Monetary policy measures: changes in money supply

Government and the Macroeconomy – Monetary Policy

What is Monetary Policy? 📈

Monetary policy is the way a country’s central bank (like the Bank of England or the Federal Reserve) controls the amount of money in the economy. Think of it as a giant watering can for the economy – too little water and plants (businesses) wilt; too much and they flood. The goal is to keep the economy healthy, with stable prices and good job growth.

Key Tools to Change Money Supply 💰

• Open Market Operations (OMO) – buying or selling government bonds.
• Reserve Requirements – the amount banks must keep on hand.
• Discount Rate – the interest rate banks pay to borrow from the central bank.
• Forward Guidance – telling the public what the bank plans to do next.

Open Market Operations (OMO) – The Ice‑Cream Stall Analogy 🍦

Imagine the central bank runs an ice‑cream stall. When it sells ice‑cream (sells bonds), people pay cash, reducing the amount of money they have to spend. When it buys ice‑cream (buys bonds), it gives people cash, increasing the money supply. This is how the bank can “add” or “take away” money from the economy.

1. Central bank announces it will buy $1 billion in bonds.
2. Commercial banks sell those bonds to the central bank.
3. Central bank credits the banks’ accounts, adding $1 billion to the money supply.

Reserve Requirements – The Safety Deposit Box 📦

Banks keep a certain amount of money in a “safety deposit box” at the central bank. If the required reserve ratio is 10 %, a bank with \$10 million in deposits must keep \$1 million in the box. Raising the ratio forces banks to hold more cash, shrinking the money supply; lowering it lets banks lend more, expanding the money supply.

Discount Rate – Borrowing from a Friend 🏦

Think of the discount rate as the interest a bank pays to borrow from a friend (the central bank). If the friend raises the rate, borrowing becomes expensive, so banks lend less and the money supply shrinks. If the friend lowers the rate, borrowing is cheap, banks lend more, and the money supply grows.

Effects on the Economy – The Money‑Supply Equation 💹

The basic relationship is:

\$\$

M \times V = P \times Y

\$\$

where:

• M = Money supply
• V = Velocity of money (how fast money changes hands)
• P = Price level
• Y = Real output (real GDP)

If the central bank increases M (e.g., by buying bonds), and V stays roughly the same, the product on the left rises, pushing up the price level P unless output Y also rises. That’s why central banks monitor inflation closely.

Case Study: 2008 Financial Crisis 🛑

During the crisis, the Federal Reserve slashed the discount rate from 5 % to 0.25 % and bought trillions of dollars in bonds (OMO). This flooded the banking system with cash, lowered borrowing costs, and helped the economy recover. The key takeaway: lowering rates and buying bonds can quickly increase the money supply and stimulate growth.

Quick Review Quiz 🎓

1. What happens to the money supply if the central bank sells bonds? Answer: It decreases.
2. Which tool directly changes the amount of cash banks must hold? Answer: Reserve Requirements.
3. Why does a lower discount rate encourage banks to lend more? Answer: Because borrowing from the central bank becomes cheaper.

Summary Table of Monetary Tools 📊