Monetary Theory and Policy. The Effects of Money in an Economy

Term Paper (Advanced seminar), 2013

29 Pages, Grade: 1,8


List of contents

List of Figures



Monetary Supply Analysis

Definition of money supply

Calculation of money supply

Basic principles of central banks

Money Demand Analysis

Demand of money

Quantity theory of money

Fisher effect

Cambridge Approach

Neo Keynesian theories

Liquidity preference theory

Money and Income Analysis

Monetary transmissions mechanisms

Interest rate channel

Asset effects

Monetary transmissions mechanisms with differential approaches

Interest rate Theory

The Loanable founds theory

Liquidity Preference

Money supply and interest rate

Gibson Paradox

The theory of interest rate structure

Expectation theory

Liquidity Premium Theory

Yield curve



List of Figures

Figure 1. Relationship between interest rate and inflation

Figure 2. IS-LM Equilibrium.

Figure 3. Classical IS-LM Model. Expansion policy.

Figure 4. Market equilibrium of Loanable Funds.

Figure 5. Liquidity Preference.

Figure 6. Yield curve.


This Paper aims to explain the effects of money in an economy. The beginning of the Paper analyses the money supply, the money demand and which variables determinate it or how they influence them. Further the paper analyses how the money stock could be used by the central bank and the government as monetary instrument to invent into economy. At certain stages endnotes will refer to the interest rate theory and try to answer, how strong it influence the money amount.


Since the recent global financial crises, that started in 2008, it is important and necessary to understand how the government or central bank are able to influence and improve the economic situation as never before. With the right directed monetary policy from all central banks of the world, it would have been possible to reduce the degree of damage, which were accrued with the financial crises, even more it would have been possible to stop the crisis at the beginning with correctly selected instruments of monetary policy. The authoritarians such as central bank and government have for example a huge feasibility to push the economy with their instruments like money stock. One of the important instrument of monetary policy, with which is it possible to influence the demand of individuals, the output level and within the price level and so on. Still, it is important to draw lessons from past experience to guide policymakers struggling to stabilize. This paper shows that a change in money stock has a lot of effects to the economy.

Monetary Supply Analysis

Definition of money supply

Money is any medium that is popularly accepted in an economy both by sellers of goods and services and by creditors as payment for debts. Jarchow (1990) defined in his approach the main functions of money. According to him, the functions are generally classified as following1:

Medium of exchange

Unit of account

Store of value (purchasing power)

Medium of exchange represents any item that sellers will accept as payment. The individuals use money as an intermediary to sale, purchase or trade of goods between each other (see Mises 2005: 3). In agreement with the Bundesbank (see 2010: 10) the medium of exchange is the most important and essential function of money, because the economic units have across this function the ability to create more trades. Also to shape them efficient, quite the reverse the traditional barter system. Simply direct exchange of goods and services, called Barter system, without the use of money is today nearly impossible, because of globalization. Unit of account, or measure of value/costs, means money is functioning as the measuring unit for prices. In other words, prices of goods are stated in terms of the monetary unit (common denominator of the price system) (see Kaiser 2011: 37). Unit of account is also a central property of money. Store of value is the ability to hold value over time, which is a necessary property of money (see Issing 2006: 2) describes that money allows the individuals to transfer value (wealth) into the future. For example gold could act as a store of value, because gold is able to be saved and retrieved at a later time, and be predictably useful when retrieved.

Money supply is the total amount of money in an economy provided by the central bank (see Ball 2012: 37). It is the total stock of currency and other liquid instruments in a country's economy as of a fixedly time. The money supply can include cash, coins and balances held in checking and savings accounts. Economists analyze the money supply and develop policies revolving around it through controlling interest rates and increasing or decreasing the amount of money flowing in the economy (see Fender 2012: 35). Money supply data is collected, recorded and published periodically, typically by the country's government or central bank. Public and private sector analysis is performed because of the money supply's possible impacts on price level, inflation and the business cycle. In Germany, the central bank policy is the most important deciding factor in the money supply (see Fahrenholz 2010: 3). Two approaches defining the money supply, transaction approach and liquidity approach. The transaction approach measuring the money supply by looking at money as a medium of exchange and the liquidity approach measuring is as a temporary store of value (see LeRoy Miller 2012: 303). The liquidity approach emphasizes the function of money as a store of money (see Dwivedi 2005: 237). It implies that money is not qualitatively different from other assets. Liquidity is the property of all assets; only the degree of liquidity varies. The liquidity approach includes in the measurement of money those assets that are highly liquid, i.e., those assets that can be converted into money quickly. In other words, any asset for which no nominal capital gain or loss is possible qualifies as a perfectly liquid asset and is therefore identified as money. The transactions approach to measuring money classified money in four types (classification by ESCB): M0, M1, M2 and M3. The first type, M0, represents the sum of currency in circulation and bank reserves, based money, which is easily convertible into cash. Currency minted coins and paper currency, not deposited in financial institution. M1 including currency circulation plus deposits accounts, which are transferable by checks (overnight deposits). M2 includes M1 (currency circulation), short- time deposits and saving accounts (see Hubbard and O´ Brien 2012: 34). M3 consists of M2 and long-term time deposits, money market funds with more than 24-hours maturity (all certificates of deposit).

