Money supply: Understanding Monetarism: The Role of Money Supply

1. What is monetarism and why is it important?

Monetarism is a school of economic thought that emphasizes the role of money supply in influencing the price level, inflation, output, and economic growth. Monetarists believe that changes in the money supply have a direct and predictable impact on the economy, and that the central bank should control the money supply to achieve stable and low inflation. Monetarism is important because it offers a different perspective and policy prescription from other economic theories, such as Keynesianism, which focuses on the role of aggregate demand and fiscal policy in stabilizing the economy. In this section, we will explore the following aspects of monetarism:

1. The history and development of monetarism. Monetarism emerged in the 1950s and 1960s as a critique of the Keynesian consensus that dominated the post-war era. The main proponents of monetarism were Milton friedman, Anna Schwartz, and Karl Brunner, who challenged the Keynesian view that money is a passive and neutral factor in the economy. They argued that money is an active and powerful force that affects the behavior of individuals and firms, and that the central bank should follow a simple and transparent rule to regulate the money supply. They also developed the concept of the natural rate of unemployment, which is the lowest level of unemployment that can be achieved without causing inflation to rise.

2. The main assumptions and implications of monetarism. Monetarism is based on a few key assumptions, such as the quantity theory of money, the Fisher equation, and the long-run neutrality of money. The quantity theory of money states that the money supply multiplied by the velocity of money (the average number of times a unit of money is spent in a given period) equals the nominal GDP. The Fisher equation states that the nominal interest rate equals the real interest rate plus the expected inflation rate. The long-run neutrality of money states that changes in the money supply only affect the price level and inflation in the long run, but not the real output and employment. Based on these assumptions, monetarists derive some important implications, such as the inflation is always and everywhere a monetary phenomenon, the Phillips curve is vertical in the long run, and the monetary policy is more effective and reliable than the fiscal policy in stabilizing the economy.

3. The empirical evidence and criticisms of monetarism. Monetarism gained popularity and influence in the 1970s and 1980s, when many countries faced the problem of stagflation, which is a combination of high inflation and low growth. Monetarists argued that stagflation was caused by the excessive expansion of the money supply and the failure of the Keynesian policies. They advocated for a tight and rule-based monetary policy to reduce the money supply and bring down the inflation. Some countries, such as the UK and the US, adopted monetarist policies and experienced a decline in inflation, but also a rise in unemployment and output volatility. Monetarism also faced some empirical and theoretical challenges, such as the instability of the money demand function, the endogeneity of the money supply, and the rational expectations hypothesis. These challenges weakened the validity and relevance of monetarism in the modern economy.

2. How is it measured and controlled by central banks?

Money supply is the total amount of money available in an economy at a given time. It includes currency, coins, and various types of deposits held by banks and other financial institutions. Money supply is an important concept in monetarism, which is a school of economic thought that emphasizes the role of money in influencing inflation, interest rates, and economic growth. Monetarists believe that controlling the money supply is the key to achieving macroeconomic stability and preventing recessions or inflationary spirals.

There are different ways of measuring and controlling the money supply by central banks, which are the institutions that have the authority to issue currency and regulate the banking system. Some of the common measures of money supply are:

1. M0: This is the narrowest measure of money supply, also known as the monetary base. It consists of currency and coins in circulation, plus the reserves held by banks and other depository institutions at the central bank. M0 is the most liquid form of money, as it can be easily exchanged for goods and services. M0 is directly controlled by the central bank, as it can increase or decrease the amount of currency and reserves in the system.

2. M1: This is a broader measure of money supply, which includes M0 plus the demand deposits, such as checking accounts, held by the public at banks and other depository institutions. M1 is also very liquid, as it can be quickly converted into cash or used for electronic transactions. M1 is influenced by the central bank, as it can affect the reserve requirements and the interest rate paid on reserves, which in turn affect the amount of deposits created by banks.

3. M2: This is an even broader measure of money supply, which includes M1 plus the near-money assets, such as savings accounts, money market accounts, and certificates of deposit, held by the public at banks and other depository institutions. M2 is less liquid than M1, as it may take some time or incur some penalty to withdraw these assets. M2 is also affected by the central bank, as it can change the interest rate paid on these assets, which in turn affect the demand for them.

4. M3: This is the broadest measure of money supply, which includes M2 plus the large-denomination deposits, such as institutional money market funds, repurchase agreements, and Eurodollars, held by the public at banks and other financial institutions. M3 is the least liquid form of money, as it may have longer maturity or higher transaction costs. M3 is the least influenced by the central bank, as it depends more on the market conditions and the preferences of the holders.

