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It is impossible to target both the money supply and the rate of interest. If you control one you have to let the other be as it will. Discuss

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Introduction

It is impossible to target both the money supply and the rate of interest. If you control one you have to let the other be as it will. Discuss To discuss the above question we must firstly view the ways in which money supply can be controlled. In order to distinguish this we must first identify how it can be measured. Money can be classified under two categories. High powered money (or monetary base) and broad money. Cash notes and coins that circulate outside the Country's central bank is the narrow monetary base. The addition of banks' balances with the central bank make up the wide monetary base, known in the UK as M0. However the monetary base system excludes bank deposits, which are the most popular source of liquidity for spending. Therefore broad money is the measuring tool used by most countries in order to measure money supply. It consists of deposits at banks and building societies and is the means of selling most debts in modern society. The UK knows this as M4. Until the 1970's fiscal policy was seen as the main policy for controlling the economy. Monetary policy was only used to prevent excessive fluctuations in interest rates. ...read more.

Middle

This is where demand for money becomes perfectly interest-elastic at a very low interest rate. It is thought that at such uncommonly low interest rates there is the expectation that they will eventually return to a normal level. Therefore everyone would also expect a fall in the price of bonds leading to capital losses for those who hold bonds. If the monetary authorities increase money supply, this increase would be added to speculative balances leaving the interest rate unchanged. This is illustrated in the previously model by a shift in supply of money from Ms2 to Ms3. Despite this shift to the right, the rate of interest remains at I2. In the above case the monetary policy is unable to push interest rates down or have any effect on consumption or investment. This enforces the argument that both money supply and the rate of interest cannot be controlled together. However it can be argued that there has been no conclusive evidence to support the Keynesian liquidity trap theory. Even if it does exist the restriction to money and bonds somewhat limits the theory. The monetarist model takes a different approach. Both models agree that peoples attempt to spend their excess money balances on bonds. ...read more.

Conclusion

Therefore all other short-term interest rates in the money market are lead by this rate. As a result of this there occurs a rise in the cost of borrowing that, in many circumstances, decreases the demand for loanable funds. This will therefore slow down the growth in supply of money. If Central bank wishes to increase the stock of money within the economy it can buy securities on the open market. This would lead to a fall in interest rates and a rise in the demand for loanable funds resulting in an increase in the money supply. Overall I believe that if money supply is raised the rate of interest can be reduced in order to restore equilibrium. Therefore both can be controlled. The difficulty lies in attempting to control both if Government wish to reduce the supply of money. This will lead to higher interest rates and a rise in demand for money as people want their assets in liquid form. Therefore Government will have to increase the supply of money. However if the economy is in a recession, no matter how low interest rates are driven, people cannot be forced to borrow. If a continuing recession is predicted firms will not borrow to invest. Therefore supply of money and rate of interest cannot be targeted at the same time. ...read more.

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