Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Seeing Monetary Policy in Action


Monetary policy refers to the use of the money supply by policy makers (usually the central bank) to influence the economy. We present a first look at how monetary policy impacts the economy in Chapter 9, but here we delve deeper into the inner mechanics of how monetary policy works.

To understand monetary policy you need to understand how the money market works, how the central bank can in effect choose the interest rate by varying the money supply and how it achieves this aim in practice. Luckily, we cover exactly these topics in this section!

Taking a stall at the money market

The money market is like any other market in that the price is determined by supply and demand. Things can get a little confusing, though, because you may be thinking: sure, a certain car or house can have a particular price, but how can money have a ‘price’? Isn’t money just money?

The price of money is the interest rate: or more precisely, the nominal interest rate (we compare the meaning of nominal versus real in Chapter 2). Cash is the most liquid of assets, which means that you can easily convert it into goods and services. But when you hold cash, you give up the return that you could get by holding a less liquid asset (say, government bonds or a savings account). Thus the opportunity cost of holding cash is the return on government bonds/savings account – that is, the nominal interest rate. So, if the nominal interest rate is 2 per cent, by holding cash you’re effectively paying 2 per cent per year for the

liquidity.

At high interest rates the demand for money tends to be low, whereas at low interest rates the demand for money is relatively high, because holding cash is very costly (in terms of opportunity cost) when the interest rate is high. That is, people hold only as much cash as is necessary to get them through the next few days (or even hours). Conversely, when interest rates are low, holding cash isn’t that costly and people demand relatively a lot of it.

Bearing in mind that the central bank controls the money supply, equilibrium in the money market occurs when the quantity of money demanded is exactly equal to the quantity of money the central bank supplies. The interest rate adjusts to ensure that demand and supply are equal, as Figure 10-1 shows:


The downward-sloping demand curve (D) shows that people want to hold more money as the interest rate falls (because the opportunity cost of holding money is reduced).


The supply of money (S) is a completely vertical line – think of this as the central bank choosing exactly how much money is in circulation.

The equilibrium interest rate (i*) is the precise interest rate that ensures that the demand for money equals the supply of money.

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Figure 10-1: Equilibrium in the money market.