What is money?
The concept of money can be viewed from different perspectives. For example, money can be used
- as an asset serving as a unit of account,
- as a medium of exchange
- as a store of value
Money Supply Measures
- M1-This money measure consists of liquid assets. They include currency and coins in circulation, demand deposits, and traveler’s checks.
- M2- This is broader than M1. It comprises of all M1elements as well as savings accounts, minor deposits, and money market deposits.
- M3- It is the broadest of all. It includes M2 elements as well as large-denomination time deposits repurchase liabilities, balance in institutional money funds, residents in foreign branches of U.S banks, and Eurodollars held by the US.
Controlling the money supply
In open markets, Fed purchases bonds and thus influencing an increase in money supply in the U.S. Selling these bonds means that money in supply decrease as people will issue out money and as a result, money held in the economy decrease.
The impact that decreases in the reserve requirement has on money supply is that money supply increases. In contrast, increasing reserve requirements lead to a decrease in the money supply in an economy.
Further, when Fed lowers both the target federal fund and discount rate, money supply increases, and hence lower interest rates. Similarly, if the bank increases the target federal fund and the rate of discount, the money supply will fall, and thus necessitating high-interest rates to curb the situation (Suranovic 240).
An increase in GDP level means that demand for money will increase to buy the surplus GDP in the economy.
Considering the GNP, a fall usually results in a decreased demand for money in the economy.
It is also argued that an increasing rate of interest results in a decreased demand for money in the economy.
Money Functions and Equilibrium
When you consider GDP and average rate of interest, it is found that a positive relationship between the two prevails. The money supplied does not depend on average interest rates.
The point at which the money supply curve intersects with the money demand curve is used to demonstrate the rate of interest at equilibrium (Suranovic 245).
Money market stories
Economists suggest that lowering the rate of people tends to decrease the rate of equilibrium. This necessitates people to liquidate the non-money deposits that bear interest. Consequently, the situation decreases what commercial banks hold as loan-able funds. Banks then react to this by raising the interest rate to such a point that money demand equals the supply of money. On the other hand, an interest rate higher than the equilibrium rate demonstrates the real situation in the economy. This situation evidences abundance in liquid assets being held by people, which are more than they would wish to hold (Suranovic 249). Consequently, they invest it into assets bearing interest e.g. deposits. As a result, banks now have loan-able funds in the form of these deposits and hence decreasing the interest rate. This trend persists until a point is reached where the supply and the money demand are equal.
Effects of a Money Supply Increase
A decrease in money supply leads to an increase in average interest rates. On the other hand, a decrease in supply leads to an increase in average interest rates. This happens when all other factors are held constant.
Effect of a Price Level Increase (Inflation) on Interest Rates
Inflation, which is the increase in the price level, affects the average interest rate. When the price level increase, interest rates tend to increase.
When prices fall, it means that there is deflation in the economy. In this case, average interest rates in the economy will result in a decrease due to the price fall (Suranovic 256). This state exists considering that all factors, which affect the economy remain the same.
Effect of a Real GDP Increase (Economic Growth) on Interest Rates
With all factors held constant, economies grow increasing the average interest rate.
A recession of the economy, decrease in the real GDP, inflicts a decrease in average rates of interest.
Integrating the Money Market and the Foreign Exchange Markets
Equilibrium shown by foreign exchange markets and the money markets are best represented by using an appropriately adjusted two-quadrant as below.
Comparative Statics in the Combined Money-Forex Model
In the U.S.A, about the money forex model, any increment in money supply with other factors held constant, tends to decrease the interest rates. Furthermore, this affects the dollar as it results in the depreciation of the currency (Suranovic 250).
Concerning the GDP, an increase tends to result in a decrease in the interest rates, and as such, it warrants depreciation. This happens when all other factors held constant,
Money Supply and Long-Run Prices
When the aggregate product in a country fall, it will mean that inflation will arise due to few products, and yet demand for those products surpass that production level. From this state of affairs, Inflation tends to arise. Besides, it is common that if the money supply increases, the aggregate demand for the products and services will tend to increase too. In the end, the effect of an increase in the money supply results to rise in the level of prices. In the short run, this has a soft effect and might not even be felt.
Furthermore, an increase in or money supplied is essential as it results in an increased gross national output.
Again, if the money increases in the economy, price levels tend to rise. Further, the national output does not experience a meaningful rise. As a result, it will lower the rate of unemployment concerning labor as well as capital.
Money supply increase hurts the natural rates of unemployment. As such, levels of prices will be large compared to the national output, which is smaller.
Finally, the money supply increasing in such a situation where the economy is larger or above the natural rate of unemployment, the level of prices will be small, but the national output will be large.
Suranovic, Steve. International Finance. New York, NY: Flat World Knowledge, L.L.C. 2010. Print.