Money Supply Influence on Economic Expansion and Price Increases: An Examination from a Monetarist Perspective
Central banks around the world employ a variety of tools to influence the economy, with the primary aim of maintaining stability and promoting growth. Two key types of monetary policy are expansionary and contractionary, each designed to address different economic conditions.
Expansionary monetary policy, as the name suggests, is used to stimulate economic growth when the economy is weak or in recession due to a decrease in aggregate demand. This policy is implemented primarily through three specific instruments: interest rate adjustments, open market operations (OMO), and changing reserve requirements.
Interest Rate Adjustments
Central banks adjust key interest rates such as the discount rate (the rate charged to commercial banks) or the policy/base rate. For expansionary policy, they lower interest rates to encourage borrowing and increase money supply, stimulating economic activity. Conversely, for contractionary policy, they increase interest rates to make borrowing more expensive, reducing money supply and slowing economic activity.
Open Market Operations (OMO)
Central banks buy or sell government securities in the open market. To implement expansionary policy, the central bank buys securities, injecting liquidity into the banking system, increasing banks’ lending capacity, and expanding the money supply. In contrast, to implement contractionary policy, it sells securities, absorbing funds from the system, reducing liquidity and money supply.
Changing Reserve Requirements
Central banks set the minimum reserves banks must hold. Increasing reserve requirements restricts banks’ ability to lend, thus reducing money supply (contractionary). Decreasing reserve requirements frees up more funds for lending, expanding money supply (expansionary). However, some central banks like the U.S. Federal Reserve have effectively abolished reserve requirements since 2020, relying more on interest on reserves and other tools.
Other tools used especially near the effective lower bound include interest on reserves (IOR) and facilities like the overnight reverse repurchase agreements, which influence banks’ behavior in holding reserves and lending. Additionally, forward guidance and targeted longer-term refinancing operations (TLTROs) as part of broader monetary policy toolkits, mainly at the European Central Bank, help to steer expectations and liquidity.
Monetarists, a school of macroeconomics distinct from Keynesian economics, believe that changes in the money supply are the main determinants of economic performance. They argue that high inflationary pressure occurs if the money supply grows faster than aggregate output.
In summary, central banks customize these instruments based on economic conditions to implement contractionary policies (to reduce inflation or cool overheating economies) or expansionary policies (to stimulate growth in recessions or slowdowns). This strategic approach allows central banks to maintain a balance and promote a healthy and stable economy.
In the context of monetary policy, expansionary policy, used when the economy is weak or in recession, stimulates economic growth by lowering interest rates, increasing liquidity via open market operations, and expanding money supply by decreasing reserve requirements. Conversely, contractionary policy, employed when the economy is overheating, is achieved by raising interest rates, reducing liquidity through open market operations, and contracting the money supply by increasing reserve requirements. These strategies in finance are integral to business operations and the overall health of the economy.
