4.12. Money supply (theory)

Question 1

The Quantity Theory of Money shows what

Answer 1

the relationship between the money supply and the price level

Question 2

The Quantity Theory of Money Equation

Answer 2

MV = PT

• M = Money supply
• P = Price level
• V = Velocity of circulation
• T = Number of transactions
• (MV = total spending in economy)
• (PT = total money received for G/S)

sometimes expressed as MV = PY (where Y = output of economy)

Question 3

The Quantity Theory of Money concept

Answer 3

• In a given time period, V and T are constant.
• Therefore M and P are directly linked.
• This means an increase in M causes and increase in P.
• This is because an increase in the money supply (M) gives consumers and firms more funds for borrowing, which increases purchasing power, which leads to more spending, which results in rising prices (P) due to
  inflation.

Question 4

Main criticisms (Keynes) of the Quantity Theory of Money concept

Answer 4

• V and T are not constant.
• MV (total spending in economy) and PT (total money received for G/S) are the same thing!
• Not an accurate prediction of how P changes when M changes.

Question 5

Money Supply

Answer 5

the amount of money available to the general public and the banking system in an economy. It includes broad money supply and narrow money supply.

Question 6

Broad money supply

Answer 6

money used for spending and saving

Question 7

Broad money supply consists of

Answer 7

cash (notes and coins), bank deposits and building society deposits.
- Known as: M4.

Question 8

Narrow money supply:

Answer 8

money that can be spent directly

Question 9

Narrow money supply: consists of

Answer 9

cash (notes and coins) held by the general public, in ATMs and deposits financial institutions hold at the central bank.
- Known as: M1 or “Monetary Base”

Question 10

Sources of the money

Answer 10

1) Credit Creation / Fractional Reserve Banking (Commercial Banks)
2) Open Market Operations (Central Bank)
3) Quantitative Easing (Central Bank)
4) Deficit Financing (Government)
5) Total Currency Flow (Trade)

Question 11

Credit Creation / Fractional Reserve Banking (Commercial Banks)

Answer 11

• Commercial banks can create “new” money (known as credit creation) when they receive cash deposits from savers.
• They know from experience that only a small proportion of savers will want to withdraw their money at any one time.
• This means a large proportion of deposits can be loaned back out.
• This is known as fractional reserve banking - the requirement banks only need to hold a certain percentage (e.g. 10%) of their loans (liabilities) in the form of cash.
• The ratio of new money created to the initial money deposits is called the credit multiplier.

Question 12

Open Market Operations (Central Bank)

Answer 12

Done through the buying and selling of government securities (bonds), a process called open market operations.

How it works:

• Central bank purchases government securities from investors.
• Investors receive cash deposits in their bank accounts.
• Deposits become part of the cash commercial banks hold at the central bank.
• Commercial banks have more money to lend.
• To attract borrowers, commercial banks lower interest rates.
• This leads to less saving and more spending.
• This increases AD and lowers unemployment.
• This is also known as expansionary monetary policy.

Question 13

Quantitative Easing (Central Bank)

Answer 13

• Similar to open market operations.
• Used during a liquidity crisis, when inflation is low (or negative) and interest rates are close to zero (i.e. monetary policy has become ineffective).
• Central bank buys a specified amount of financial assets (bonds).
• This gives commercial banks lots of deposits, which increases the money supply.
• This improves bank liquidity, which increase lending.
• Used by US, UK and the Eurozone from 2008-2016 due to the effects of the Credit Crunch and Great Recession.

Question 14

Deficit Financing (Government)

Answer 14

Government has a budget deficit (G > T) which increases consumption, investment, AD, GDP and employment.

Two ways to finance it:

1) Borrow from the general public
2) Borrow from banks (central / commercial)

Question 15

Borrowing from the general public in Deficit Financing

Answer 15

• Government sells bonds to the general public.
• The general public buy the bonds using their savings (bank deposits).
• Only existing money is used, there is no increase in the money supply.

Question 16

Borrowing from banks (central / commercial) in Deficit Financing

Answer 16

• Government sells bonds to banks.
• Government’s cash deposits rise.
• Credit creation occurs using the additional deposits.
• There is an increase in the money supply.

Question 17

Total currency flow

Answer 17

• X > M results in a net inflow of money from abroad.
• Exporters deposit money into commercial banks.
• Commercial banks carry out “credit creation” on these additional deposits.
• Money supply increases.

Question 18

Transmission mechanism of monetary policy

Answer 18

the process which connects changes in the money supply to changes in output and inflation.