ECO104

Raisa Afsana (RsA)

Money and Monetary Policy

Money consists of Currency (notes and coins) and bank Deposits (Current account and Savings
account balances).
Functions of Money:
o Medium of exchange – used to purchase goods and services
o Unit of account – used to measure value of goods and services
o Store of value – transfer of purchasing power from present to future.
Monetary Policy – Deciding the level of money supply in the economy and the interest rate.
Real interest rate – This is the opportunity cost of holding money. The equilibrium real interest
rate is when the Demand for Loanable Funds (i.e. Money Demand) equals the Supply of
Loanable Funds (i.e. Money Supply). [Graph shown in class]

DRAW GRAPH HERE

Expansionary Monetary Policy – Increase in Money Supply and the resulting decrease in the
Real Interest Rate. This causes Consumption and Investment to increase, and as a result, AD
increases. It is used during Recessions, in order to increase output and employment and
decrease the level of unemployment. When AD increases, Price Level increases – so
expansionary monetary policy causes inflation. [You should be able to show this using AD-AS
graphs] DRAW GRAPH HERE

Contractionary Monetary Policy – Decrease in Money Supply and the resulting increase in the
Real Interest Rate. This causes Consumption and Investment to decrease, and as a result, AD
decreases. It is used during Expansions, in order to decrease output and over-employment.
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Raisa Afsana (RsA)

When AD decreases, Price Level decreases – so contractionary monetary policy causes deflation.
[You should be able to show this using AD-AS graphs]
DRAW GRAPH HERE

Long-run effect of Monetary Policy: In the long-run, monetary expansion or contraction has no
effect on output, and only affects the price level. [You should be able to show this with Long
Run AD-AS graphs].
Graph: Increase in MS Graph: Decrease in MS

Quantity Theory of Money (Q-Theory): This theory states that in the long-run, an increase in the money
supply brings an equal percentage increase in the price level. This theory is arrived at using 2 concepts:
“Velocity of Circulation” and “Equation of Exchange”.

Velocity of Circulation – This is the average number of times a dollar is used annually to buy the
goods and services that make up GDP. If the money supply in the economy is M, and each dollar
is used for transaction V times, then the total value of transactions that can be financed is given
be MV. Example: if there is a single one dollar note in the economy, then the total money supply
is $1, so M = 1. If this $1 note changes hands 10 times, it can finance transactions worth $10.

Equation of Exchange – The economy produces a level of output given by Y (i.e. real GDP),
which is sold at price P. So the value of this output in terms of price is PY (i.e. nominal GDP). If
this is the total value of output in the economy, it must also be the total value of the
transactions in the economy. But we saw above that the total value of transactions in the
economy is given by MV. Therefore, it must be the case that:
MV = PY This is the equation of exchange
Deriving the Q-Theory:
The Equation of Exchange becomes the Quantity Theory of Money under 2 assumptions:
1. Velocity of circulation is not influenced by the quantity of money, i.e. V is constant.
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Raisa Afsana (RsA)

2. Potential GDP is not influenced by quantity of money, i.e. Y is constant.

Under these 2 assumptions, the equation of exchange says that a change in the money supply M, brings
an equal and proportionate change in the price level P.

Proof: [To be done in class]

Quantity Theory and the AD-AS Model:

The AD curve shows the relationship between quantity of real GDP demanded (Y) and the price level (P),
all other things remaining constant. If “all other things” are remaining constant, it means we assume
that Money Supply (M) and Velocity of Circulation (V) are also constant.

So…

How Monetary Policy Works:

Central Bank is in charge of implementing monetary policy. It decides what should be the level
of money supply and interest rate in the economy. The central bank in USA is known as the
Federal Reserve Bank (commonly known as the Fed) and central bank in Bangladesh is the
Bangladesh Bank (I bet you already knew that!).
Policy Tools for Changing the Money Supply: The central bank has 3 different policy tools that it
can use to increase or decrease the money supply in the economy. These are:
1. Required Reserve Ratio (RRR) – This is the minimum percentage of the total deposits of
commercial banks that need to be kept as reserve with the central bank. This means if
the RRR is 10% and I deposit 100tk. at SCB, then SCB has to keep 10tk. with the
Bangladesh Bank as reserve, and it can lend out the remaining 90tk. to you!
How RRR Works:
If RRR increases, banks must hold more reserves lending MS
If RRR decreases, banks can hold less reserves lending MS

2. Discount Rate – This is the interest rate at which the central banks lend to commercial
banks. If I go to SCB to withdraw my deposit of 100tk. but it has already given you a
90tk. loan from that money, SCB will not have enough cash to pay me back. In that case,
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Raisa Afsana (RsA)

SCB can take a loan from Bangladesh Bank to pay me back my deposit. But it has to pay
Bangladesh Bank some interest for this loan, let’s say 2%. This 2% is the “Discount Rate”.

How Discount Rate Works:

3. Open-Market Operations – This refers to the purchase and sale of government

How Open Market Operations Work: