Understanding Money Supply And Monetary Policy Term Paper

Length: 7 pages Sources: 7 Subject: Economics Type: Term Paper Paper: #35187819 Related Topics: Monetary Policy, Money, Central Bank, Macroeconomics
Excerpt from Term Paper :

Commercial Banks and Money Supply

Money supply in the economy refers to the circulation of currency in the hands of people and institutions within an economy. This is the volume and speed with which money changes hands and moves from one entity to another within the country. This volume and speed affect the growth of the economy and the way it can serve the needs of the people. There are two categories of banks in the economy. These are the commercial banks, which are many, and the central bank, which is only one in any country. The central bank regulates the operations of the commercial banks and influences government policy on finances. This institution also sets the benchmarks for the expenditure levels within the country. However, the commercial banks are the most influential banks when it comes to controlling the supply of money in the economy (Crosse & Hempel, 2012).

The role of commercial banks in money supply

Commercial Banks play a central role in the supply of money in the economy. They act as borrowing and saving agents for all the monies in the economy. They do this through a credit and savings mechanism. It is through this that the people can oversee their financial needs. There are three special roles that the commercial banks play in the process of fulfilling the process of money circulation. One is by enabling people who have liquid cash to save them. The commercial banks do this by providing a haven for all the monies at an interest rate to be earned (Thomas, 2013). From the interest earned, people can have more income by depositing to the savings accounts offered by these banks. It is also seen that the commercial banks are all there to allow people to borrow loans. These loans are borrowed from the savings made by others. The borrowings act as a source of income for the bank. This makes the process of credit and savings a profitable one hence sustainable (Avadhani, 2012).

In all instances, there is always al chance to expand to the next level of the business. Reasonably, people who run these commercial banks can make a profit out of this. This process of lending and savings contributes to the agenda of the money supply. Money can originate from the source and move to the other end of the economy (Conant, 2011). The source of money in any case is the central bank. Once the central bank has generated the money, it is then circulated to the people all over the country. Such circulation is healthy for the growth of the economy because it enables all the features of the economy to function harmoniously. Money is always needed at the beginning and the end of the economy. The volume and speed with which this happens can be used to determine the growth and the vibrancy of the economy. This is seen as a way of fulfilling the obligation of making the works of the economy be achieved (Crosse & Hempel, 2012).

Money demand vs. Money Supply

Supply refers to the bulk of money that is injected into the economy at any time. The Fed undertakes this role in the U.S. It happens during the process of money creation and distribution. On the other hand, money demand refers to the amount of money that is needed in the economy. This amount of money is directly proportional to the size of the economy. The larger the size of the economy, the more money is demanded to run it. This amount of money can be higher, equal or lower than the capacity of the money supply. The most desirable point in the economy is when the money supply is equal to the money demand (Motley, 2010). This point is referred to the point of equilibrium. The point of equilibrium is that point where all the sectors of the economy seem to be growing at the expected rate and can sustain it. The major contributors to this are the ways of establishing a system where the economy moves with the other growing factors in the economy.

The determinants of money demand and money supply are majorly two. First, is the economic status of the country and secondly a political process in the guise of the desires of a political leader, mainly the president. The situation of the economy dictates whether the money shall increase or not. For instance, during the recession, the economy needs more money to be supplied to it. A low volume of money in circulation will require that more money be printed for distribution....


The economy grows better when the money circulation hits the desired mark and can achieve the desired target. The leader of the country can as well dictate that the amount of money in circulation be increased to meet some level (Avadhani, 2012).

Banks as a source of money supply

Banks act as a source of money for the people who need them. Banks receive orders from the central bank regarding the interest rates to charge on the borrowers. They also borrow from the central bank for issuing to individual borrowers among the citizens. All these maneuvers affect the volume of money that goes to the people. The nature of the circumstances that take place in the economy depend on the number of people who go through the business processes that the economy. When the commercial banks increase the interest rates, most of the borrowers will shy away from taking loans. This will reduce the amount of money in circulation. This comes as a desired motive by the central bank to reduce the amount of money in circulation within the economy (Crosse & Hempel, 2012).

In most cases, the leadership of the country will wish to regulate the amount of money that circulates in the economy. On the contrary, if the commercial banks reduce the amount of money in the circulation, the money to be borrowed will have to be increased (Macesich, 2009). Consequently, there will be an increased amount of money in the circulation. Most importantly, the borrowers will have a better life as they make use of the borrowed money. This happens at that time when the economy goes into a recession and the economy must grow at such a rate that is sustainable and supportive to human existence (Motley, 2010).

Money supply and the monetary policy

Monetary policies are exercised by the treasury of any country. This involves manipulating the inflation rate and interest rates on borrowings to manage the amount of money to be borrowed by entities in the economy. The main tool of monetary policy is the use of open market operations. Open market operations refer to the purchase and sale of treasury bills and bonds. The circumstances surrounding the purchase and sale of these government securities revolve around the flow of the money in the economy, whether high or low. When the amount of money circulating is high, it is always advisable for the government to reduce the money in circulation by selling these securities. The securities are paper certificates with amounts printed on them. The person purchasing them holds them as a show of ownership of some part of the government stake in the treasury (Chapman, 2013). They will be required to hold the papers until such a time when they see it profitable to sell to the government. When the government sells the securities to the individuals, they will be retrieving money from them.

In the end, the money that will be in circulation will be reduced to desirable levels. This is done when is relatively high or rising in the economy. When the status of the economy has regained its feet, the government then buys back treasury bills and bonds from the holders. Eventually, a desirable economic growth and development is essential as the money volumes are brought under manageable limits. The government manages the process of issuing money by altering the reserve ratios. The central bank always requires that the commercial banks have to deposit some amount with the central bank. When this amount is raised, the bank remains with little amounts of it. The reverse happens during the time of recession, and the government wants to increase the amount of money in circulation.

Recent development in commercial banks funding strategy

Commercial banks have evolved to been seen as the focal point of development in the economy. They act as the link between the people and the government in the sense that the government uses these institutions to link the government activities and the growth of every sector of the economy. The nature of duties that the commercial banks perform in the economy shows that they are the most crucial financial agencies in the society. In all instances, money has to get to the people in one way of the other. The process of lending must always be executed in such a way that the borrowers are protected from risks that befall them as they…

Sources Used in Documents:


Avadhani, V. (2012). Fundamentals of money and banking. Mumbai [India: Himalaya Pub. House.

Chapman, J. (2013). Commercial banks and consumer instalment credit. New York: National Bureau of Economic Research.

Conant, C. (2011). The principles of money and banking. New York: Harper.

Crosse, H., & Hempel, G. (2012). Management policies for commercial banks (2d ed.). Englewood Cliffs, N.J.: Prentice-Hall.

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