Chapter 7: The Money Supply Process and Monetary Management
INTRODUCTION One key principle in monetary theory is that the money supply is determined by the central bank, while the demand for money is determined by money-holders, namely, households and businesses. The stock of money is a nominal variable, and it is exogenously determined under a flexible exchange rate system. The demand for money is the demand for real balances. Real balances in a simplified form depend on real income and the nominal interest rate. Wealth-holders decide on the optimal level of real money holding given wealth and the returns on money vis-à-vis other real and financial assets (Friedman, 1956; 1992). Central banks implement monetary policy by changing the money supply or the interest rate. Under a deregulated market environment, they cannot change or do not have control simultaneously over both the money supply and the interest rate. In general, the central bank aims to change the money stock or its growth rate to influence the price level and/or economic growth. There are both direct and indirect policy instruments that central banks can use to bring changes in the money supply. Monetarists generally believe that there exists a stable long-run money demand function. They suggest that changes in the money supply can therefore bring changes in the price level, which re-establishes equilibrium in the real money market. But changes in the money supply can affect output in the short run. Wages and price flexibilities determine the extent to which changes in the money supply affect output and other real...
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