Monetary Policy (Essay Sample)

Monetary Policy
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Introduction
The designing and implementation of a country monetary policy focuses primarily on three economic variables; money supply (MS), Money Demand (MD) and interests rate (i). Effective monetary policy formulation, therefore, requires policy makers to identify and analyze how various economic events cause changes in MS, MD and i. For the purpose of this discussion, this paper will focus on effect three main events on MS, MD and i. These include; when the Fed buys securities in the open market, if the reserve requirement (r) is increased, and when Consumers decide to save and reduce their spending on consumer goods.
Discussions
Even 1: The Fed buys securities in the open market
This is one of the monetary policy instruments used by Fed in controlling money supply in an economy. Ideally, the act of the Fed buying securities from the money market through OMO is likely to affect three economic variables differently. This can be illustrated by the following figure.

From the above figure, the money demand (MD) curve is downward sloping, since at high interest rates, borrowers will shrink back from borrowing (Hall & Lieberman, 2010, p. 391). Since money supply is an exogenous variable (fixed by the central bank), the MS-curve is vertical. In the figure, the initial MS in an economy is represented by MS0. The initial equilibrium in the money market is achieved at a point where MS0=MD. At this point, i is the equilibrium interest rate. Fed’s act buying securities from the money market will increase money supply, which will shift the MS-curve from MS0 to MS1. As a result, the equilibrium interest rate will fall from i to i*.
The argument behind such a fall in interest rate is based on the relationship between security prices and interest rates. When Fed buys securities from the money market, the demand for securities will increase making their price to increase, also. Given that, from economic theory, the relationship between security price (p) and interest rate (i) is inverse; Fed’s act is likely to drive interest rates down (Chandra, 2008, p. 184). This will in turn incentivize borrowers to demand more money from lending institutions.
Even 2: The reserve requirement is increased
According to banking laws of many countries, each deposit taking institution is required, by law to keep a fraction of depositor’s money as reserves, usually 10% (r). However, this ratio can be adjusted accordingly, being a monetary policy instrument, to suit specific monetary policy objectives. If the central bank decides to increase r from say 10% to 12%. The banks’ excess reserves (ER) will decline. This implies that less money will be available to lend out by banks in form of loans. To maintain their revenue and profits, banks are likely to increase their lending interest rates (cost of borrowing). Given an inverse relationship between MD and i, borrower will demand less loans (money) from lending institutions.
Event 3: Consumers decide to save and reduce their spending on consumer goods
For the purpose of our discussion, we will assume that consumers’ savings will be deposited with deposit taking financial institutions. If consumers increase their saving, banks and other deposit taking institutions will have more money to lend out in form of loans (loanable funds base will increase). This means that an economy money supply will expand. If MS increases, there are chances of interest rates moving down a...