Central banks use various tools to control the money supply, depending on their objectives and the economic situation. Some of the common tools are:

- open market operations: This is the buying and selling of government securities, such as treasury bills and bonds, by the central bank in the open market. When the central bank buys securities, it pays with new money, which increases the money supply and lowers the interest rate. When the central bank sells securities, it takes money out of the system, which decreases the money supply and raises the interest rate.

- discount rate: This is the interest rate that the central bank charges to banks and other depository institutions when they borrow money from it. When the central bank lowers the discount rate, it encourages more borrowing and lending, which increases the money supply and lowers the interest rate. When the central bank raises the discount rate, it discourages borrowing and lending, which decreases the money supply and raises the interest rate.

- Reserve requirements: This is the percentage of deposits that banks and other depository institutions must keep as reserves at the central bank or in their vaults. When the central bank lowers the reserve requirements, it allows more deposits to be used for lending, which increases the money supply and lowers the interest rate. When the central bank raises the reserve requirements, it reduces the amount of deposits available for lending, which decreases the money supply and raises the interest rate.

An example of how central banks use these tools to control the money supply is the quantitative easing (QE) program implemented by the Federal Reserve (the central bank of the United States) in response to the global financial crisis of 2008-2009. QE involved the large-scale purchase of government securities and other assets by the Federal Reserve, which increased the money supply and lowered the interest rate. The aim of QE was to stimulate the economy by providing more liquidity and credit to the financial system and lowering the cost of borrowing for households and businesses. QE was gradually tapered off as the economy recovered and inflation expectations rose.

3. How does money supply affect inflation and economic growth?

The quantity theory of money is a fundamental concept in economics that explores the relationship between money supply, inflation, and economic growth. It posits that changes in the money supply directly impact the overall price level in an economy. When the money supply increases, there is a corresponding increase in prices, leading to inflation. Conversely, a decrease in the money supply can result in deflation.

From different perspectives, economists have provided insights into the quantity theory of money. Some argue that changes in the money supply have a direct and proportional effect on prices, assuming other factors remain constant. This perspective emphasizes the role of monetary policy in controlling inflation and stabilizing the economy.

Others highlight the importance of velocity of money, which refers to the rate at which money circulates in the economy. According to this view, changes in the money supply may not have an immediate impact on prices if the velocity of money changes concurrently. For example, if people start hoarding money instead of spending it, the increase in money supply may not lead to inflation.

1. money Supply and inflation:

- An increase in the money supply, without a corresponding increase in the production of goods and services, can lead to inflation.

- This occurs because there is more money chasing the same amount of goods, driving up prices.

- Conversely, a decrease in the money supply can help combat inflationary pressures.

2. money Supply and Economic growth:

- The quantity theory of money suggests that an increase in the money supply can stimulate economic growth.

- With more money available, individuals and businesses have increased purchasing power, leading to higher levels of consumption and investment.

- However, excessive money supply growth can also lead to economic instability and asset price bubbles.

3. Examples:

- In the 1970s, many countries experienced high inflation due to significant increases in the money supply.

- Zimbabwe's hyperinflation in the late 2000s serves as an extreme example of the detrimental effects of excessive money supply growth.

4. How does money supply affect unemployment and inflation trade-off?

One of the most influential concepts in macroeconomics is the Phillips curve, which shows the relationship between unemployment and inflation. The Phillips curve suggests that there is a trade-off between these two variables: lower unemployment implies higher inflation, and vice versa. However, the Phillips curve is not a stable or universal phenomenon, as it depends on many factors, such as the expectations of economic agents, the degree of price and wage rigidity, and the role of monetary policy. In this section, we will explore how money supply affects the unemployment-inflation trade-off, and how different schools of thought have interpreted the Phillips curve.

1. The original Phillips curve: This was based on the empirical observation of a negative correlation between unemployment and inflation in the UK from 1861 to 1957. The original Phillips curve implied that policymakers could choose any combination of unemployment and inflation along the curve, depending on their preferences and social welfare function. For example, a government that wanted to reduce unemployment could increase the money supply, which would stimulate aggregate demand and lower unemployment, but at the cost of higher inflation.

2. The expectations-augmented Phillips curve: This was developed by Milton Friedman and Edmund Phelps in the late 1960s, in response to the breakdown of the original Phillips curve in the 1970s, when many countries experienced stagflation (high unemployment and high inflation). The expectations-augmented Phillips curve introduced the concept of the natural rate of unemployment, which is the level of unemployment that prevails when inflation is stable and expected. The expectations-augmented Phillips curve suggested that there is no long-run trade-off between unemployment and inflation, as any attempt to lower unemployment below the natural rate by increasing the money supply would only result in higher inflation and higher expected inflation, which would eventually push unemployment back to the natural rate. Therefore, the only way to reduce unemployment in the long run is to lower the natural rate, which depends on structural factors such as labor market institutions, demographics, and technology.

