Monetary System and Monetary Policies

Today every country has a Central Bank. It acts as a lender to commercial banks and it acts as a banker to the government, taking responsibility for the funding of the government’s budget deficit and the control of the money supply which includes currency outside the banking system plus the slight deposits of the commercial banks against which the private sector can write cheques. Thus, money supply is partly a liability of the Central Bank (currency in private circulation) and partly a liability of the commercial banks (chequing accounts of the general public).

The Central Bank controls the quantity of currency in private circulation and the one held by the banks through purchases and sales of government securities. In addition, the Central Bank can impose reserve requirements on commercial banks, that is, it can impose the minimum ratio of cash reserves to deposits that bank must hold. The Central Bank also sets discount rate which is the interest rate commercial banks have to pay when they want to borrow money. Having set the discount rate, the Central Bank controls the money market.

Thus, the Central Bank is responsible for the government’s monetary policy. Monetary policy is the control by the government of a country’s currency and its system for lending and borrowing money through money supply in order to control the level of spending in the economy.

The demand for money is a demand for real money, that is, nominal money deflated by the price level to undertake a given quantity of transactions. Hence, when the price level doubles, other things equal, we expect the demand for nominal balances to double, leaving the demand for real money balances unaltered. People want money because of its purchasing power in terms of the goods it will buy.

The quantity of real balances demanded falls as the interest rate rises. On the other hand, when interest-bearing assets are risky, people prefer to hold some of the safe asset, money. When there is no immediate need to make transactions, this leads to a demand for holding interest-bearing time deposits rather than non-interest-bearing sight deposits. The demand for time deposits will be larger with an increase in the total wealth to be invested.

Interest rates are a tool to regulate the market for bonds. Being sold and purchased by the Central Bank, bonds depend on the latter for their supply and price.

Interest rates affect household wealth and consumption. Consumption is believed to depend both on interest rates and taxes. Higher interest rates reduce consumer demand. Temporary tax changes are likely to have less effect on consumer demand than tax changes that are expected to be permanent.

There also exists a close relationship between interest rates and incomes. With a given money supply, higher income must be accompanied by higher interest rates to keep money demand unchanged.

A given income level can be maintained by an easy monetary policy and a tight fiscal policy or by the converse.

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