In every economy in the world, money is an important factor. The presence of money in the economy facilitates the trade of goods and services. However, there is a common misconception of equating money to wealth, however, economics clearly shows a distinction between the two terms. As such, the term money is specifically used to refer to currency, which is a part of a persons wealth, however not the only source of wealth or assets. Money, in most economies, is in the form metal coins and paper bills that are created by a nations government. Such paper bills and metal coins are considered as money because they possess three aspects of any currency; they are a medium of exchange, serve as units of account and are a store of value (Selgin, A Monetary Policy Primer, Part 1: Money, 2016). Since money is a medium of exchange it is also considered a good and as such, it is susceptible to shortages and surpluses.
A shortage of any good in an economy is viewed as a bad thing as it leads to increased demand which affects other sectors of the economy such as increases in the prices of the particular good. Consequently, the shortage of money also has adverse effects, however, one would not expect the surplus of money to be detrimental to the economy, as the surplus of any other good is viewed positively in an economy. Shortages and surpluses of money are as a result of the demand and supply of money. In this regard, a surplus of money is a situation where the supply of money exceeds its demand in the economy. This supply is at the discretion of the Federal Reserve; however, demand is determined by the interest rates.
Since money is used by businesses and individuals to acquire goods and services, the higher the currency value of aggregate output, the more money these individuals and businesses hold on to so as to spend it. however, as there is an opportunity cost to holding money as it does not earn interests, as the interest rates rise the opportunity cost also rises leading to less demand for money. As a result, the money demanded in the economy is less than the money supply (Beggs, 2015). Similar to shortages of money, a surplus of money hinders the correct determination of prices of various goods and services which causes certain goods to be underpriced while others are overpriced relative to others. As such, there is a need to maintain an equilibrium in the money market in order to avoid such undesirable effects in the economy.
An equilibrium in the money market is achieved as expected where the demand for money curve and the supply for money curve intersect, that is the point where the money demanded is equivalent to the money in supply. Regulation of the of the money market is done by the central bank through open market operations. The central bank achieves money market equilibrium by adjusting the money in circulation as well as the bank reserves. These adjustments are through the adjustment of the central banks balance sheets which are as a result of selling or acquiring assets (Beggs, 2015).
In the case of a shortage of money, the federal reserve has to increase the banks' reserves stock. As such the federal reserve would purchase treasury bonds or other assets from buyers in the open market. Subsequently, to pay for the treasury bonds, the central bank would in return transfer the money to the open market buyers bank account effectively increasing the total amount of the banks reserves. The banks, with their replenished reserves, have more raw material to support their own creation of various money substitutes as well to support other financial firms in also creating money substitutes (Selgin, A Monetary Policy Primer, Part 5: The Supply of Money, 2016). This process thus leads to the introduction of more money into the market thus clearing the shortage of money.
On the other hand, in the case of a surplus of money in the economy, the central bank has to decrease the amount of money in circulation in the economy. To achieve this reduction, the central bank can sell some of its assets of treasury bond or it can opt to let the treasury bond roll off its balance sheet as they mature as opposed to replacing them with new assets and treasury bonds. In the event that the central bank opts to sell some of its assets, the open market sellers have their respective banks deposits some of their money to the federal reserve which is equivalent to the central bank reducing the reserves of the banks in the economy (Selgin, A Monetary Policy Primer, Part 5: The Supply of Money, 2016).
Overall, an economy should have a money supply that increases over time so as to produce a stabilizing effect on the economy. However, to avoid the surplus of money in an economy, the rise in money supply should be as a response to a rise in the demand for money caused by an increase in output as opposed to the increase in prices of goods and services so as to avoid instances o elevated inflation in an economy.
Beggs, J. (2015, December 31). Nominal Interest Rates and Money Supply and Demand. Retrieved from ThoughtCo.: https://www.thoughtco.com/nominal-interest-rates-and-money-supply-and-demand-1147766
Selgin, G. (2016, April 21). A Monetary Policy Primer, Part 1: Money. Retrieved from Alt-M: Alternative Monetary Future: https://www.alt-m.org/2016/04/21/a-monetary-policy-primer-part-money/
Selgin, G. (2016, May 26). A Monetary Policy Primer, Part 5: The Supply of Money. Retrieved from CATO Institute: https://www.cato.org/blog/monetary-policy-primer-part-5-supply-money
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