Monetary System and Monetary Policies (I)

Today every country has a Central Bank. It acts as a lender to commercial banks and its acts as a banker to the government. It takes responsibility for the funding of the government's budget deficit and the control of the money supply, which includes currency outside the banking system. Thus, money supply is partly a liability of the Central Bank (currency in private circulation) and partly a liability of commercial banks (chequing accounts of the general public).

The Central Bank controls the quantity of currency in private circulation and the one held by the banks through purchases and sales of government securities. In addition, the Central Bank can impose reserve requirements on commercial banks, that is, it can impose the minimum ratio of cash reserves to deposits that banks must hold. The Central Bank also sets discount rate which is the interest rate commercial banks have to pay when they want to borrow money. Having set the discount rate, the Central Bank controls the money market. Thus, the Central Bank is responsible for the government's monetary policy. Monetary policy is the control by the government of a country's currency and its system for lending and borrowing money through money supply in order to control the level of spending in the economy.

The demand for money is a demand for real money, that is, nominal money deflation by the price level to undertake a given quantity of transactions. Hence, when the price level doubles, other things equal, we expect the demand for nominal balances to double, leaving the demand for real money balances unaltered.