Calculation of money supply

The relation between money base (MB), the amount of money in the economy, and supply of money (M) is explained by the money multiplier (m). So we can define the money supply function as following:

MB, the monetary base, is the total amount of a currency that is either circulated in the hands of public or in the commercial bank deposits held in the central bank's reserves. The money multiplier (m) is the multiplier by which the money supply changes as a result of a change in fresh reserve in the banking system (see Brochert 2001: 49). The simple money multiplier equals the reciprocal of the required reserve ratio, or 1/r, where r is the reserve ratio (see Ball 2012: 324). So if the central bank wants to increase the money supply, they have to reduce the reserve ratio. Important, by simple multiplier, to assume that banks hold no excess reserves, that borrowers do not let the funds sit idle, and that people do not want to hold more cash (see Hubbard and O´Brien 2012: 424-426). The higher the reserve requirement, the greater the fraction of deposits that must be held as reserve, so the smaller the money multiplier. For example, if the central bank will reduce the reserve equipment from 10 percent (r = 0, 1) to 5 percent (r = 0, 05), banks would set aside less for required reserve, leaving more excess reserves available for loans. The simple money multiplier in that case would be 10, before the reduction of r and it would amount 20 after the reduction. With 1000€ in fresh reserves and 5 percent reserve requirement, the banking system could increase the money supply by a maximum of 1000€ x 20, which equals 20.000€. Thus, the charge in the required reserve ratio affects the banking system to create money.

Basic principles of central banks

“Central banks must in a figurative, not literal sense- create their own social welfare function based on their legal mandate, their own value judgment and perhaps their reading of the political will.” (Alan. S. Blinder-Former Deputy Chairman of FED) (see Blinder 1999: 6)

A reserve bank, or central bank is an entity responsible for monetary policy of its country of a group of member’s states, such as the European Central Bank (see Deutsche Bundesbank 2010: 108). The primary responsibility of the central bank, is to maintain the stability of the national currency and money supply, but more active duties include controlling loan interest rate, and acting as a “bailout” lender of last resort to the banking sector during financial crisis (see Görgens, Ruckriegel and Seitz 2004: 78). In most countries the central bank is state owned and has minimal degree of autonomy, which allows for the possibility of government intervening in monetary policy. The ESCB is an “independent central bank”, because it operates under rules designed to prevent political interference. The main goals of central banks are low inflation, output stability, external balances, full employment and economic growth (see Hubbard and O´Brien 2012: 445). Unless it has only a single goal, the central bank is forced to strike a balance among competing objectives. The main monetary policy instruments available to central bank are open market operations, bank reserve requirement, interest rate policy, re-lending and re-discounting and credit policy. The central bank is able to influence the money supply though open market operations, if the central bank buys securities it increases the money stock and on the other hand if the central bank selling the securities, for example government bonds, it reduce the money supply (see: Deutsche Bundesbank 2010: 153-165). Bank reserve requirement is also an important instrument of central banking, because all banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor, if the central bank increases the percentage of reserve equipment this will lead to a reducing of money supply (see Spahn 2012: 22). By far the most visible and obvious power of many modern central banks is to influence market interest rates and with it the money supply. The primary objective of the European Central Bank is to maintain price stability (see Hubbard and O´Brien 2012: 470). Without prejudge to this goal, the ESCB also aims to support the general economic policies in the community with a view to contributing the achievement of the objectives of the community as laid down in Article 2.2, which include high level of employment and sustainable, non-inflationary growth.

Money Demand Analysis

Demand of money

The demand of money correlates with different economic variables. For example it has a negative relation to the interest rate (the amount that a person receives for allowing another person to use his assets for a period of time). Whenever the interest rate is higher than the equilibrium interest rate (set up by central bank), economic units want to reduce their opportunity cost of losing the interest, which are higher than the cost of holding the money (see Ball 2012: 100). So they will have a higher profit if they invest this money for instance in security papers as though to keep their money. In other words, if all the people want to invest money or to lend it to somebody this will leads to a decrease of money demand. But there are also positive relations, for example between the demand of money and the national income. If the economic units have a higher level of income, they are able to spend more money, buy more goods and services, than before the increase in wages (see Hubbard and O´Brien 2012: 519). In that case the demand of money will increase, because of larger amount of desired transactions. There is a second positive proportional relationship between demand of money and the current price level. This means if the economy suffering from an inflation (every euro will buy a smaller percentage of good) so the economic units need more money, a higher amount, to buy goods and services, thus also will leading to a increase of money demand.

