Money Creation In The Money

Money Creation In The Mo

Complete the following sentence from the above article. “Banks first decide how much to lend depending on ………”

The article by McLeay, Radia, and Thomas (2014) indicates that banks initially determine how much to lend based on their assessment of the Reserve Bank’s monetary policy stance, their own funding costs, and their perceptions of credit risk, rather than solely on the prevailing level of reserves. Banks' lending decisions are driven by both regulatory requirements and demand for loans from borrowers, all within the context of the monetary environment shaped by central bank policies. Specifically, the decision depends on factors such as the existing supply of reserves, the interest rates set by the central bank, and expectations about future economic conditions. Therefore, banks first decide how much to lend depending on their profitability considerations, their liquidity positions, and regulatory constraints, influenced by the overall monetary policy framework.

In the long run, when the monetary base increases and the economy is at full capacity, the price level is expected to rise. An increase in the monetary base leads to an increase in the total money supply, which, assuming velocity remains stable, results in inflationary pressures. When the economy is already operating at full capacity, meaning resources are fully employed, additional money supply tends not to increase output but instead causes prices to rise. This phenomenon aligns with the Quantity Theory of Money, which states that an increase in the money supply, all else equal, leads to proportional increases in the price level over the long term. Consequently, persistent increases in the monetary base in an economy at full capacity will ultimately result in sustained inflation rather than economic growth.

To illustrate what happens to the interest rate in the money market following an increase in the monetary base by the central bank, consider the standard money market diagram with the money demand (MD) and money supply (MS) curves. An increase in the monetary base shifts the money supply curve to the right because the central bank injects additional reserves into the banking system. Consequently, at the initial interest rate, the surplus of reserves lowers the cost of borrowing money. This surplus causes the interest rate to decrease as banks are willing to lend at lower rates to attract borrowers. The downward movement along the demand curve indicates that as the supply of money increases, the equilibrium interest rate falls, reflecting an ease in monetary conditions. This dynamic shows the inverse relationship between money supply and interest rates during expansionary monetary policy.

When there is a decrease in expected future income, the impact on the equilibrium interest rate and the level of loanable funds can be explained through the loanable funds market framework. Expectations of lower future income reduce households' and firms' propensity to save, leading to a decrease in the supply of loanable funds. With a reduced supply of savings, the equilibrium interest rate tends to rise because there are fewer funds available for lending. Simultaneously, the equilibrium level of loanable funds decreases, resulting in less investment and borrowing in the economy. This scenario reflects decreased optimism about future economic prospects, causing both savings and investment to decline, and consequently pushing up interest rates as lenders require higher compensation for the increased perceived risk and lower availability of funds.

Paper For Above instruction

The complex interplay between monetary policy actions and their effects on the economy has been a central topic in macroeconomic research, particularly following the insights provided by McLeay, Radia, and Thomas (2014) in their analysis of money creation in the modern economy. Their detailed exploration of how banks decide on lending levels and how central bank policies influence money supply offers vital understanding of the mechanisms governing macroeconomic stability and inflation dynamics. This essay discusses three key aspects: the determinants of bank lending decisions, the long-term effects of increasing the monetary base at full capacity, and the short-term interest rate and loanable funds responses to monetary policy changes and changes in expectations.

First, banks’ lending decisions are influenced by multiple factors. McLeay et al. (2014) explain that banks do not merely lend based on reserves but also consider the overall financial environment, regulatory constraints, and their risk assessments. The initial decision on how much to lend is primarily dependent on the central bank’s monetary policy stance and prevailing economic conditions. Specifically, the availability of reserves and the interest rate environment, shaped by central bank policies, play a crucial role in determining lending capacity. When reserves are abundant, banks are more willing to extend credit, as the cost of funds is lower, and their liquidity positions are favorable. Furthermore, expectations about future economic conditions and perceived risk levels influence banks’ willingness to lend, making their decisions sensitive to both monetary conditions and macroeconomic expectations (McLeay, Radia, & Thomas, 2014).

In the context of the economy operating at full capacity, increasing the monetary base in the long run predominantly leads to inflationary pressures rather than increased output. According to classical macroeconomic theory, an expansion of the money supply, while holding all else equal, results in a proportional increase in the price level—an outcome consistent with the Quantity Theory of Money. When resources are fully employed, additional money supply does not translate into higher real GDP but simply pushes prices upward. Empirical evidence supports this view; historically, sustained growth in the monetary base without corresponding productivity growth has resulted in inflation rather than real economic expansion. This understanding underscores why central banks aim to balance their monetary policy to promote growth without triggering uncontrollable inflation (McLeay et al., 2014).

Graphically, the effect of an increase in the monetary base on the interest rate is depicted through the money market diagram. An upward shift of the money supply curve (MS) leads to a lower equilibrium interest rate, assuming money demand (MD) remains stable. The surplus of reserves reduces the opportunity cost of holding money, thereby decreasing the interest rate. This is a classic demonstration of the inverse relationship between money supply and interest rates—an increase in the money supply relaxes monetary conditions, making borrowing cheaper. Such a shift stimulates economic activity in the short term but can fuel inflation if sustained (Mishkin, 2019). This theoretical framework aligns with the evidence from central bank policies aimed at managing economic growth and inflation targeting.

Regarding the effects of decreased expected future income on the loanable funds market, a decline in future income expectations diminishes the incentive to save, leading to a drop in the supply of loanable funds. This reduction causes the equilibrium interest rate to rise, as lenders demand higher returns to compensate for increased risk or decreased savings propensity. Simultaneously, the equilibrium level of loanable funds falls, leading to lower investment and borrowing in the economy (Rognlie, 2015). This endogenous response reflects typical macroeconomic dynamics where expectations influence savings and investment behavior profoundly. The higher interest rates discourage borrowing, further constraining economic activity and potentially slowing growth, emphasizing the importance of macroeconomic stability and positive expectations for sustained development (Bernanke & Gertler, 1995).

References

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