Monetary Policy (Copy)

4.4.1 Definition of Money Supply and Monetary Policy

• Money supply:
  • The total stock of money circulating in the economy at a point in time.
  • Includes:
    • Notes and coins in circulation.
    • Bank deposits (savings + current accounts).
    • Near-money assets (easily converted to cash).
• Monetary policy:
  • Policy carried out by the central bank (e.g., State Bank of Pakistan, Federal Reserve, Bank of England).
  • Involves controlling money supply, interest rates, and exchange rates.
  • Aim: influence aggregate demand, inflation, employment, growth, and stability.

Diagram: Components of Money Supply

Money Supply
│
├─ Cash (notes + coins)
├─ Bank deposits
└─ Near-money assets

4.4.2 Monetary Policy Measures

Interest Rate Adjustments

• Increase in interest rates:
  • Borrowing becomes expensive.
  • Saving becomes attractive.
  • Consumption and investment fall.
  • Reduces inflationary pressure.
• Decrease in interest rates:
  • Borrowing becomes cheaper.
  • Saving becomes less attractive.
  • Consumption and investment rise.
  • Stimulates economic growth and jobs.

Diagram: Interest Rate Effect

Interest Rate ↑ → Borrowing ↓, Saving ↑ → Demand ↓ → Inflation ↓
Interest Rate ↓ → Borrowing ↑, Saving ↓ → Demand ↑ → Growth ↑

Money Supply Control

• Central bank can control money circulating in economy.
• Methods:
  • Open market operations (buy/sell government securities).
  • Reserve requirements (banks must keep % reserves, limiting lending).
  • Direct credit controls.
• Increasing money supply → stimulates demand.
• Reducing money supply → slows demand, reduces inflation.

Diagram: Money Supply Impact

Money Supply ↑ → More Spending → Growth ↑
Money Supply ↓ → Less Spending → Inflation ↓

Exchange Rate Policy

• Central bank may intervene in foreign exchange markets.
• Devaluation/depreciation:
  • Domestic currency falls in value.
  • Exports cheaper → export demand rises.
  • Imports expensive → imports fall.
  • Improves balance of payments but may increase inflation.
• Revaluation/appreciation:
  • Domestic currency rises in value.
  • Imports cheaper → inflation control.
  • Exports expensive → may reduce competitiveness.

Diagram: Exchange Rate Impact

Currency Depreciation → Exports ↑, Imports ↓ → Growth ↑ but Inflation ↑
Currency Appreciation → Imports ↑, Exports ↓ → Inflation ↓ but Growth ↓

4.4.3 Effects of Monetary Policy on Government Macroeconomic Aims

1. Economic Growth

• Low interest rates + higher money supply → encourage borrowing and investment → GDP growth.
• But excessive growth may lead to overheating and inflation.

2. Employment

• Expansionary monetary policy (low rates, high money supply) → increases demand for goods and services → more jobs.
• Contractionary policy may cause unemployment in short run.

3. Stable Prices (Low Inflation)

• High interest rates or reduced money supply → lowers demand → controls inflation.
• If too restrictive, can cause deflation or recession.

4. Balance of Payments Stability

• Depreciation of currency → improves export competitiveness → BOP improves.
• Appreciation → helps reduce imported inflation but may worsen trade deficit.

5. Redistribution of Income (Indirect Impact)

• Not a primary tool for redistribution (fiscal policy better suited).
• But changes in interest rates affect savers and borrowers differently:
  • High rates → benefit savers, hurt borrowers.
  • Low rates → hurt savers, benefit borrowers.

Diagram: Effects of Monetary Policy

Monetary Policy
│
├─ Growth ↑ or ↓
├─ Jobs ↑ or ↓
├─ Prices Stable
├─ BOP Improved or Worsened
└─ Redistribution (Indirect)