Quantity theory of money

The quantity theory of money proposes that the quantity of money and price levels increase at the same rate in the long run (see Pilbeam 2010: 89). This concept is explained by the equation of exchange. The households hold money to carry out transactions. The more money humans need for the transactions, the more money they want to hold. The total amount of money of the whole economy has a close regard to the count of euros which are essential for the transactions. We can describe the relationship between transactions and money with following equation, the equation of exchange:


M represents the total amount of money (money stock) in a certain period in circulation. V is the transactions, it measuring the average frequency of 1 euro. How often this euro was used for purchasing of goods and services in one period. P represents the price level of the economy. Y, is the quantity of goods and services which were produced in the period of time, the nominal value of output (see Ball 2012: 421). The equation of exchange is describable also on this way: M x V=P x T, T for the real value of aggregate transactions, but it is nearly impossible to count all the transactions during one period. Therefore a close relationship between transactions (T) and total production (Y), because of this is it feasible to substitute T by Y, due to the fact, if that the economy produces more goods and services, humans will buy more of them and thus the rate of transactions rises (see Anderegg 2007: 33). The Quantity Theory of Money holds that in the long run, where output and velocity are constant, the central bank has no ability to regulate them. So in the long run a change in money stock will only leads to a higher price level and with it to a higher inflation rate (see Lewis and Mizzen 2000: 616). With this equation is it achievable to explain the effects of money and the effective effects of monetary policy. If we assume that in the long run the velocity of circulation is constant: M x V = P x Y, it implicates that increasing the money supply will lead to an increase in price (Inflation). So if the economy has a growth rate of one point in money stock, it leads to a growth of one point in inflation rate (see Fender 2012: 14). The equation of exchange can be converted into the demand for money function as following:

Fisher effect

This theory, discovered by economist, Irving Fisher, describes the relationship between real (r) and nominal interest rates (i) and inflation ((see Hubbard and O´Brien 2012: 105). According to this theory, a rise in the real interest rate (r) raises the nominal rate (i) (see Ball 2012: 98). Economists term the interest rate, which investors get on a savings account, as nominal interest rate. A change of purchasing power whereas is the real interest rate. Fishers approach shows that the nominal interest rate may be changed in two cases, if the real interest rate changed, or if inflation rate varies. The equation shows us that the real interest rate is independent of monetary changes:


But it is also possible to define the Fisher equation as following, because of the expected rate of inflation:


Of course the humans cannot predict the exactly rate of inflation, but they have expectations about the inflationary process (see Pilbeam 2010: 87). There are two types of real interest rate, the one is the “ex-ante” real interest rate and the other is the “ex-post” real interest rate. The first interest rate, ex-ante return, is what the investors expected on return of investment and the second, ex-post, is what they finally get on return. Fisher used the ex-ante real interest rate in his approach. The nominal interest rate can only adjust to the ex-ante real interest rate, because the economic units do not know the ex-post real interest rate at the moment of the conclusion of investment.

Figure 1. Relationship between interest rate and inflation

illustration not visible in this excerpt


The illustration shows the ratio between nominal interest rate and inflation (percentage of the price shift of Consumer Price Index) of U.S. The Fisher Effect is clearly recognizable, a higher rate of inflation leads to a higher rate of nominal interest rate (data in percent on y-axis). The inflation rate, in this case, is also called “leading indicator” for the nominal interest rate.


1 For detailed Information see Jarchow (1990: 15 – 18).

2 Institutionelle Vorschriften, Satzung des Europäisches Systems der Zentralbanken und der Europäischen Zentralbank 2012: 7.

3 Represented equation is based on: Holtemöller 2008: 57.

4 Reffering to: Mankiw 2003: 109.

5 Own representation based on Mankiw 2003: 111.

6 Own represantation based on Mankiw 2000: 194.

Excerpt out of 29 pages


Monetary Theory and Policy. The Effects of Money in an Economy
Justus-Liebig-University Giessen
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money demand, money, money supply, gibson paradox, fisher effect, interest rate
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Inna Baier (Author), 2013, Monetary Theory and Policy. The Effects of Money in an Economy, Munich, GRIN Verlag,


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