Group2

1.3 The Supply of Money

Introduction

• Changes in quantity of money are pivotal for economic development and price stability.

• Controlled expansion of money supply is essential for sustainable development without inflation or deflation.

• Mild inflation can stimulate investment, while runaway inflation harms growth.

• Central banks manage money supply, influencing interest and inflation rates, and aggregate output significantly.

• Understanding money supply processes, including multipliers, is crucial for economic health.

Learning Objectives

• Explain Money Supply/Stock, including Financial Innovations.

• Describe Endogenous Money Supply and Credit Creation Process.

• Explain the Monetary Base Model and distinguish between Flow of Funds and Base Multiplier approaches.

• Analyze the relationship between Fiscal Balance and Money Supply.

• Understand empirical studies of money supply.

1.3.1 Money Supply/Stock and Financial Innovations

Demand and Supply of Money

• Money is demanded and supplied like other goods. Key determinants of money demand:

  • National income

  • Price level

  • Interest rates.

• Money supply is primarily controlled by the central bank through monetary policy.

• Equilibrium money amount occurs where demand equals supply.

Nominal vs Real Value of Money

• Nominal value refers to the currency itself (e.g., $1 = 1).

• Real value is its purchasing power, calculated as 1/P, where P is the average price level.

Money and Bond Markets

• Money market refers to the demand and supply of money, not short-term bonds.

• "Bonds" include all non-monetary financial assets (loans, shares).

Financial Innovations

• Innovations since the 1960s include ATMs, online banking, and credit/debit cards that influence money demand.

• Credit cards acquire debts, decreasing the need to hold cash.

• Debit cards reduce cash payments but do not eliminate the necessity of maintaining sufficient bank account balances.

1.3.2 Endogenous Money Supply: Credit Creation Process

Central Bank’s Role

• Major players in money supply: commercial banks, depositors, borrowers, and central bank.

• Central bank balance sheet shows assets and liabilities, including currency in circulation (liability) and reserves.

Money Supply Control

• Monetary Base (MB) = Currency in circulation (C) + Reserves (R).

• The central bank can alter MB through open market operations (buying/selling securities).

• Buying securities increases MB and thus impacts money supply (MS).

Credit Creation Process

• The central bank's activities influence MS using T-accounts to balance assets and liabilities.

• Loans increase MB, while repayments decrease it.

1.3.3 Monetary Base Model of Money Supply

Understanding Monetary Base Model

• Focuses on monetary stocks, highlighting that money supply is a multiple of the monetary base (MB).

• Assumes stable relationships between MB and money supply; central banks can manage MB to influence the money stock.

Calculation of Money Stocks

• M (money) = Cp + Dp (currency + deposits)

• Stabilized relationships underpinning the B-M model must be empirically examined and can change.

1.3.4 Flow of Funds Approach to Money Supply

Introduction to Flow of Funds

• Focuses on changes in stocks captured through flows, especially bank lending to the non-bank public.

• Money supply = ΔM = Flows of ΔLp (private sector loans) + ΔLg (public sector loans).

Implications of FoF Approach

• Highlights the interconnectedness of money stock changes with lending behaviors.

• Important for understanding monetary growth and flow dynamics.

1.3.5 Fiscal Balance and the Money Supply Process

Importance of Fiscal Balance

• A fiscal deficit influences money supply through higher interest rates and potential government borrowing increases.

• Central banks may intervene to prevent rate increases by augmenting money supply.

Central Bank’s Dilemma

• Balancing fiscal expansion risks inflation, especially near full employment.

• Avoids crowding out private investment through strategic money supply management.

1.3.6 Empirical Studies of Money Supply

Cointegration and Empirical Findings

• Empirical studies employ cointegration to assess money supply relationships.

• Notable findings indicate shifting relationships over time, emphasizing changes in central bank policies.

Case Study: Money Supply in Ghana

• Analyzes drivers of M2 money supply, revealing fiscal deficit financing's early impact, shifting to foreign capital inflows later.

• Monetary management strategies have historically focused on balancing various financial components.