of exchange instead of the local currency. There are different degrees to which a foreign currency takes the role of the local currency. There can be partial currency substitution where local currency is partially substituted by a foreign currency or there can be full dollarization where individuals switch entirely away from domestic currency in favour of the US dollar. In this case, the monetary authorities totally will lose the ability to manage the money supply as the Central bank of any country only has jurisdiction over the local money supply. For instance, the Central Bank of Trinidad and Tobago can only print and issue TT dollars but it cannot print and issue US dollars. Thus, currency substitution limits the Government’s control over the domestic component of money and this reduces the effectiveness of monetary policy.<br />3b<br />Transactionary motive – this refers to the amount of money held for daily use to carry out routine transactions. <br />Precautionary motive – This accounts for money held for unforeseen expenditures or unforeseen events or contingencies. <br />Speculative motive – This is any money held by individuals as they aim to take advantage of capital gains and avoid capital losses due to changes in the price of financial assets. <br />3c<br />Higher Interest Rate or Decrease in the money SupplyContractionary Monetary PolicyDecrease in Aggregate ExpenditureDecrease in ConsumptionDecrease in Investment<br />Repo Rate and the Discount Rate<br />The Repo rate is the rate at which the Central Bank is prepared to provide overnight financing to commercial banks. On various occasions, commercial banks may need to borrow from the Central Bank for just one day or an overnight period. This might apply at the end of a particular month when commercial banks might need additional cash reserves to meet the withdrawal requirements of customers who cash their pay cheques on that day. As the Repo rate is increased, commercial banks are subjected to more cost and respond by increasing the rate of interest charged to borrowers. <br />The Discount Rate is the rate charged to commercials banks on short term loans from the Central Bank. Commercial banks may also need to borrow from the Central bank for short term purposes when they are temporarily unable to meet their liquidity requirements over such periods. Similar to the Repo rate, as the discount rate is increased the rate of interest charged by commercial banks increases and vice versa. <br />Reserve Requirements and Special reserve deposits – This is a banking regulation which requires that a percentage of commercial banks’ deposits must be kept in the form of cash. As the reserve requirement ratio changes, so too does the banking multiplier (see chapter 27). As the reserve requirement ratio is increased, the banking multiplier decreases, as banks are obligated to keep a larger proportion of their deposits in liquid form. As a consequence, less money is lent and the credit creation process is diminished. As a result, the money supply contracts and this causes the rate of interest to increase leading to a contraction of aggregate expenditure. In addition to the reserve requirement ratio, the Central Bank can institute special reserve deposits onto financial institutions. For example, in 2005, the Central Bank of Trinidad and Tobago required that commercial banks make special deposits at the Central Bank in addition to the reserve requirement ratio. It must be noted that an increase in the reserve requirements may not have any impact on the banking multiplier if commercial banks keep excess reserves. In this scenario, commercial banks would be able to meet the new reserve requirements without reducing lending. This can therefore make the use of this instrument ineffective. <br />Open Market Operations – This is the principal tool of monetary policy. This involves the buying and selling of government securities in the open capital market. If the Central Bank purchases securities from the public, then this increases the amount of money in circulation which eventually finds itself into the commercial banking system. This therefore leads to a multiple expansion of deposits and hence a further increase in the money supply. The rate of interest consequently decreases and aggregate expenditure expands. In contrast, the sale of securities does the opposite, as money is withdrawn from the banking system resulting in a higher interest rate and a contraction of aggregate expenditure. It must be noted that if the Central Bank purchases securities and the recipients of the money invest it abroad, then the domestic money supply would not be increased, rendering this tool ineffective under this circumstance. <br />Issue of notes and coins (M0) – The Central Bank of any country can easily control the amount of cash in circulation in the economy as it has the sole responsibility for minting coins such as a 25 cent piece and printing bank notes such as a $1 bill and $10 bill and so. As such, the Central Bank is also able to increase the money supply by simply minting more coins and printing more bank notes and releasing them into circulation. Of course, this cash would be released into circulation as the government spends the newly created money.<br />Moral suasion – the Central Bank may attempt to extend its monetary policy stance on the economy by simply communicating its wishes to the financial sector. If the Central Bank wanted to effect a monetary contraction, the monetary authorities may request, without any compulsory consequences, that commercial banks increase their liquidity ratio or reduce the amount of loans issued. These actions would definitely result in a decrease in the money supply and a reduction in the level of aggregate expenditure. In this situation, commercial banks are not obligated to comply with such requests and as such, this tool may not be an effective monetary policy weapon.<br />3d<br />As the money supply increases, a surplus of money is created in the money market. In order for the money market to clear, the rate of interest must fall to entice individuals to hold larger money balances. <br />MIRLP= DME1IR1SM1IR2SM2E2<br />As the figure shows, an increase in the money supply results in the establishment of a new equilibrium in the money market at a lower rate of interest. This represents expansionary monetary policy, as the lower interest rate would lead to an increase in the level of output and employment in an economy.<br />3e<br />The Elasticity of the Demand for Investment – The effectiveness of monetary policy depends on the impact of changes in the rate of interest on investment spending (and consumer spending) in the economy. In the previous section, the monetary transmission mechanism was demonstrated under different assumptions. According to the Keynesian transmission mechanism, if the demand for investments (MEI) is highly inelastic, then a change in the rate of interest may not have a profound effect on the level of investments. This may occur for interest insensitive investments which may be dependent on other factors such as business expectations or Government incentives and taxation In this situation, the effectiveness of monetary policy would be weak.<br />Changes in the Velocity of Circulation – Referring back to the equation of exchange where:<br />MV = PY.<br />The product between the money supply and the velocity of circulation gives the total level of expenditure in the economy for the entire year. The value of V is said to be inversely proportional to the level of money demand, in that if the demand for money is high, money would slowly circulate in the economy. If the demand for money is low, then a given supply of money in the economy would circulate or change hands at a relatively faster rate. If it assumed that the velocity of circulation of money is constant, then the demand for money is expected to be stable. As such, any change in the money supply, M, would directly result in a change in total expenditure, MV.<br />If the velocity of circulation of money were to vary and move in the opposite direction to a change in the stock of money, then it is likely that there would be no change in the level of aggregate expenditure in the economy. Thus, if for instance the monetary authorities reduced the supply of money, but the public responded by holding less money, then there would be an increase in the circulation of money. This means that as the supply of money shifts to the left, the demand for money curve also shifts to the left. As a result, the rate of interest remains constant and there is no impact on aggregate expenditure.<br />