Monetary Policy
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Monetary Policy
Monetary Policy
Monetary policy actions may either:
directly control the amount of money in circulation (the money supply); or
attempt to reduce the demand for money through its price (interest rates).
By exercising control in these ways, governments can regulate the level of demand in the economy. Those who see the use of monetary policies as crucial in the control of macroeconomic activity are known as monetarists.
1. Direct and Indirect Control of the Money Supply
Governments or central banks can directly control the money supply in the following ways:
1.1 Open market operations
If the central bank sells government securities, the money supply is contracted, as some of the funds available in the market are "soaked up" by the purchase of the government securities.
The sale of government securities will lead to a reduction in bank deposits due to the level of funds that have been soaked up.
This in turn can lead to a further reduction in the money supply, as the banks' ability to lend is reduced. This is known as the multiplier effect.
Equally, if the central bank were to buy back securities, then funds would be released into the market.
1.2 Reserve asset requirements (cash reserve ratio): the central bank can set a minimum level of liquid assets which banks must maintain. This limits their ability to lend and thereby reduces the money supply.
1.3 Special deposits: the central bank can have the power to call for special deposits. These deposits do not count as part of the bank's reserve base against which it can lend. Hence, they have the effect of reducing the bank's ability to lend and thereby reducing the money supply.
1.4 Direct control: the central bank may set specific limits on the amount which banks may lend. Credit controls are difficult to impose as, with fairly free international movement of funds, they can easily be circumvented.
Indirectly, governments can reduce the demand for money, and therefore indirectly reduce the money supply, by encouraging an increase in short-term interest rates.
2. Problems of Monetary Policy
Various problems arise with monetary policy.
There is often a significant time lag between the implementation of a policy and its effects.
Credit control is ineffective in the modern global economy.
The relationship between interest rates, level of investment and consumer expenditure is not actually stable and predictable.
Increasing interest rates produces undesirable side effects, including:
Less investment, leading to reduced industrial capacity, leading to increased unemployment (as higher interest rates increase the cost of capital for a company using debt finance).
An overvalued currency, which reduces demand for exports.
3 Measuring the Money Supply
If governments want to control the money supply, it is necessary to be able to measure the supply of money in the economy.
In the UK a number of alternative indicators have emerged, including the following:
M0 Notes and coins in circulation and in banks' tills.
M3 M0 plus deposits at banks.
M4 M3 plus deposits at building societies.
M5 plus private sector holdings of certain types of government debt.
Although M5 may be the most suitable measure to use, it is the hardest to control.
Equally, although M0 is the easiest measure to control, it is probably the least representative of overall economic activity.
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