Monetary Policy Discuss Some of the Major Term Paper

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Monetary Policy

Discuss some of the major determinants of the demand for money by sector and in total. Discuss some differences in the demand for money which might exist for countries other than the U.S.

An effective formulation of the Monetary Policy depends on the determining factors of the demand for money. Money Demand acts as a channel on transmission mechanism for monetary policy. Therefore the consistency of the money demand function is crucial for the monetary policy for attaining predictable effects on inflation and real output. The classical economists regard money as a numeraire, i.e. A commodity, the unit of which is used to represent the prices and values; keeping its own value unaffected by such a role. Money is assumed to be neutral having no tangible economic consequences. This is done by limiting the role of money as a store of value having the assumption of perfect information and negligible transaction costs. The concept of money demand under the classical theorem is based on the quantity theory. This is developed against the background of the classical equilibrium framework. (Katafono, 2001)

Fisher during 1911 put forth his famous theorem of the equation of exchange. He propounded that money is held simply to facilitate transaction and does not have intrinsic value. Alternatively the Cambridge group of economist advanced their own approach emphasizing that the demand for money was in terms of public demand for money holdings. This was with regard to the demand for real balances and it was an important factor in determining the equilibrium price level. This was being considered as consistent with a given quantity of money. Further John Maynard Keynes during 1930s refined the Cambridge approach and concentrated on the motives of holding of money to devise the theorem of demand for money. He depicted the demand for money in terms of transaction, precautionary and speculative motives. The interest rate as another explanatory variable in influencing the demand for real balances was introduced in his theorem. The Keynesian theorem put forth that the aggregate demand for money becomes perfectly elastic with respect to the interest rate. This is because the economic agents, expecting a future increase in interest rates at the time when interest rates are low, prefer to hold whatever amount of money is supplied. The post Keynesian models in this respect were formulated in terms of transactions, asset and consumer demand theories of money.

Under the approach of transaction theory, the inventory-theoretic approach and the precautionary demand for money models were introduced. This was being derived from the medium-of-exchange function of money. The asset function of money gives rise to the asset or portfolio approach. Here the major stress is placed on risk and the expected returns of assets. The consumer demand theory framework regarded the demand for money as a direct extension of the traditional theory of demand for any durable good. As a whole all these models implied that the optimal stock of real money balances is positively related to the real income. This is inversely related to the nominal rate of return and the differences of the approach depend upon the selection of variables while formulating the approach. Money stock is a crucial determinant of the demand for money. Money stock may be narrow money consisting of assets which are readily available for transactions and broad money encompasses a wider range of assets. The scale variable which is used as a unit of transactions in the sphere of economic activity is regarded as another determinant of money demand. The common variables in this regard are gross national product -- GNP and associated variables like gross domestic product -- GDP and net national product -- NNP. In some limited countries like the United Kingdom and United States, wealth has also been used as a scale variable. (Katafono, 2001)

The opportunity cost of holding money is also taken into account as a determinant of the demand for money. This is associated with the rate of return of money and the rate of return on alternative assets. The studies in different developed countries indicate that there is variation in the results and the difference is due to the co-integration tests selected and the combination of money and interest rates. Analysis of money demand in Australia normally focuses on money in real terms. Orden and Fisher found no co-integrating relationship for the full sample in New Zealand. Similarly, the Canadian evidence reveals that money, output, prices and interest rates are only fractionally co-integrated. Drake and Chrystal in United Kingdom found that a co-integrating relationship prevails for all the monetary aggregates analyzed and the ECM depicts a fast rate of adjustment.

The results for money demand in developing countries vary to a great extent. This is because the financial markets are not very developed and are subject to control. The money demand function in ten developing countries including India, Mexico and Nigeria reveal that the co-integration was only established in minority cases. However, a stable relationship for narrow money was revealed for the West African Economic and Monetary Union even during the period of financial liberalization. Alternatively, Dekle and Pradhan are of the opinion that in the Association of South East Asian Nations -- ASEAN continuing instability in the Demand for money occurred as financial liberalization intensified. These empirical studies reveal the financial liberalization is the most significant determinant of the stability of money demand. (Katafono, 2001)

2. Discuss some aspects of the money supply process which you find interesting and of some importance

Money refers to anything applied for purchasing goods and services and comprises of anything that is used for trading. The variation to the total money supply in an economy occurs for many of the reasons which include: the variations in behavior, the variations in expectations, and the variations in monetary policy. (The Money Supply Process and Interest Rate Determination) The supply of money normally is indicated to mean the supply of M1. This is the value of coins and currency held by the public outside of the banks including the value of our account balances. The below chart shows the year-to-year variations in U.S. M-1 which is the narrowest measure of money. (Schmidt, 2004)

The money supply is understood to start with the printing of money by the mint and sending of the same to Federal Reserve. However, it is the Fed that puts the money into the system and the currency that it provides is known as high-powered money. The Fed in this way regulates but it does not regulate the money supply. Actually the high powered money goes to the banks as reserves and a fraction goes to the people's pockets and for business purposes. Taking into consideration the nature of banking system, it is the banks that really generate money. The cash reserve maintained by banks constitutes the base of the banks for the expansion of checking accounts. The total money supply includes such deposit accounts along with the currency held by the public with the deposit accounts. (Money Supply: The Fed and the Creation and Control of Money)

Thus the money is created with the interaction of functions of the two institutions, namely the Fed and the banks. The high powered money is held by the public in terms of currencies and a portion as the reserves by the banks. The Fed regulates the reserves to be maintained by the Banks. The ability of the banks to create money from the cash has an inverse relationship with the amount of reserve. A small amount of reserves mean a bigger amount of demand deposits. The creation of demand deposits by banks is guided by basic principles such as bank profitability and bank discretion over money supply. Bank profitability means that the banks are guided by the profit motive and its activities are not in the interest of the nation. Bank discretion over money supply means that the decision of bankers to enhance the value of demand deposits will enhance the money supply. This would conversely influence their decision to hold excess reserves and would decline the money supply. It would lead to prospective conflict between the profits and safety. This would mean that the banks earn profits by enhancing demand deposits. But they cannot utilize all their cash reserves for creating demand deposits since they should be ready to meet the situation when all the depositors wanted their cash. (Money Supply: The Fed and the Creation and Control of Money)

Actually when a bank advances a loan, the borrower normally issues a claim against himself by way of a promissory note. In turn the bank issues a claim against itself in the form of an addition to the borrower's checkable deposit account. The promissory note that the borrower issues in not regarded as money. It is the addition to the account balance issued by bank. That contributes towards the money supply. Next what is done is that in order to purchase the goods and services, the borrower on getting…

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