Here’s the second tool the government uses to stimulate the economy – Monetary Policies! Similarly to fiscal policies, there are expansionary and contractionary monetary policies too.
In the event where the government increases the money supply, that’s an expansionary monetary policy. And where it reduces the money supply, it’s called a contractionary monetary policy.
So how exactly does the government increase or decrease the money supply? It doesn’t load a C-130 with tons of money and drop it to us loyal citizens. It also does not use a giant vacuum cleaner to suck the cash out of our pockets, even though it seems like it most of the time… not literally.
What the government does to change the number supply is to either sell or buy bonds from financial institutions, your banks. So let’s say the government wishes to pump some money into the economy. Here’s what happens:
Government buys bonds from banks
Gives them loads of cash in return
Money supply has increased
There is now an excess supply of money in the banks
The banks makes you withdraw the cash by reducing interest rates
You withdraw your cash because it is now less attractive to put money into the banks
You rather put it into investments.
Investment increases which causes income to increase
This increase in income makes you want to withdraw more money!
The banks now have to maintain it money balances so it increases its interest rates this time to eliminate your excess demand for money
You then choose to withdraw lesser from the bank.
It seems like a load to remember eh? But not to worry. At Quickienomics, we believe in systematic teaching. So in the video lecture, you will see exactly the sequence of events. Here’s some tips on how to remember this better:
While watching the video, pause at intervals to write down the main points of the events that happen. Do not draw the graphs first!
After that, draw the graphs WITHOUT referring to the video.
Rewatch the video to see if you got it right.
At the end of this video, you should be able to:
Understand fully how the ISLM model works
Explain in detail, what happens during a monetary policy implementation
Define mix policy
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