<4.4 MONETARY POLICY>

--THINK AHEAD--

List the last 5 purchases you made, and mention how you paid.

-4.4.1: WHAT IS MONEY SUPPLY?--

--"WHAT IS CONSIDERED MONEY?"--

--"Easy!, it's all the notes and coins added together, right?" --

--⚠️"WRONG!!!"⚠️--

If I asked you, "How much money do you have?" You would not only empty your pockets and wallet for coins and notes, but you would also open your banking app and show me your balance right!

"Money is not just the physical asset of notes and coins in your pockets and wallets, it also includes the number you see on the screen when you go to the ATM and check your available balance, in other words, its the cash and notes circulating outside of bank vaults as well as the amount of digital money it says exists in your demand deposit."

--"HOW IS MONEY SUPPLY LINKED TO AD?"--

Money supply as defined above, refers to funds that are likely to be used relatively quickly for transactional purposes, (The notes in my wallet and the bank funds I use to finance my shopping when I use my octopus or debit card); hence, THE SIZE OF THE MONEY SUPPLY DIRECTLY IMPACTS THE AMOUNT OF SPENDING by Consumers (C), Businesses (I), Government (G) on both domestic and overseas (M) goods and services.
The GREATER the MS = The GREATER the level of SPENDING
The LOWER the MS = The LOWER the level of SPENDING

--THINK AHEAD--

"What would happen to the price of school lunches if the amount on your ocotopus card doubled each week?"

--"HOW DOES 'CREDIT' IMPACT MS?"--

"Did you know that a lot of economic activity is based on credit?"

That's right people regularly decide to accept the prevailing interest rate and borrow money from banks to purchase goods and services. Furthermore, these purchases result in income for sellers who in turn use the money to purchase goods and services.

"Did you know that banks don't have to keep all your money?"

That's right banks only need to keep a portion of your deposit as cash reserves, the rest can be loaned out to people who will use it to purchase goods and services.

"Did you know that banks can use deposits to create multiple loans?"

That's right when they lend it out to people to purchase goods and services the sellers of these goods generally redeposit this income in ther own bank accounts, which their bank then lends a portion out again to people to purchase goods and services. and this process continues multiple times. Each time, not only are goods purchased by the borrower, but the seller's digital accounts grow, meaning the money supply grows.

"Did you know that the price of credit is the interest rate?"

That's right; banks charge people interest for borrowing the money. Hence, the lower the rate, the more likely people are to borrow money to purchase goods and services, and vice versa.

--THINK AHEAD--

"Do you think that all the notes and coins you deposit in the bank is equal to the amount of money people have?"

"Do you think it's possible for everyone in HK to go to their bank and withdraw all their money in notes and coins today?"

"If I deposited £100 in the bank and you asked me how much money I had, I would say "$100," right? Now if the bank lent my £100 to someone who spent it on a new watch, and the seller deposited the £100 in their bank, if I asked them how much money they had, what do you think they would say? What has happened to the money supply?"

--EXTRA: "HOW DO BANK'S CREATE MONEY?"--

The question above should have helped you answer this question; we saw that loaning money can create extra money (this process is called 'credit creation') in the form of multiplied digital demand deposits; as such, it is not a matter of printing more notes; it's simply a digital process tied to lending.

Let's look at an example:

A Deposit is Made: You deposit $1,000 in cash into your bank account. The bank now has an asset (the $1,000 cash) and a liability (its promise to pay you back your $1,000).
Reserve Requirement: The central bank mandates that the bank must keep a fraction of this deposit in CASH reserve (say, 10%). So, the bank sets aside $100.
The Loan: The bank can now lend out the remaining $900 to a new borrower, say, someone wanting to buy a car.
New Money is Created: The borrower now has a $900 loan, and the car seller now has a $900 deposit in their bank account. That $900 deposit is brand new money. The total money supply has increased from your original $1,000 to $1,900 ($1,000 in your account + $900 in the car seller's account). So, now you can see the amount of cash in the bank does not equal the amount that appears on your screen.
The Cycle Repeats: The car seller's bank now has a new $900 deposit. It keeps 10% ($90) in reserve and lends out the remaining $810 to another borrower, creating even more new money.

Below we can see that the initial £1000 in cash can be 'multiplied' into a larger amount when it is loaned out and then returned, then loaned and so on. Don't forget every loan/deposit represents the borrower spending on a good or service, so the greater the multiplier effect the greater the level of spending and vice versa.

--"WHY/HOW TO CONTROL IT?"--

As mentioned above each deposit creates multiple loans that facilitate spending which of course impacts AD, so we can conclude the following:
"The GREATER the #LOANS the GREATER the spending"
"The LOWER the #LOANS the LOWER the spending"
"The GREATER the INTEREST RATE the LOWER the spending"
"The LOWER the INTEREST RATE the GREATER the spending"
Therefore to control it we need to...
1) CONTROL THE BANKS' ABILITY TO CREATE CREDIT.
& 2) CONTROL INTEREST RATES

--THINK AHEAD--

"We know that if the supply of any good rises, it leads to surpluses, putting downward pressure on the price, and vice versa, so what do you think happens to the 'price of borrowing money' when the banks have too much supply, and vice versa?"

