However, using quantitative easing, forcing interest rates down

shortly after house prices started to fall from their all-time high, subprime
market began collapse. March 2007 was marked with the failure of Bear Stearns,
which was followed by Lehman Brothers bankruptcy and many others. The Federal
Reserve implemented monetary policies to put downward pressure on long-term
interest rates and help the financial stability of the economy. This was done
by buying securities, such as ten-year bonds and mortgage-backed securities
using quantitative easing, forcing interest rates down and rescuing troubled
firms and institutions.19 The balance of money demand and supply in an economy
is crucial. Equilibrium of these both can let the economy grow in a smooth path
and with relatively stable prices.

The financial
crisis of 2008 made all sectors of our economy unstable. The money demand and
money supply equilibrium was in disorder. Because of the rapid growth of
mortgage backed securities, housing prices and low interest rates, the
financial sector was booming. Banks, companies and individuals wanted to invest
and there was a great demand for money. The Federal Reverse purchased MBS
(Mortgage Backed Security) products essentially increasing the money supply and
boosting the economy.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now


Frederic S. Mishkin (1997). The Causes and Propagation of Financial
Instability: Lessons for Policymakers. Pp. 75-91


The central
bank uses money to indirectly influence the economy, using monetary policy it
can help to stabilize the economy assuming that money demand is stable. On the
other hand, money demand can become volatile and monetary policies will also
influence real and nominal interest rates and there is a big chance of economic
fluctuations. If monetary and credit conditions are too relaxed, then there may
be higher levels of spending which would cause prices and in turn inflation to
increase. High money supply can cause inflation and high inflation erodes the
value of money and assets. Germany in the 1920s, Zimbabwe in 2004 and a more
recent example – Venezuela in 2013 all experienced hyperinflation, which caused
major economic instability and social unrest.18


17. (2018). Monetary Policy and the Federal Reserve: Current
Policy and Conditions. online Available at: Accessed 8 Jan. 2018.

Geert Bekaert, Marie Hoerova and Marco Lo Duca (2013). Risk, Uncertainty and
Monetary Policy. Pp. 760-787

Tejvan Pettinger. (2015). The link between Money Supply and Inflation,

Robert L. Hetzel. (1984). A Monetarist Money Demand: Function. Pp. 15-19

Taradas Bandyopadhyay and Subrata Ghatak. (1990). Current Issues in Monetary
Economics. Pp. 12-15



To counter this
the central bank implements contractionary monetary policy. By raising the bank
rates, increasing reserve requirements or using open market operations, central
banks effectively decrease the money supply and in turn slow down economic
growth, spending and borrowing and increase unemployment, but its main purpose
is to target inflation. The target inflation rate is near 2 percent, which is
considered to be the best for price stability and maximum employment.17


Notes: graph
shows Us interest rate changes. After the financial crisis of 2008, Ben
Bernanke, former chairman of the Federal Reverse, pushed the interest rate to
nearly zero.




The central
bank can use expansionary monetary policy to stimulate the economy, increasing
the money supply it in turn will increase consumer spending, economic growth
and decrease unemployment. As a result interest rates will go down and money
demand will go up. However, the central bank risks triggering inflation if it
injects too much liquidity. In that case demand increases faster and businesses
start to up their production and hire additional workers. If businesses expect
prices to rise they will in turn raise the prices of their products or services
to counteract inflation. If the central bank doesn’t intervene inflation may
increase even more and there is a risk of hyperinflation.16

Having said
that, raising money supply because of money demand increase caused by a price
jump rather that an output increase is unwise, as that would most likely
intensify the problem of inflation, rather than stabilizing it.15

Nonetheless, a
slow increase in money supply will have a stabilizing effect on the economy
over time. Real GDP growth will increase money demand and will in turn increase
nominal interest rate. If the money supply and money demand both increase, the
central bank can stabilize nominal interest rates.

If there was an increase in nominal income, it would shift the money demand
curve, and raise the equilibrium interest rate.


Because the
elements that influence money demand are difficult to calculate directly,
central banks judge how monetary policy affects money demand using statistics.
Nevertheless, because money demand fluctuates considerably in short-term, the
relationship between inflation and money supply is weak.

If, for
example, interest rates are too high to begin with, it means that quantity of
money supplied is greater than the demand for it. The response to this would be
a purchase of bonds by the government which would reduce money and the greater
demand for the bonds would push interest rates down.14