3. The new Keynesian Phillips curve: This is a more recent version of the Phillips curve, which incorporates the idea of price and wage rigidity, or the tendency of prices and wages to adjust slowly to changes in economic conditions. The new Keynesian Phillips curve suggests that there is a short-run trade-off between unemployment and inflation, but only when there are deviations from the natural rate of output, which is the level of output that prevails when prices and wages are fully flexible. The new Keynesian Phillips curve implies that monetary policy can affect the unemployment-inflation trade-off by influencing the output gap, which is the difference between actual output and natural output. For example, an expansionary monetary policy that increases the money supply can boost aggregate demand and close a negative output gap, which would lower unemployment and raise inflation. However, in the long run, the output gap would return to zero, and the unemployment-inflation trade-off would disappear.

5. How does central bank set interest rates based on money supply and inflation targets?

One of the most important aspects of monetarism is the monetary policy rule, which is a formula that guides how the central bank sets the interest rate based on the money supply and the inflation target. The monetary policy rule is based on the assumption that there is a stable and predictable relationship between the money supply and the price level, and that the central bank can control the money supply through its open market operations. The monetary policy rule aims to achieve price stability, which is the primary objective of most central banks, and to avoid excessive fluctuations in output and employment. However, the monetary policy rule is not without its critics, who argue that it is too rigid, ignores other factors that affect the economy, and fails to account for the uncertainty and complexity of the real world. In this section, we will explore the following topics:

1. The basic form of the monetary policy rule and how it works.

2. The advantages and disadvantages of the monetary policy rule from different perspectives.

3. The variations and modifications of the monetary policy rule to address some of its limitations.

4. The empirical evidence and practical challenges of implementing the monetary policy rule.

## 1. The basic form of the monetary policy rule and how it works.

The most famous and influential version of the monetary policy rule is the Taylor rule, named after the economist John B. Taylor, who proposed it in 1993. The Taylor rule is a simple equation that specifies how the central bank should set the nominal interest rate (i) based on the following variables:

- The inflation rate (π), which is the percentage change in the price level over a given period, usually a year.

- The inflation target (π*), which is the desired level of inflation that the central bank aims to achieve and maintain in the long run, usually around 2% per year.

- The output gap (y - y), which is the difference between the actual level of output (y) and the potential level of output (y), which is the maximum amount of output that the economy can produce without generating inflationary pressures.

- The equilibrium real interest rate (r*), which is the interest rate that would prevail in the absence of inflation and output fluctuations, and that reflects the underlying preferences and productivity of the economy.

The Taylor rule can be written as follows:

$$i = r + π + 0.5(π - π) + 0.5(y - y)$$

The Taylor rule implies that the central bank should raise the interest rate when the inflation rate is above the target or when the output gap is positive, and lower the interest rate when the inflation rate is below the target or when the output gap is negative. The coefficients 0.5 indicate how much the central bank should adjust the interest rate in response to deviations from the target inflation and output. The Taylor rule also implies that the central bank should set the interest rate equal to the sum of the equilibrium real interest rate and the inflation target when the inflation rate and the output gap are both zero, which is the optimal situation for the economy.

The Taylor rule is based on the idea that the central bank can influence the real interest rate, which is the nominal interest rate minus the inflation rate, and that the real interest rate affects the aggregate demand and the output gap. By adjusting the nominal interest rate, the central bank can stimulate or restrain the economy and bring it closer to the potential output and the target inflation. For example, if the inflation rate is higher than the target and the output gap is positive, the central bank can raise the nominal interest rate, which will increase the real interest rate and reduce the demand for goods and services, leading to lower output and lower inflation. Conversely, if the inflation rate is lower than the target and the output gap is negative, the central bank can lower the nominal interest rate, which will decrease the real interest rate and increase the demand for goods and services, leading to higher output and higher inflation.

## 2. The advantages and disadvantages of the monetary policy rule from different perspectives.

The monetary policy rule has been praised and criticized by different schools of thought and policy makers. Some of the main arguments for and against the monetary policy rule are:

- Advantages:

- The monetary policy rule provides a clear and transparent framework for the conduct of monetary policy, which enhances the credibility and accountability of the central bank and reduces uncertainty and confusion in the financial markets and the public.

