Money, Banking and Monetary Policy
Core Concepts
This domain covers money functions, money supply (M1, M2), the role of central banks, commercial banking, and monetary policy tools (open market operations, reserve requirements, discount rate). You must understand the money multiplier, quantity theory of money, interest rate determination (liquidity preference), and the transmission mechanism. In Bangladesh, Bangladesh Bank uses repo, reverse repo, and CRR/SLR to manage liquidity.
Common Traps
- Confusing money supply with money base (high-powered money).
- Forgetting that the money multiplier is (1+c)/(r+e+c) where c is currency-deposit ratio, r is reserve ratio, e is excess reserves.
- Assuming central bank directly controls money supply; commercial banks and public behavior matter.
- Mixing up nominal and real interest rates (Fisher effect).
- Overlooking that monetary policy affects inflation with a lag.
Worked Example / Rule of Thumb
Rule of thumb: Money multiplier m = (1 + c) / (r + e + c). If c = 0.2, r = 0.1, e = 0.05, then m = 1.2 / (0.1+0.05+0.2) = 1.2/0.35 ≈ 3.43. Money supply = m * monetary base.
Example: Suppose the monetary base is 1000 crore taka, c = 0.3, r = 0.1, e = 0.05. Then m = 1.3 / (0.1+0.05+0.3) = 1.3/0.45 ≈ 2.89. Money supply = 2.89 * 1000 = 2890 crore. If the central bank reduces reserve requirement r to 0.05, new m = 1.3 / (0.05+0.05+0.3) = 1.3/0.4 = 3.25, money supply = 3250 crore. This shows how reserve requirements affect money supply.