Essay Sample on Money Supply: Understanding Its Role in Economic Growth

Introduction

The money supply is an integral part of a country's economic growth as well as the financial market and consists of all the money in a given economy. Effective money supply entails mostly the demand deposits as well as currency circulation in a specific economy. Money supply consists of the liquid assets held by individuals as well as banks and other financial institutions. It should be noted that the quantity of money kept by the government and the central bank is not accounted for when assessing the money supply. Just like money demand, the supply of money is also variable. Any shift in the supply of money can have a severe effect on the country's economy, and if not addressed, it can lead a state into a financial meltdown. The central bank of any state is tasked with the mandating of balancing the supply of money in an economy and ensuring the country does not get into a financial crisis (Carlin & Soskice, 2014). This paper aims at discussing the advantages as well as disadvantages of both money supply rule and interest rate rule about the conduct of Central bank monetary policy. The paper also addresses the redundancy of the LM curve and if it should be discarded from policy decisions using the Bank of England (BoE) as the case example.

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Money Supply Rule

There are various money supply rules which play a vital part in the central bank monetary policy. The commonly used money supply rule is Friedman's k-percent rule. This regulation states that the central bank should grow the supply of funds by a set amount of money, k%. The rule aims to set money supply growth at a rate equivalent to the growth of real GDP each year. This rule would raise the money supply by a specific fixed proportion per duration, which cannot be adjusted by the central bank. The central bank conducts monetary policy by amending the supply of money through open market operations (Romer, 2000). For instance, a central bank can opt to minimize the supply of money through the sale of government bonds listed in 'sale as well as repurchase' agreement, thus taking in money from the central bank. When conducting monetary policy, the central bank significantly benefits from the application of Friedman's k-percent rule in various ways.

One of the major duties of a central bank is to protect as well as stabilize a country's economy. This means ensuring that the economy neither grows too slow or too quickly. Quick growth, in particular, can lead to inflation. The central bank applies the money supply rule here and regulates how much the supply of money grows in the country, thus keeping inflation in check (Mason, 2018). Often the K-percent rule reflects the GDP, meaning that K=GDP growth which is often between 1percent and 5 percent. If the central bank wants to stimulate a stagnating economy, it might opt to have a K greater than the GDP growth (K>GDP growth), which implies that it grows the supply of money at a rate greater than the overall economic growth rate. Similarly, if the central bank wants to slow down a rapidly growing economy through its monetary policy, set the K to be less than the GDP growth (K<GDP growth), which implies that the supply of money will grow at a rate lower than the overall economic growth rate. Also, the rule gives a high degree of predictability to central bank monetary policy, which makes it suitable to curb inflation. The rule also helps in the formulation of monetary policy, which can stabilize the purchasing power of money. Since under this rule, the supply of money is expected to grow at k-percent annually, with a low figure, the monetary policy ensures that inflation cannot be an issue, and it can cease to be an independent source of cyclical fluctuations (Lazonick & Mazzucato, 2013). The use of money supply rule excludes the central bank from any possible monetary policy pitfalls through communicating the simple policy rule, which can be used as a framework for setting as well as implementing policy rule.

Monetary policy is focused on changing the money supply stock as well as the interest rate to even-out the economy at full-employment or possible yield level through impacting the cumulative demand scales. This is used hand in hand with the money supply rule. Specifically, during the times of recession, the central bank monetary policy applies money supply rule to adopt monetary approaches which aim to raise the supply of money as well as lower the rates to encourage comprehensive demand in the economy while during inflation, monetary policy seeks to contract summative spending by lessening the money supply or raising the interest rate (Mazzucato, 2013). In developing countries such as India, the money supply rule is applied by the Reserve Bank together with monetary policy to achieve total employment equilibrium or probable output level to promote as well as support economic growth in various sectors of the economy such as industrial and agricultural among others. Also, in the developing countries, it has various advantages as it helps the countries' monetary policies in achieving price stability through controlling inflation as well as deflation and promoting as well as encouraging economic growth in these countries. Rules-based monetary policies are also advantageous in that they promote credibility as well as accountability of future policymakers. Following the money supply rule helps reduce the incentive to achieve the money supply and demand objectives. In a country with no rule-based structure, the central bank may guarantee to keep the inflation small but with time, be convinced to print additional funds to create revenue for the government. The presence of the money supply rule helps the economists and the general public to track the economy and supply of money, and if it is wanting, the central bank is held answerable (Gordon, 2012).

