Definitions of money supply and monetary policy

Government and the Macro‑economy

Monetary Policy

Key Definitions

Money Supply – the total stock of money available in an economy at a particular point in time. It includes cash, coins and the balances held in bank accounts that can be used for transactions. Economists usually refer to different measures of the money supply:

Monetary Policy – the set of actions undertaken by a country’s central bank to influence the quantity of money and credit in the economy, with the aim of achieving macro‑economic objectives such as price stability, full employment, and sustainable economic growth.

Objectives of Monetary Policy

• Control inflation (keep price rises low and stable)
• Support economic growth and employment
• Stabilise the currency and manage exchange‑rate pressures
• Maintain financial stability

Instruments of Monetary Policy

1. Open Market Operations (OMO) – buying or selling government securities to increase or decrease the amount of money banks have to lend.
2. Policy (Discount) Rate – the interest rate at which commercial banks can borrow short‑term funds directly from the central bank.
3. Reserve Requirements – the proportion of deposits that banks must hold as reserves and cannot lend out.
4. Quantitative Easing (QE) – large‑scale purchases of longer‑term securities to inject liquidity when short‑term rates are already very low.

How Monetary Policy Affects the Economy

When the central bank expands the money supply (e.g., by buying securities), the following chain is expected:

• More reserves for commercial banks → lower interest rates.
• Cheaper borrowing → increased investment and consumer spending.
• Higher aggregate demand → upward pressure on output and employment.
• Potential upward pressure on prices → inflation risk.

Conversely, a contractionary stance (selling securities, raising rates, increasing reserve ratios) aims to reduce inflation by slowing demand.

Key Relationship

The relationship between the money supply (M) and the price level (P) can be expressed by the Quantity Theory of Money:

\$\$

M \times V = P \times Y

\$\$

where:

• \$M\$ = money supply
• \$V\$ = velocity of money (average number of times a unit of money is spent in a period)
• \$P\$ = price level
• \$Y\$ = real output (real GDP)

Suggested Diagram