Money market

Countries have a Central bank - such as The Federal Reserve in the USA - that governs the banking system and creates money. It doesn’t print money, which is done by the treasury.

Central banks also control the money supply. Money supply is the quantity of money available.

The money supply impacts interest rates. The greater the supply, the lower the market price - ie interest rates. Conversely, decreasing the money supply increases interest rates. This follows basic principles of supply and demand.

Typically, The Federal Reserve has 3 goals with its Monetary policy:

  1. Maximize employment / minimize unemployment
  2. Stabilize the price of money
  3. Moderate long-term interest rates

Central banks control the money supply in three ways:

  1. Setting the Required reserve ratio
  2. Discount policy (the Interest rate for loans from the Central bank to commercial banks)
  3. Open market operations (buying and selling government bonds on the open market)

Central banks control the money supply by setting the required reserve ratio (RRR). RRR governs the minimum ratio of deposits banks are required to keep as cash. The RRR limits how much money banks can loan out. Higher RRR => more cash in the reserves. By loaning out money, banks “create” money - money is credited to one customer without leaving the account of whoever deposited it! While this increases the money supply, it doesn’t create wealth.

Loaned money can be re-deposited, then re-loaned at the rate allowed by the RRR infinitely. The limit to how much money can be created is limited; it can be calculated using the Money multiplier.

The equation for the Money multiplier is 1RRR\frac{1}{RRR}.

The money market obeys supply and demand just like any other good. The market price of money is the interest rate that banks pay to borrow from each other.

Since the central bank has total control over the money supply, it’s not affected by interest rates. The supply curve is a vertical line.

In the money market, the equilibrium point is when the money demanded is equal to the money supplied, and results in an equilibrium interest rate.

Expansionary monetary policy is used during a recession to increase aggregate demand to Potential real GDP and decrease unemployment.

Contractionary monetary policy is used when inflation rates are high. By decreasing the money supply, they increase the interest rate to decrease aggregate demand.

Quantity theory of money

The quantity theory of money states that there is a directly proportional relationship between the money supply and inflation rate.

Under the quantity theory of money:

  1. Inflation occurs when the money supply grows faster than output - the aggregate supply
  2. Deflation occurs when the money supply grows slower than aggregate supply