However, the money supply rule has a disadvantage in that it cannot adjust to sudden as well as unexpected changes and fluctuations in the economy, more so in money demand, which can lead to abrupt 'shocks' to income as well as employment. Monetary policy works on basis projections and forecasts and the ability to adjust to any immediate economic crisis, which can be challenging when applied with the money supply rule as it cannot be aligned with these immediate changes and shocks. Also, economists believe that central bank policymakers are often intentioned; they cannot determine the state of the financial market and economy as a whole. The financial market complexity goes beyond the indulgent of even effective policymakers and regulators; by trying to regulate it, policymakers often stimulate distortions, which are difficult to remedy using money supply rule-based systems (Lazonick & Mazzucato, 2013). Another setback of the money supply rule is that it cannot address the lag between detecting the developments in the financial market as well as the implementation of monetary policy in response. This delays the Central bank's respond to macroeconomic trends, which can worsen the economic volatility of a country. Another shortcoming of the money supply rule is that many economists view money supply and demand as volatile so that a constant supply of money could lead to more inflation variations, even output, than expected, which can lead to economic challenges and crises to the country's financial market. Another setback of this rule is that it places too much emphasis on meeting-by-meeting discretion, which is not sufficiently systematic to be integrated with central bank monetary policy. This leads to issues since it's a challenge to attain simultaneously maximum employment as well as price stability.

Interest Rate Rule

Interest rate rule opts to set a goal for the temporary interest rate. Whenever inflation or productivity in an economy rises beyond the desired rates, the central bank uses monetary policy to raise the mark by constricting the money supply, and if inflation, as well as output, falls lower the preferred rates, the central bank increases the supply of lendable funds hence lowering the interest rate (Mason, 2018). Taylor rule is the most used interest rate rule, which advocates how central banks should adjust rates of interest to account for inflation as well as other economic situations. This interest rate rule recommends that central banks should increase rates when inflation is greater than the mark or when the GDP scale is larger as well as the above probable. It also advocates that the central bank should reduce interest rates when inflation is less than the desired scale or when GDP growth is very dawdling and lower than the likely. The rule helps in monitoring the variation of the inflation rate from the desired inflation level as well as the variation from the real GDP from probable GDP (Mitchell, Wray & Watts, 2019). Rule-based central bank monetary policy increases transparency as well as predictability, which helps the central bank to clarify its measures to the public as well as helping the market in forecasting the possible performance of the financial market and economy as a whole. Monetary policy has a major impact on the lives of the people as low-interest rates benefit debtors at the expense of the creators.

One of the advantages of the interest rate rule about monetary policy is that it is a summary form of estimation of the sensitivity of the nominal interest rate which is recommended by the central bank to adjust inflation, productivity, and other economic circumstances, which is one of the aims of central bank monetary policy. Also, the rule provides a vital framework useful benchmark to the central bank policymakers as it relates monetary policy setting analytically to the economic state such that over time will create rationally good results on average, which facilitates the long-term regulation of the country economic growth and money supply. It is the mandate of a country's central bank to ensure its financial markets are stable and perform well (Mason, 2018). One way through which it can use this is by integrating interest rate rule in its monetary policy, which helps the central bank, and another financial market partakes a baseline for the prospects regarding the future course of the monetary policy. These anticipations and forecasts are very useful to the central bank as they help in decide which strategies and policies to apply in case of the undesired outcome about the country's economy and financial market. Another key benefit of interest rate rule is that it acts as a central bank toll for communicating with the general public. Upon the implementation of monetary policy, the central bank has to communicate with the public about the policy to implement it effectively. Interest rate rule acts as an effective way of achieving such communication objectives and helps in the creation of transparent monetary policy, which helps in the establishment of procedures as well as rules suitable to eliminate unnecessary volatility and uncertainties as well as reduce the costs of anti-inflation monetary policy. The use of money supply rules helps in the formulation of monetary rules and promotes transparency and openness of the central bank to the general public and accountable for any action or decision made deviating from such rule. For instance, when the USA Federal Reserve deviates from the rule, it has to testify the relevant congressional committee as to why.

However, the interest rate rule has various disadvantages regarding the central bank monetary policy, which reduces its effectiveness. One of the major setbacks of this rule is that its application requires a single assessment of inflation to be applied to acquire the rule recommendations. Contrary to this, there are various measures that the central bank can u...