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How Money Supply Influence Interest Rate?

How money supply to influence interest rate: Monetary policy

Most nations across the globe have their independent monetary policy and exchange rate. As such in case of liquidity problems like the one experienced during the eurozone crisis, central banks of these nations can print their own money and manage the liquidity issues (Froyen 27). For example, in the case of the Japanese economy, monetary policy has influenced the interest rates due to increased money supply.

The Japanese money supply has been relatively optimistic in recent months as the rate of inflation has dropped by 6%. Following the increased demand for heavy industry products across the globe and strengthening domestic demand for goods and services, the rate of deposit growth reached 14% in 2015 (CMA par. 9). The rate of liquidity is expected to remain high in the short foreseeable future because the current market reforms by the government favor increased money supply. For example, the Ministry of Finance has introduced different market reforms that have increased bank reserves around the country. These reforms should sustain time and savings deposits in 2016.

The sustained growth of monetary aggregates has remained at an average of 10% since the year 2009, immediately after the global financial crisis (OECD par. 19). This sustained growth stems from stable interest and exchange rates.

For example, economic reforms have ensured interest rates remain relatively stable and favorable in 2015 because the government’s monetary policies aim to encourage more private sector growth to support its goal of diversifying the economy from excessive dependence on the manufacturing sector. Existing monetary policies favor liquid non-interest bearing deposits that should further increase the rate of money supply in the coming months to support the same cause (Asafu-Adjaye 421).

Factors that influence the quantity of money to hold

Speculative motives

When people are expecting the value of money to increase in the future, they are likely to hold more money to gain from the expected value increase. On the other hand, when the value of money is expected to reduce, people would dispose of their stock to avoid losses (CMA par. 8).

Market dynamics

When the interest rates reduce, it would be profitable to hold more money than when the rates increase. Besides, an increase in the rate of inflation would eventually result in increasing nominal money demand (CMA par. 8).

Change in lifestyle

An increase in disposable income or spending power would influence people to hold more money, especially when it is influenced by improved household income. Moreover, when the future seems uncertain because of market or political swings, people would hold more money to cushion against the potential impacts of such swings (CMA par. 8).

Tools of Monetary Policy

The main monetary policy tools are the discount rate, open market operations, and reserve requirements. The discount rate refers to the interest rate that commercial banks are charged by reserve banks for loans, especially in the short-term. On the other hand, the open market operation is used by relevant agencies to buy and sell government securities to either increase or reduce the money supply. Lastly, the reserve requirement is a tool used by the government to hold a percentage of money from commercial banks to support the short term loans, customer deposits, and increase the money supply (Park 28).

Notes, bonds, and treasury bills are part of the open market operations to increase or decrease the money supply. For instance, when the monetary agency wants to increase the money supply, it buys these securities and vice versa. When the money supply increases, the interest rates will reduce and vice versa.

Equation of exchange

M.V =P.Q

Where;

  • M: Sum of the nominal money supply circulating in the economy
  • V: The average velocity in spending a single unit of money
  • P: Level of price
  • Q: Index of expenditures on services and goods that are newly produced

Works Cited

Asafu-Adjaye, Jordan. “International Trade and Sustainable Development in Sub- Sahara Africa.” International Journal of Social Economics, 31.4 (2011): 417–429. Print.

CMA. Publication and Reports: Annual Reports. 2015. Web.

Curran, George, and Emanuel Acker. Business and the Politics of Globalization: After the Global Financial Crisis, Alabama, Al: Pearson Education, 2010. Print.

Froyen, Richard. Macroeconomics: Theories and Policies, New York, NY: Macmillan Publishing Company, 2011. Print.

OECD. Japan: Economic Forecast Summary. 2015. Web.

Park, Gerald. Monetary Management in GCC Countries, IMF Staff Papers: Washington DC, 2009. Print.