Tuesday, 21 August 2012

Your Humble Guide to Public Finance III. - Monetary Policy, Basics

In the third post of our series on public finance, we will provide a brief introduction into monetary policy. Given the fact that monetary policy is more complex than it's fiscal counterpart, this section will be divided into two posts – and this post will explain the main goal of monetary policy, and why do we need it at all. Read more about the supply of money, inflation and the role of central banks, below.



What is monetary policy?


So what is monetary policy? Following a quick Google search and clicking on the first result of Wikipedia, the article's first lines read that monetary policy 'is the process by which the monetary authority of a country controls the supply of money, often targeting... '
Okay, okay, stop. Two questions rightfully come to mind. What the heck is the supply of money, and what is a monetary authority?

Money supply


Firstly, the money supply, a.k.a. The supply of money – this is, simply put, the total amount of money in the economy. Now why is controlling money supply important? Consider the following equation:

MV = PQ

or

Money supply * Velocity of money = Average price of goods * Quality of goods

Money supply: as mentioned above – the total amount of money in the economy.
Velocity of money: the number of times each unit of currency (say, dollars) is spent per year
Average price of goods: the average price of goods and services sold per year
Quality of goods: the average quality of goods and services sold per year

Don't forget that money doesn't have value on it's own – it's an universal medium of exchange of wealth in the economy, hence every f.e. dollar has to be backed up by the appropriate amount of goods or services. Now imagine what happens if the amount of the money supply goes up, because somebody starts to create money out of nowhere – to finance their expenses – according to the equation above, the prices would rise, because the other variables wouldn't change, but suddenly more money would be present for each unit of goods or services. This is inflation – and if it's too high, money will loose it's value. Remember the Germany of the 1920s from history lessons? One of the main goals of monetary policy is to curb excessive inflation.

Central authority


The second question is – what is a central monetary authority? And why do we need such a thing?
The answer lies with the above example – in order to prevent money from loosing it's value, authorities have always tried to stop people from issuing money besides their own. While currencies were made of gold and silver, the mere scarcity of these resources was a stopping power – but the introduction of paper money changed things. From that point on, everybody could theoretically print paper money – to stop this, individual countries did two things – firstly, sanction citizens who forged banknotes (and coins), and secondly, give the power of printing money to an individual, state institution which is independent from the government (in order to stop the government from printing money to cover their expenses). These are central banks, and they are the worldwide conductors of monetary policy to this day.

Conclusion


The main goal of central banks is to control inflation, the phenomenon of decreased money value due to a growth in the money supply. We will write further about how central banks influence money supply, and what effects does it have on the economy in our next post – and until then, don't stop reading us.



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