Question

Citing relevant examples, describe how the following factors affect the supply of money in the economy:

a) High powered money

b) Size of the money multiplier 

Answer 1

The supply of money in a modern economy and financial system is determined by three key factors:

1. “Open market operations” – this is effectively the same as Quantitative Easing. The Central Bank buys government bonds, effectively creating money
2. The “reserve requirement” imposed on banks – this is the % of deposits made by customers at the bank that the bank must keep hold of rather than lending it out
3. The policy interest rate set by the central bank – the rate of interest will influence how many households and businesses are willing and able to borrow. Most money in a modern economy is created by commercial bank lending so the rate of interest ultimately does have a bearing on the supply of money

Key factors affecting the demand for money

1. The rate of interest on loans
2. The number / value of monetary transactions that we expect to carry out
3. The extent to which we also want to hold other financial assets, such as bonds, property, saving (this is also influenced by the rate of interest) – this is known as the speculative motive for holding money
4. Changes in GDP
5. The extent to which it is possible to use debit cards / credit cards i.e. the pace of financial innovation
6. The extent to which we might have to pay out large unexpected payments, for example, for i.e. the precautionary motive
7. The rate of anticipated inflation