In my essay practise revision notes, I took all of the past paper questions from previous years and split them up into sub-questions to help me to formulate paragraphs based on different concepts and arguments that I could memorise for the exam. The document will include my own style of writing and...
11. ‘The money supply varies with economic activity and cannot be
determined solely by the government or central bank.’ Discuss.
The Money supply essentially refers to the amount of money in circulation in
an economy. In economic theory, Money is usually defined by a functional
definition. A commonly recognised function of money is the medium of
exchange. There are also many other economic functions of money for
example, accounting, saving and credit, where money can be a means of
deferred payment, this has increased with technical change. The relationship
between the money supply and economic activity is complex. I believe that the
money supply cannot be determined solely by the government or central bank.
While the government and central bank play a key role in determining the
money supply, the money supply fluctuates with economic activity and cannot
be fully controlled as it is influenced by multiple factors in the economy. The
money supply is affected by the behaviour of consumers, businesses, and
financial institutions. If consumer spending increases, the demand for money
increases hence, the money supply increases for instance. Though, the
central bank can influence the money supply by using monetary policy, for
example, changing the interest rate. So, if the money supply is too high, the
central bank can increase the interest rate to reduce spending and reduce the
demand for money, which in turn will reduce the money supply. Overall, the
money supply is determined by external factors in my opinion.
In the literature, on the other hand, Neoclassical economists argue that the
money supply is solely determined by the state, assuming the money supply is
exogenous in their theory. Neoclassical economics focuses on exchange but
has always had difficulties in providing a rationale for money. In their static
model, a competitive equilibrium is timeless and defined through rates of
exchange of real goods, so it is unclear where money fits in the model. Money
prices are arbitrary, creating a dichotomy between the real and monetary side
of the economy. This means that they theorise that the monetary side of the
economy is completely separate from other parts of the economy. In practice,
we can easily observe that there are patterns that provide evidence that there
is a relationship between economic activity and the money supply.
On the other side of the literature, Post Keynesian economists view money as
a means of managing fundamental uncertainty by transferring purchasing
power over time through savings and credit. Institutions create credit money,
, which is a financial asset for the holder but a liability for the creator. Credit
money has value only through its general acceptability and can be increased
in supply at little or no cost. The development of credit money is one of the
main features of modern capitalism. Some Post Keynesian economists such
as Chick and Dow (2002) argue that the money supply is determined within
the financial sector, with bank lending initiated by borrowers being the origin of
money supply. The growth of money supply and credit availability is
determined by demand-side pressures within financial markets. While financial
markets today generally manage money supply, borrowing, and lending well,
endogenous crises can still occur, as demonstrated by the Global Financial
Crisis of 2008. According to Minsky's Financial Instability Hypothesis, financial
structures during an economic expansion become increasingly unstable,
eventually leading to a financial crisis and economic recession (Minsky, 1992).
Recession may encourage more secure types of finance until the next round
of expansion and financial instability. In some cases, government or central
bank intervention may be necessary to mitigate such risks. Since the Global
Financial Crisis, the government and the central bank have had a greater role
in financial regulation so it can be argued that they do generally control the
money supply. However, if demand-side and supply-side shocks add enough
pressure like the COVID-19 pandemic did, there’s only so much the state can
do to influence the money supply when the economy is going into a downturn
and inflation is on the rise globally.
Post Keynesian economists see money as a response to fundamental
uncertainty, since savings and credit help to transfer purchasing over
time, thereby overcoming short-term uncertainties. Credit money is
created by an institution, yielding a financial asset for the holder and a
liability for the creator. It is valuable only through its general
acceptability, often it has no physical existence, and can be increased in
supply at little or no cost. Modern capitalism has seen the widespread
development of credit money. They have explored the question of the
endogeneity of money, whether money supply is determined within the
financial sector. In Chick and Dow (2002), the origin of money supply
was ascribed to bank lending, initiated by borrowers. The rate of money
supply growth and credit availability are fundamentally determined by
demand-side pressures within financial markets (Pollin, 1991). As the
economy expands, bank lending increases and the money supply grows,
such that it imposes no immediate constraint on economic activity.
Overall, we do see in financial markets today good management of the
money supply, borrowing and lending. However this does not mean that
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