The role of money in the macro economy Assignment

The role of money in the macro economy - Assignment Example Money supply in an economy is closely linked to economic growth of the nation, unemployment, inflation in economy and interest rates prevailing in the banking system of the country. ECB (2011, p. 63) states â€Å"The volume of broad money in the economy is the result of the interaction of the banking sector (including the central bank) with the money-holding sector, consisting of households, nonfinancial corporations, the general government other than central government, as well as non-monetary financial intermediaries.† Money supply determines liquidity in the economic system and credit growth. Credit growth depends upon the liquidity in the banking system, ability of the banking system to scale up their exposure in relation to demand, interest rates, internal rate of return expected on investments and the general economic condition. Therefore credit growth is considered an important indicator of economic development in a country. A country needs to overcome the imbalances in the current account through regulations for maintaining the exchange rate parity of its currency in the international markets for sustainable growth and development. The US subprime crisis and the European financial crisis have underlined the importance of financial services sector in macroeconomics. The globalization phenomenon necessitates revisiting of global monetary system with International Monetary Fund at the helm of affairs. Surveillance system of the International Monetary Fund should be able to detect the warning signals of impending economic crisis and support the countries in overcoming their economic imbalances. Money supply Keynesian expansionary policy envisages increasing supply of money and government spending for revival of economy and growth. Central banks control money supply using various tools. For example, the Federal Reserve can regulate money supply and manage liquidity through reserve requirements imposed on the banks. By increasing or decreasing the reserve ratios the Federal Reserve can regulate money supply. Also, the Federal Reserve buys and sells securities in open market with repurchase agreements for this purpose. When the economy is on growth mode, banks can borrow money through Federal Reserve’s discount window or avail facilities through autonomous factors that increase supply of money in the economy. The central bank of a country can use ‘Bank Rate’ as a tool to regulate money supply. The change in bank rates leads to changes in the short term and long term interest rates. The impact of the changes on financial and capital markets need to be carefully reviewed after taking into account several factors. For example, decrease in the interest rates will have impact on the pensioners’ income by way of interest on fixed income securities. The economic indicators such as Consumer Price Index related to inflation, Jobless Claims related to unemployment, GDP r elating to economic growth and industrial production statistics are useful in taking decisions by the monetary authorities. Increase in money supply increases aggregate demand which encourages entrepreneurs to establish production facilities for meeting the consumer demand. The additional employment generated in this process increases the consumption level and demand. The multiplier effect caused due to expansionary policies needs to be regulated to avoid