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Monetary Policy for A2
The document discusses monetary policy and the money supply. It defines money as having four key functions: medium of exchange, store of value, unit of account, and standard of deferred payment. It also discusses the spectrum of liquidity and defines the money supply. The document contrasts broad and narrow definitions of money supply and explains how monetary policy aims to control inflation by managing the money supply and interest rates, which influence demand for money.
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Monetary Policy for A2
- 1. Aquinas College EconomicsDepartment Monetary Policy for A2 Building on ECON2 ECON4
- 2. Aquinas College EconomicsDepartment Functions of Money A medium of exchange – Used the for the exchange of goods/services A store of value or wealth – Good way of holding purchasing power A unit of account – Expressions of value allow comparison A standard of deferred payment – Allows the function of credit
- 3. Aquinas College EconomicsDepartment Defining the Money Supply No one part of money can fulfil all the functions of money Therefore there must be a spectrum of liquidity Money Supply: The total amount of money circulating in an economy Cash Current Accounts Deposit Accounts Treasury Bills Property Spectrum of Liquidity More Liquid Least Liquid Liquidity: The degree to which financial assets can be easily converted into money
- 4. Aquinas College EconomicsDepartment Broad or Narrow? Broad Includes money held in banks that is not readily accessible Narrow Includes money that is readily available in banks or cash Monetarism is one of the economic theories that states inflation should be controlled using the money supply
- 5. Aquinas College EconomicsDepartment Demand for Money Determined by two key factors 1. Income – Higher levels of income cause people to demand higher levels of money in an economy 2. Rate of Interest – High rates = high opportunity cost for holding money
- 6. Aquinas College EconomicsDepartment The Rate of Interest Interest Rates are the price of holding money InterestRate S Quantity of Money D1 As interest rates rise, demand for money falls The Money Supply is drawn as a straight line as the Central Bank should be able to control the supply, irrespective of priceD
- 7. Aquinas College EconomicsDepartment Nominal or Real Interest Nominal – not adjusted for inflation Real – adjusted for inflation Calculation of Real Rate (Correct as of June 2013) Nominal Rate of Interest – Rate of Inflation Real Interest Rate 0.5% - 2.4% -1.9%=
- 8. Aquinas College EconomicsDepartment Monetary Policy Objectives These are a target set by the Bank of England Controlling inflation is the main target of the BoE 1980s – Focus on Money Supply 1985-1992 – Focus on Exchange Rate Post 1992 Control on inflation directly
- 9. Aquinas College EconomicsDepartment Monetary Policy Instruments Method used to achieve the objectives. Sometimes called Weapons Two main groups 1. Altering the Money Supply 2. Influencing the Demand for Money
- 10. Aquinas College EconomicsDepartment Controlling the Money Supply Credit Limits through base controls – Places limits on the amount of money commercial banks could lend out – Also through Reserve Asset Ratios, which defined how much a bank must hold in cash to their assets Buying and selling of Government Bonds
- 11. Aquinas College EconomicsDepartment Demand for Money Done mainly through the changing of interest rates Lower rates should increase the demand for money as its cheaper to borrow and there is no incentive to save