- The monetary policy rule helps to anchor the inflation expectations of the agents in the economy, which makes the inflation target more credible and achievable, and reduces the volatility and persistence of inflation.

- The monetary policy rule promotes macroeconomic stability and efficiency, by preventing excessive fluctuations in output and inflation, and by aligning the interest rate with the natural rate of interest, which reflects the optimal allocation of resources in the economy.

- The monetary policy rule is simple and easy to implement, as it only requires the central bank to monitor and measure a few variables, and to follow a mechanical formula to set the interest rate, without relying on subjective judgments or discretionary decisions.

- Disadvantages:

- The monetary policy rule is too rigid and inflexible, as it does not allow the central bank to respond to unexpected shocks or changes in the structure of the economy, or to take into account other relevant factors that affect the economic performance, such as financial stability, exchange rates, or fiscal policy.

- The monetary policy rule is based on unrealistic and questionable assumptions, such as the existence and measurability of the potential output and the equilibrium real interest rate, which are unobservable and variable concepts that depend on many factors and are subject to estimation errors and revisions.

- The monetary policy rule is not robust and reliable, as it may fail to deliver the desired outcomes or even generate instability and inefficiency, depending on the model and the parameters used to derive and calibrate it, or on the behavior and expectations of the agents in the economy, which may not conform to the rational expectations hypothesis.

- The monetary policy rule is not enforceable and binding, as it does not prevent the central bank from deviating from the rule or changing the rule over time, either intentionally or unintentionally, due to political pressures, institutional constraints, or informational limitations.

## 3. The variations and modifications of the monetary policy rule to address some of its limitations.

The monetary policy rule is not a unique or definitive formula, but rather a general and flexible framework that can be adapted and modified to suit different contexts and objectives. Some of the most common and important variations and modifications of the monetary policy rule are:

- The forward-looking version of the monetary policy rule, which uses the expected or forecasted values of the inflation rate and the output gap, rather than the current or lagged values, to set the interest rate. This version of the rule aims to incorporate the forward-looking behavior and expectations of the agents in the economy, and to improve the timeliness and effectiveness of the monetary policy actions, by anticipating and preventing future deviations from the target inflation and output, rather than reacting to past deviations.

- The inflation-forecast targeting version of the monetary policy rule, which uses the inflation forecast as the only variable to set the interest rate, and adjusts the interest rate to ensure that the inflation forecast converges to the inflation target over a given horizon, usually two to three years. This version of the rule simplifies the implementation and communication of the monetary policy, by focusing on a single and transparent objective, and by implicitly taking into account the output gap and other factors that affect the inflation forecast, without having to measure or estimate them directly.

- The flexible inflation targeting version of the monetary policy rule, which allows the central bank to balance the trade-off between stabilizing the inflation rate and stabilizing the output gap, by assigning different weights to the two variables in the rule, depending on the preferences and the circumstances of the central bank. This version of the rule acknowledges that the central bank may have other objectives besides price stability, such as output stability, employment, or growth, and that the central bank may face situations where achieving the inflation target may entail large and costly fluctuations in output or other variables.

- The optimal control version of the monetary policy rule, which uses a dynamic and stochastic model of the economy, and a numerical optimization technique, to derive the optimal path of the interest rate that minimizes a loss function that reflects the objectives and the constraints of the central bank, subject to the expectations and the reactions of the agents in the economy. This version of the rule aims to provide the most efficient and consistent solution for the conduct of the monetary policy, by taking into account the intertemporal and stochastic nature of the economy, and by incorporating all the relevant information and variables in the model and the loss function.

## 4. The empirical evidence and practical challenges of implementing the monetary policy rule.

The monetary policy rule has been extensively tested and evaluated by empirical studies and practical experiments, which have provided mixed and inconclusive results. Some of the main findings and challenges of implementing the monetary policy rule are:

- The monetary policy rule seems to describe reasonably well the actual behavior and the historical performance of some central banks, especially the US Federal Reserve, which suggests that the monetary policy rule captures some of the key features and principles of the conduct of monetary policy, and that the monetary policy rule can serve as a useful benchmark and reference for the central bank and the public.

- The monetary policy rule also seems to outperform some alternative policy strategies, such as constant money growth, fixed exchange rate, or discretionary policy, in terms of achieving lower and more stable inflation and output, which suggests that the monetary policy rule can improve the effectiveness and the credibility of the monetary policy, and that the monetary policy rule can enhance the welfare and the efficiency of the economy.

- However, the monetary policy rule is not a universal or a dominant policy strategy, as it may perform worse than some other policy strategies, such as optimal control, state-contingent policy, or simple heuristics, in

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