An Insight into the Different Aspects of Monetary Economics

Monetary economics is a broad area within the domain of economics that may seem quite simple. However, if you proceed to explore the area further, you will begin to notice the intricacies involved.

Such intricacies may lead to a lot of confusion about the different layers of monetary economics among the students. If you happen to go through the same dilemma, then you can ponder over this extensive discussion on monetary economics. Here’s everything you needed to know about the topic.

Definition of Monetary Economics

Monetary economics primarily delves into the role of money and monetary authorities within a modern economy. The topic can be further categorised into two sections Monetary Theory and Monetary Policy with particular application to the international financial crisis.

Monetary economics emphasises on the impact of monetary institutions and policies on economic variables. These variables include commodity prices, interest rates, wages, consumption, quantities of employment, and production.

The study of monetary economics allows you to understand how an economy functions. In fact, it also elaborates how monetary policy can support the economy shift from one state to another and how it can attain a proper balance and grow.

Dive Deep into Monetary Theory

Monetary theory suggests that the shift in money supply is the driving force behind the change in economic activities. When the monetary theory is practised, central banks, which regulate the monetary policies can exercise much power over the economic growth rates.

As per the monetary theory, if a nation's supply of money elevates, economic activity will also amplify. Monetary theory is guided by a simple formula, MV = PQ, where M is the money supply, V is the velocity (number of times every year average amount of money is spent), P is the price of products and services, and Q is the quantity of produce. If V is constant, M is raised, either P, Q or both P and Q increase. Usual price levels happen to go up more than the production of products and services when the economy is close to full employment. When the economy is slow, Q will increase at a quicker pace than P under monetary theory.

The government or its central bank decides the nominal quantity of money that circulates, but the public decides the real value of the money. If the central bank offers more money than the public wants to keep, the public invests the excess on goods, services, or assets.

Inflation has a huge impact on the demand for money because currency pays no interest, and checking deposits usually receive little or no interest return (a majority of the direct return to money balances assumes the form of transaction services and convenience). As the opposite of inflation, deflation increases the return on money that is possessed by giving each nominal unit more command over goods and assets.

Thus, the expenditures of the consumers will reduce as people hold onto their money in the hope of lower prices in the future. Other instances influencing the amount of money that people willingly retain are wealth, income, and some measure of transactions volume. The increase in the real value of these measures will be followed by escalations in the number of real balances.

The Difference between the Monetary Economy and Barter Economy

Some considerations differentiate a monetary economy from the barter economy.

Basics of bartering

Since the beginning of human history, people have directly exchanged goods and services with each other as part of a trading system known as bartering. Typically, the bartering process was utilised within the local community, but progress in technology make it possible for modern society to barter on a global scale.

A person who has milk and eggs can trade them to a local baker in exchange for a loaf of bread. The baker then bakes more bread with milk and eggs and gives it to the appliance repairman as payment for repairing her oven. Bartering makes negotiations a lot easier, but it doesn’t come with the flexibility of a currency system. Many small businesses accept non-monetary payments for their services.

Emergence of the monetary economy

As currency systems developed with time, governments introduced coins and paper notes to grow their economies and to allow trade within the region. The monetary system is a norm for most countries now, but individuals can still barter or adopt another accepted system. The barter system may be implemented as a replacement for or in addition to the national monetary system in place.

A comparison of both the systems

One great advantage of money is that it is always flexible than goods. Now, let’s assume you earn a living through raising cattle. If you had to take cows with you to trade every time you wanted something in return, this would be a tedious process. It could also be difficult to transfer the cows. Money, on the contrary, is designed to be convenient, small, and portable.

Also, money comes in manageable units. Drawing from the same example above, a cow is a valuable commodity, but what if you only need a small bit of cloth or some grain? What you’re asking for is worth less than the cow, so what do you do? Should you give up the cow for less than it’s worth, or do you take a pile of goods you don't need? It is obvious that money is far more convenient.

If you can sell the cow for money, you can get it converted into small coins or bills and use these to buy only what you need, and save or invest the rest. Money was primarily introduced considering these advantages.

The Significance of Monetary Economics

Monetary economics is another essential aspect with which objectives of macroeconomic policy can be attained. The vital thing to note here is that the central bank of a country forms and enforces the monetary policy in a country. In some countries, the central bank works on behalf of the Government and functions as per its guidelines and directions.

However, in some countries, the central bank comes with an independent status and pursues an independent policy. Like the fiscal policy, the primary purpose of monetary economics is to maintain equilibrium at a full-employment level of output. In fact, monetary economics also ensures price stability and promotes the economic growth of a nation.

Monetary economics means altering the supply of money stock and rate of interest with the objective of stabilising the economy at full-employment or potential output level.

At times of recession, monetary economics involves the implementation of some tools. These tools elevate the money supply and reduce the interest rates so as to accelerate the demand in the economy. On the other hand, at times of inflation, monetary economics aims to control the aggregate expenditures by tightening the money supply or raising the rate of interest.

You must note here that in a developing country, achieving equilibrium at full employment or potential output level is the goal. However, monetary economics has to promote economic growth both in the agricultural and industrial sectors of the economy.

The Relationship between Monetary Economics and Finance

Monetary economics and finance are interrelated. One of the major roles of any central bank is to manage the inflation rate. Inflation destroys the real value of nominal assets and it is expensive for society. However, when a government imposes a bond on its own currencies, inflation eliminates the financial burden of inherited debt.

When a financial authority analyses how to finance its obligations with debt and taxes, it takes into consideration its expectations about future monetary policies. Issuing more debt today may lead the central bank to increase inflation, which would make the new debt less burdensome. This lenience towards deficit financing is reduced or eliminated by the fact that higher expected inflation turns into lower demand for bonds. This leads to higher interest rates.

Various establishments have been formed to reduce the incentives and utilise inflation as a way to finance present and/or past deficits. More and more central banks are provided with explicit low-inflation objectives and are sheltered from political influence. Other than that, central banks are usually prohibited from directly financing, a lesson learnt from numerous hyperinflation episodes.

The Economic Functions of the Monetary Policy

The following are some of the economic functions of the monetary policy laid down below.

1. Monetary policy should attempt to maintain the most suitable interest rate structure in the economy.

At present, the interest structure can be modified in the upward direction and very little in the downward direction. However, with the help of monetary policy, the structure turns in the downward direction as well.

For a large public debt that has to be accumulated in poor economies, rates of interest should be kept low.

2. Monetary policy can be useful in these economies for implementing necessary adjustment between the supply of and demand for money. The demand for money can go up in case there are more transactions and eventual disappearance of the non-monetised sector.

The use of money and credit for various purposes has to be limited by the monetary authorities through suitable monetary policy. Also, the government should implement direct physical controls, failing which, inflation is likely to become evident, which may stifle growth instead of accelerating it.

3. Monetary policy can probably be more useful in influencing a method of investment and production by regulating the provision of credit by banks. It can also prompt the banks to advance medium-term and long-term loans of productive nature.

4. Monetary policy can assist in the expansion of financial institutions by allowing subsidies and special facilities to new institutions. It also offers the provision for training facilities for the staff.

5. Monetary policy can also propel growth. The impact of such policies in a developing economy is quite evident. Monetary expansion can be integrated (at least in theory) to modify the terms of trade against the agricultural sector.

If the prices of industrial goods can be increased through inflation without affecting the prices of foodstuffs and raw materials, it may prove to be useful for growth, but in practice, it might be tough to follow.

In conclusion,

These insights will help you solidify your understanding of monetary economics to a great extent. That way, you will have no trouble putting together a stellar piece of economics assignment in class.

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