Question

1) Explain from chapter 27 why there are various 'levels' of money supply, and what main characteristic separates them.

2) Explain how the banking system 'creates money'. Please indicate whether you think this ability has grown in the past few decades or declined (your support of your answer is more important than your answer).

3) Identify what monetary policy is and what it should do during the growth phase and recessionary phase of an economy.

Answer 1

1) Money supply in the economy can be divided into M1, M2, M3 and M4. Moneys supply is the physical cash in circulation in the economy and also the money in savings accounts of the banks. Where M1 is the monetary base and it is the sum of currency in circulation and the demand deposits. M2 is the summation of savings account in post office with M1. M1 is known as narrow money, which is the most liquid form of money. M3 consist of the summation of M2 and time deposits win banking system. M4 is M3 plus all the deposits in savings bank. The circulation of money and the deposit determine the difference between the four measures of the money. On the other hand, the demand for money and the liquidity rate also have influence over the supply of money. Velocity of money determines the liquidity of the money in the money market. The money supply is exogenously determined by central bank and will not change with respect to changes in market.
2) Most of the banks create money through their deposits. Bank makes money through increasing the number of deposits for lending the money. Every new loan by the bank creates money in the economy. If a new account is started in a bank, the consumer will take loans through this account. So the bank is responsible to give the money to the customer. On the other hand, the customer will deposit the money in this account. The bank will be responsible to give money at any time when the customer demanded. In each of the case the bank is responsible towards its customers. The concept of money multiplier can be used here for the creation of money. If a customer deposits a particular amount of money in bank A. Bank A will lend the money to bank B as loan. At this time bank A will get a percentage of money from bank B as interest rate. While giving the money to bank B by bank A, it will reserve a certain amount of money in bank A. Bank B will lend the money to bank C by keeping certain amount of money in their account. This process will continue until the money in the market ended. This money multiplier process will increase the level of money in the market. Most of the commercial banks used this process for the creation of money in the economy.
3) In recession period, the monetary authority should follow an expansionary monetary policy to help the economy. There is high rate of inflation, negative economic growth and scarcity of money in economy, low production and productivity, low wage rates etc. can be seen in the economy during recession. This can be over come through expansionary monetary policy by increasing money supply through pumping money to the economy. There are several tools used to do these mechanisms. Like open market operations, fund rates, discount rates, reserve requirements etc. If the central monetary authority reduces its reserve rates, the amount of lending rate by the banks increased. This will helps to fulfil the needs of the people to manage their economic conditions. The reduction in fund rates will enhance to make the money demand of the markets. So commercial banks will avail more money to increase their operations and helps the customers to fulfil their economic needs.