ECON 102 - Chapter 9

Prepared by Ifeanyi Uzoka, Sheridan College Principles of Macroeconomics

Authors: Sayre, Morris, Ghayad

Edition: Eleventh
Chapter: 9 - The Money Market and Monetary Policy

Learning Objectives

Describe the determinants of money demand and supply, and explain how equilibrium in the money market is achieved.
Define monetary policy and explain the two main monetary targets.
Explain how the monetary transmission process works in effecting expansionary and contractionary monetary policy.
Explain why monetarists believe that controlling the money supply is vital.
Explain the difference between how the two opposing schools of thought believe that monetary policy works.
Explain what anti-inflationary policy is and how it works.
List some of the recent criticisms of anti-inflationary monetary policy.

The Money Market

Interest Rate Definition

Interest Rate: The annual rate at which payment is made for the use of money (or borrowed funds).
- It is expressed as a percentage of the borrowed amount.
- It represents the price of money.

Supply of Money

Supply of Money: The amount of money available in the economy.
- Determined by the Bank of Canada.
- Constant at any given point in time and not affected by the rate of interest.

The Bank of Canada

Overview

Canada's Central Bank: A government-owned institution.
- Directors and the governor are appointed by the federal cabinet.
- Current governor: Tiff Macklem (since June 2020).

Functions of the Bank of Canada

Sole issuer of currency.
Acts as the government’s bank and manager of foreign currency reserves on behalf of the government.
Functions as a bankers' bank and lender of last resort.
Audits and inspects commercial banks.
Regulates the money supply.

Bank of Canada Balance Sheet at December 31, 2021

Assets:
- Cash and foreign deposits: $7 million
- Short-term loans to banks: $23 million
- Treasury bills: $1,331 million
- Government bonds: $408 million
- Other assets: $66 million
Liabilities:
- Notes in circulation: $115,155 million
- Government of Canada deposits: $70,089 million
- Deposits of banks: $267,394 million
- Other liabilities: $46,727 million

Demand for Money

Types of Demand

Transactions Demand for Money
- Desire to hold money as a medium of exchange to affect transactions.
- Demand is based on levels of real GDP and prices.
- Not related to interest rates.
Asset Demand for Money
- Desire to use money as a store of wealth; to hold money as an asset.
- Inversely related to interest rates.

Total Demand for Money

Total demand for money (MD) is the sum of transactions demand (MDT) and asset demand (MDA):
$MD = MDT + MDA$

Equilibrium in the Money Market

Equilibrium is reached when the quantity of money demanded (MD) equals the quantity of money supplied (MS).
- At the equilibrium interest rate ( $r_1$ ), there is neither a surplus nor a shortage of money.
- If the interest rate is higher than the equilibrium rate ( $r_2$ ), a surplus occurs.
- If the interest rate is lower than the equilibrium rate ( $r_3$ ), a shortage occurs.

Tools for Monetary Policy

Types of Monetary Policy

Expansionary Monetary Policy
- Aims to increase the money supply in the economy, making credit cheaper and more readily available.
- Also referred to as an easy money policy.
Contractionary Monetary Policy
- Aims to decrease the amount of money in the economy, making credit harder and more expensive to obtain.
- Also referred to as a tight money policy.

Tools Used by Bank of Canada

Open Market Operations (OMO)
- Buying or selling treasury bills (T-bills) in an open market.
- OMO can be initiated quickly, are impactful, and can be performed for any amount.
Switching Government Deposits
- Transferring deposits to/from Bank of Canada to commercial banks.
- This method is increasingly popular.

Monetary Transmission Process

Function of Money Supply Changes

The monetary transmission process illustrates how changes in the money supply affect real economic variables through interest rates.
- A lower interest rate due to an increase in the money supply leads to increased investment and aggregate expenditures.
- It results in a multiplied impact on real GDP and an increase in the price level.

Monetarist View

Concept Overview

Monetarism: An economic school of thought asserting that fluctuations in GDP and inflation are driven by changes in the money supply.
- Popularized by Milton Friedman.

Equation of Exchange

$MV = PQ$
- Where:
- $M$ : Money supply
- $V$ : Velocity of money
- $P$ : Price level
- $Q$ : Real GDP

Contrasting Keynesian and Monetarist Views

Keynesian View

Elastic Demand for Money: Change in money supply only slightly impacts interest rates; investment demand remains inelastic.
- An increase in money supply leads to minimal investment spending effect.

Monetarist View

Inelastic Demand for Money: Change in money supply significantly impacts interest rates, resulting in substantial changes in investment spending.
- Focus on maintaining price levels and exchange rates, deeming comprehensive monetary policy as overly ambitious.

Anti-Inflationary Monetary Policy

Objectives

To maintain low, stable, and predictable inflation rates (between 1-3%).
To stabilize the currency's internal and external value.

Criticisms

Concerns that an excessive focus on inflation control may lead to lower economic growth, higher unemployment, and large budget deficits due to high interest costs.

Key Concepts to Remember

Determinants of money demand, supply, and equilibrium.
The role of monetary policy and the two main targets.
Mechanisms of the monetary transmission process.
Significance of controlling the money supply as endorsed by monetarists.
Contrasts between Keynesian and monetarist views on monetary policy effectiveness.
Understanding anti-inflationary policies and their criticism.