Money, Banking, and Monetary Policy
Core concepts
Money functions: medium of exchange, unit of account, store of value. Money supply measures: M1 (currency + checkable deposits) and M2 (M1 + savings and small time deposits).
Banking: banks hold reserves; the reserve ratio determines how much can be lent. The money multiplier ≈ 1 ÷ reserve ratio. The central bank controls the money supply and influences interest rates.
Monetary policy tools: open market operations (buying bonds increases reserves and money supply), the discount rate, and reserve requirements. Expansionary policy lowers rates to stimulate; contractionary raises rates to fight inflation.
Transmission: lower interest rates raise investment and consumption, shifting aggregate demand right. Quantity theory: MV = PY; money growth beyond real growth tends to raise prices.
Common traps
- Confusing the money multiplier with the deposit multiplier direction - higher reserve ratio means smaller multiplier.
- Assuming the central bank sets market interest rates directly rather than influencing them.
- Mixing up buying vs. selling bonds: buying injects reserves, selling drains them.
- Forgetting that monetary policy affects inflation with a lag.
Worked example
Reserve ratio = 10%, so the multiplier ≈ 10. A $1,000 new deposit can support up to $10,000 in total deposits (ignoring leakages). If the central bank buys $500 in bonds, reserves rise by $500 and the potential money supply rises by up to $5,000.
Rule of thumb
Buy bonds → reserves up → money supply up → interest rates down → spending up. Reserve ratio up → multiplier down.