Back to: ECONOMIC ANALYSIS & MONETARY POLICY
Monetary Theory Definition
The monetary theory is a macroeconomic theory that maintains that a currency or money supply is an important factor in economic activities. Changes in the economy are also linked to the money supply as posited by the monetary theory. In practice, the monetary theory believes that the federal reserve of central banks can cause changes in economic growth through the levers to control money supply in an economy. The three major levers through which central banks control the supply of money in an economy are through;
- The Reserve Ratio
- The Discount Rate
- Open market operations
A Little More on What is Monetary Theory
Central to the monetary theory is the relationship between money (a country’s currency) and economic activities. This theory holds that an increase in the money supply leads to an increase in the economic activities of a country and vice versa.
The formula for the monetary theory is; MV=PQ
In the above formula,
M means the money supply,
V means the Velocity of a currency (that is, how often a currency is spent in a year),
P means, the prices of goods and services, and
Q means the number of goods and services.
Since the central banks or federal reserves of countries have full control over the money supply, the monetary theory is also under their control. Through levers, they effectively control the supply of money in the economy in order to stimulate growth and development.
Controlling Money Supply
The Federal Reserve Board in the United State controls the money supply and in extension the monetary theory. Through three levers, the Federal Reserve ensures that enough money is in circulation which will create increased economic activity. Reserve ration, discount rate, and open market operations are the three levers used in different situations for the control of the money supply.