--"HOW ARE MS & INTEREST RATES LINKED?"--

"THE CONTROL OF THE MONEY SUPPLY ('MS'), DIRECTLY IMPACTS 'THE RATE OF INTEREST ('ROI')' CHARGED ON LOANS TO THE PUBLIC" but how are they related?
Remember the rate of interest is the 'price' of borrowing money (taking out a loan') and like any good or service it is determined by the forces of supply and demand.
Therefore WHEN THE SUPPLY OF MONEY AVAILABLE TO BE LOANED OUT INCREASES, the BANKS, SEEKING TO MAKE PROFITS FROM LENDING THESE FUNDS OUT, WILL NEED TO LOWER THEIR PRICE, in order to ENTICE CONSUMERS AND FIRMS TO BORROW (AKA INCREASE THE QUANTITY OF LOANS DEMANDED) and vice versa.
So, as shown previously,
- - - - When MS ↑, then ROI ↓, Qd of loans by C & I ↑, AD ↑.
      - When MS ↓, then ROI ↑, Qd of loans by C & I ↓, AD ↓.

--"SO WHAT IS MONETARY POLICY?"--

MONETARY POLICY is the process by which a country’s central bank (e.g., the Federal Reserve, Bank of England, or Hong Kong Monetary Authority) manages the MONEY SUPPLY and INTEREST RATES to influence economic activity.

4.4.2: MONETARY POLICY TOOLS

"TYPE OF MONETARY TOOL?"

--EXPANSIONARY--

EXPANSIONARY MONETARY POLICY refers to policies enacted by the Central Bank (CB) that are aimed at INCREASING the money supply and subsequently LOWERING the interest rate.

The CB BUYS BONDS FROM THE BANKS This is a financial asset owned by the banks, which the CB buys, thus giving MORE money to the bank to make MORE loans.
THE CB LOWERS THE RESERVE RATIO for commercial banks, meaning banks are allowed to LEND MORE of their deposits. E,g from 20% to 10%.

--CONTRACTIONARY --

CONTRACTIONARY MONETARY POLICY refers to policies enacted by the Central Bank (CB) that are aimed at DECREASING the money supply and subsequently RAISING the interest rate.

SELLING BONDS TO BANKS in exchange for their loanable funds, so banks have LESS money to make loan.
RAISING THE RESERVE RATIO for commercial banks meaning banks can LEND LESS of their deposits.

--"HOW THEY IMPACT SPENDING/AD--

--EXPANSIONARY--

LOWER INTEREST RATES leads to:

Debt repayments FALL, so households (C) have HIGHER DISPOSABLE INCOMES and therefore may spend MORE. Likewise, firms (I) have MORE DISPOSABLE PROFITS to spend.
The ‘Cost of borrowing’ FALLS so consumers (C) and firms (I) will be more likely to borrow and spend MORE.
LOWER reward for saving, so people save LESS.
MORE spending and MORE economic activity.

--CONTRACTIONARY --

HIGHER INTEREST RATES leads to:

Debt repayments RISE, so households (C) have LOWER DISPOSABLE INCOMES and therefore may spend LESS. Likewise, firms (I) have LESS DISPOSABLE PROFITS to spend.
The ‘Cost of borrowing’ RISES so consumers (C) and firms (I) will borrow and spend LESS.
HIGHER reward for saving so people save MORE.
LESS spending and LESS economic activity.

--4.4.3: IMPACT ON MACRO AIMS?--

--EXPANSIONARY--

=> RISE IN SPENDING

=> HIGHER ECONOMIC GROWTH

=> LOWER UNEMPLOYMENT

=> INFLATIONARY PRESSURE

--CONTRACTIONARY --

=> FALL IN SPENDING

=> LOW ECONOMIC GROWTH

=> HIGHER UNEMPLOYMENT

=> DEFLATION PRESSURE

MONETARY.pdf

By controlling the price of borrowing, the government can DIRECTLY INFLUENCE THE LEVEL OF CONSUMER and BUSINESS BORROWING and subsequently CONSUMER ('C') and BUINESS ('I') SPENDING, leading to INCREASES or DECREASES in the LEVEL OF AGGREGATE DEMAND in the economy.
- - - EXPANSIONARY = MS ↑, then ROI ↓, C↑ + I ↑, AD ↑.
    - CONTRACTIONARY = MS ↓, then ROI ↑, C↓ + I ↓, AD ↓.

*In most countries monetary policy measures are carried out by CENTRAL BANKS on behalf of governments.

--ANALYSE PRACTICE--

6-MARK-QUESTIONS:
- - - -Analyse how monetary policy can reduce the rate of inflation.
    - -Analyse how monetary policy could increase the price level.

--DISCUSS PRACTICE--

8-MARK-QUESTIONS:

-Discuss whether an increase in bank lending will benefit the economy.

-Discuss whether or not a central bank should limit the amount that a commercial bank can lend to its customers.

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