For the second part of the macroeconomics series of posts, I will be covering the next most common method of influencing aggregate demand in an economy; monetary policy.

What is Monetary Policy?

A simple explanation of monetary policy is “the utilization of changes in the monetary base in an economy to achieve price stability or low inflation, achieving Government objectives for employment and growth”.

Before we dig a little deeper, it is necessary to define the factors which are targets of monetary policy.

Which Factors can be Influenced by Monetary Policy?

The first of these factors is the money market; this is where an institution or individual can lend or borrow short term funds (up to 1 year in maturity). Such instruments include treasury bills, and certificates of deposit.

The number of investors is heavily dependent on the going rate of interest – if the interest rates are too high, the supply of money market instruments will be greater than the demand (more people willing to lend than borrow).

Alternatively if the interest rates are too low, then money market instruments will be below demand as firms will want to borrow cheap, and many investors will not consider the risk return reward as being desirable.

The second of these factors is around the Marginal Propensity to Consume: how much of an individual’s disposable income is spent rather than saved.

It is important to define this, as just assuming that an individual earns £25,000 a year in income means they are going spend every penny is not correct 100% of the time.

It is the desire of an individual to save a portion of their income which can have an effect on monetary policy, especially when aggregated for an economy.

The reason that this is important is that money demand is a key factor in monetary policy – the higher the interest rates in an economy, the less likely an individual is to store their money in savings (low interest deposits), with more money spent on longer term and higher interest instruments.

Whether individuals want to save in deposits or in long term instruments is vital, as the Bank of England’s definition of the money supply in an economy is dependent on this distinction.

The money supply in the economy is measured in two ways; “narrow money” or M0 is the sum of all physical exchanged money, plus deposits held in the Bank of England, with the second term “Broad Money” or M4 being defined as the sum of all physical exchanged money, plus deposits at all private financial instutitions (other banks such as HSBC or Natwest).

Both of these terms for the money supply do not consider money invested in financial instruments outside of physical cash or deposits as relevant for these definitions, so the proportion of savings in deposits or longer term securities can affect the level of the money supply.

How can the Central Bank use Monetary Policy?

In order to show how the Central Bank is able to use Monetary Policy, we need to demonstrate the vertical money supply theory.

This theory stipulates that for any given rate of interest, the money supply is constant (all else constant). This is important as changing the money supply in the economy can move the vertical money supply line left or right, having the impact of changing the interest rate due to a change in money demand.

As the money supply is increased, then interest rates fall as money demand is less at this new equilibrium (there is less demand for investment instruments, so interest rates fall to compete for the remaining demand).

The reverse happens with a fall in the money supply, which results in an increase in the interest rate as money demand is higher. This is the fundamental principle of monetary policy.

The key point to take from monetary policy is that the interest rate which is to be influenced cannot be changed directly; the Central Bank will have to adjust the money supply in an economy to meet their target interest rate (money supply adjusted by the previously defined money market).

When the Central Bank attempts to influence the money supply, it must also take into consideration the creation of money due to fractional reserve banking and the current reserve requirements.

Whenever a bank gets £100 in deposits, the reserve requirements may expect the bank to put aside 10% to cover daily liquidity expectations.

The other £90 which isn’t deposited can be loaned out to businesses. Once a business receives the loan, they can then deposit this £90 into their account, and the bank can then lend out all but 10% of this amount as a new loan (£81). At this point, the bank has loaned £171, with the original deposit being £100.

This process continues until the bank can loan no more. For the £100 stored as a deposit, the money supply can expand to £1000 to include £900 of new loans at this reserve ratio. This is the demonstration of a money multiplier (which in this case is 10).

The money multiplier is simply calculated as the inverse of the reserve ratio.

The Central Bank takes the reserve ratio into consideration as setting the reserve ratio for a bank to follow can impact the money supply.

By increasing the reserve requirement, banks may need to reduce their loans and deposits which means that the money supply will fall, and interest rates will rise.

Conversely, a decrease in the reserve ratio will allow banks to loan more, the money supply will rise and interest rates will fall.

The Central Bank may also decide to use the open market to make a purchase of Government securities from the secondary market which increases the bank reserves held at the Central Bank increasing the money supply (a form of expansionary monetary policy which increases the money supply and reduces interest rates).

The distinction between an open market purchase and that of Quantitative Easing is not entirely clear as the two have been used interchangeably, but the duration of financial instruments purchased in the market may be the differentiating factor.

The uses of monetary policy are not just to influence interest rates – the main goal is to assist the Government to achieve its objectives for inflation and growth. Governments will typically aim for an inflation rate of around 2% (not too high, and not too low) as a high inflation rate is likely to slow down economic growth, but low inflation rates can lead to deflation.

Despite this being a positive to households who see an increase in the standard of living, there are a number of potential consequences for businesses who see prices falling, leading to less profits, increases in job cuts, and greater difficulty in paying back loans which remain at the same value.

Is Monetary Policy Effective?

As with fiscal policy, the effectiveness is something which is often called into question. As there are time lags associated with any change in the money supply, or reserve ratio, the true impact cannot be assessed immediately or accurately.

There is also a heavy dependency on the expectations of economic agents (investors, borrowers, consumers, producers) as the marginal propensity to consume and/or save impacts the monetary base.

Despite the lags, it is a clearly popular choice for Governments to use for stimulating a slow economy, or slowing down an economy fighting with high inflation.

Even the European Union brought in a large Quantitative Easing program earlier in 2015 to boost the competitiveness of its exports and bring itself out of a deflationary trap!