<4.4 MONETARY POLICY>

-4.4.1: WHAT IS MONEY SUPPLY & MONETARY POLICY?--

The MONEY SUPPLY consists of all the money in an economy at any one time.
There exist different measures, but what we are concerned with is that one that counts MONEY THAT FACILITATES REGULAR TRANSACTIONS (MEDIUM OF EXCHANGE), as such we include banknotes, coins, and of particular importance to policy, we also include current accounts and deposit accounts, that can be USED BY BANKS AS LOANS TO FACILITATE MORE TRANSACTIONS.

MONETARY POLICY refers to government* decisions regarding THE CONTROL OF THE MONEY SUPPLY ('MS'), which DIRECTLY IMPACTS 'THE RATE OF INTEREST ('ROI')' [PRICE OF BORROWED MONEY] CHARGED ON LOANS TO THE PUBLIC and 'THE EXCHANGE RATE'.
By controlling the price of borrowing, the government can DIRECTLY INFLUENCE THE LEVEL OF CONSUMER and BUSINESS BORROWING and subsequently CONSUMER ('C') and BUINESS ('I') SPENDING, leading to INCREASES or DECREASES in the LEVEL OF AGGREGATE DEMAND in the economy.
- - - EXPANSIONARY = MS ↑, then ROI ↓, C↑ + I ↑, AD ↑.
    - CONTRACTIONARY = MS ↓, then ROI ↑, C↓ + I ↓, AD ↓.

*In most countries monetary policy measures are carried out by CENTRAL BANKS on behalf of governments.

We just stated that "THE CONTROL OF THE MONEY SUPPLY ('MS'), which DIRECTLY IMPACTS 'THE RATE OF INTEREST ('ROI')' [PRICE OF BORROWED MONEY] CHARGED ON LOANS TO THE PUBLIC" but how are they related?
Remember the rate of interest is the 'price' of borrowing money (taking out a loan') and like any good or service it is determined by the forces of supply and demand.
Therefore WHEN THE SUPPLY OF MONEY AVAILABLE TO BE LOANED OUT INCREASES, the BANKS, SEEKING TO MAKE PROFITS FROM LENDING THESE FUNDS OUT, WILL NEED TO LOWER THEIR PRICE, in order to ENTICE CONSUMERS AND FIRMS TO BORROW (AKA INCREASE THE QUANTITY OF LOANS DEMANDED) and vice versa.
So, as shown previously,
- - - - When MS ↑, then ROI ↓, Qd of loans by C & I ↑, AD ↑.
      - When MS ↓, then ROI ↑, Qd of loans by C & I ↓, AD ↓.

--HOW THE GOV'T/CB CHANGES THE MONEY SUPPLY--

ABLE TO INCREASE MS by...

PRINTING MORE MONEY which ends up in the banking system, thus increasing the money the banks have to make loans to the public.
BUYING BONDS from banks, banks have MORE money to make loan.
LOWERING THE RESERVE RATIO for commercial banks meaning banks can LEND MORE of their deposits.

ABLE TO DECREASE MS by...

PRINTING LESS MONEY, thus limiting the money the banks have to make loans to the public.
SELLING BONDS to the banks, so banks have LESS money to make loan.
RAISING THE RESERVE RATIO for commercial banks meaning banks can LEND LESS of their deposits.

--HOW CHANGES IN ROI IMPACTS SPENDING/AD--

LOWER INTEREST RATES leads to:

Debt repayments FALL, so households (C) have HIGHER DISPOSABLE INCOMES and therefore may spend MORE. Likewise, firms (I) have MORE DISPOSABLE PROFITS to spend.
The ‘Cost of borrowing’ FALLS so consumers (C) and firms (I) will be more likely to borrow and spend MORE.
LOWER reward for saving, so people save LESS.
MORE spending and MORE economic activity.

HIGHER INTEREST RATES leads to:

Debt repayments RISE, so households (C) have LOWER DISPOSABLE INCOMES and therefore may spend LESS. Likewise, firms (I) have LESS DISPOSABLE PROFITS to spend.
The ‘Cost of borrowing’ RISES so consumers (C) and firms (I) will borrow and spend LESS.
HIGHER reward for saving so people save MORE.
LESS spending and LESS economic activity.