Monetary policy is the process by which the monetary authority of a country controls the supply of money, usually targeting a rate of the interest for the purpose of promoting economic grown and stability. ( Wikipedia ) In the short run, monetary policy affects the lever of output as its compositions can also affects the lever of output. An increase in money leads to a decrease in interest rates and a depreciation of the currency. Both of them can lead to an increase in the demand for goods and an increase in output.(Blanchard, 2009) There are two different ways of monetary policy, an increase in money supply is called monetary expansion and a decrease in the money supply is called monetary contraction. This essay express how monetary policy can rise the lever of aggregate demand in the short run based on money supply, interest rate, income and bond price.
The relation between the nominal income and demand
As we know thar the relation between the demand for money, nominal income and the interest rate is: Md =$Y L(i)
that means the interest rate has a negative effect on money, an decrease in the interest rate increases the demand for money. In other words, the demand for money increases in proportion to nominal income, and the demand for money depends negatively on the interest rate.
According to the Figure1, the initial equilibrium is at point A. As increase in nominal income from $Y to $Y’, increasing the level of transactions, which increases the demand for money at any interest rate. The money demand curve shifts from left to the right(Md to Md’) the new equilibrium moves from A up to A’, and the equilibrium interest rate increases from i to i’. [pic]
Figure 1: The effects of an Increase in Nominal Income on the Interest Rate. Source: Adapted form Blanchard 2009
Thus, an increase in nominal income can raise the level of demand for money in the short run.
The relation between the money supply and demand
When the money supply changes, the interest rate will changes in proportion to the supply. The relation between them shows in figure 2. [pic]
Figure 2: The effects of an increase in the Money Supply on the Interest Rate Source: Adapted form Blanchard 2009
The initial equilibrium is at point A, the interest rate is i. An increase in the money supply, from Md=M to Ms’=M’, leads to a shift of the money supply curve to the right. The equilibrium moves moves from A down to A’, the interest rate decreases from i to i’. It indicate that an increase in the supply of money by the central bank leads decrease in the interest rate, thus can raise the level of demand for money in short run.
At the same time, an increase of the demand for money needs more output in order to satisfy the high demand for money, then people will earn more money, in the end the level of aggregate demand would also increase.
The relation between monetary policy and interest rate
When analysis the IS-LM curve, a same answer can be got. For the IS curve, as the money supply does not directly affect either the supply of or the demand for goods, a change of M does not appear in the IS relation to shift it. For the LM curve, however, as we know that an increase in the money supply shifts the LM curve down, from LM to LM’. In other words, an increase in money leads to a decrease in the interest rate. Take all factors into consideration, the economy moves along the IS curve, and the equilibrium moves from A to A’, output increases from Y to Y’, and the interest rate decreases from i to i’. [pic]
Figure 3: The effects of a Monetary Expansion
Source: Adapted form Blanchard 2009
Therefore, increasing money supply, decreasing interest rate and increasing income can raise the level of aggregate demand(Blanchard 2009)
Turn to consider about the effects of an open market operation. “The price of the bond today is equal to the final payment divided by 1 plus the interest rate”(Blanchard 2009). $PB=$F/1+i That means the higher the price of the bond, the lower the interest rate. So the central bank increases the money supply in open market operations by buying bonds lead to an increase in the price of bonds, a decrease in the interest rate, an increase in the level of aggregate demand in the short term.
The relevance for the UK since 2009
For example, according to the figure 4, the level of GDP in UK has experienced a plunge since 2007 because of the crisis. At the same time, we can see from the figure5, the bank rate gradually increased since 2007, more and more companies do not willing to invest new projects, that leads to a lower output. However, since 2009 the level of GDP consistent rise and will continue this trend in the following years. The main reason is bank rate experienced a plummet, from 6% in 2007 to 0.8%.
Figure4:Projection of the level of GDP based on market interest rate expectations and £375 billion asset purchases Source: Bank of England August 2012 Inflation Report
Figure5: Bank of England Rate: observed and predicted by markets Source: Bank of England August 2012 Inflation Report
As mentioned before, an decrease interests leads to an increase output, thus leads to an increase demand,
Therefore, government and central bank can use monetary policy to rise the level of aggregate demand, including buying bonds, decreasing rates, increasing income and money supply.
Blanchard, O. (2009). Macroeconomics. New Jersey: pearson education, Inc