The money market deals with the sale and purchase of short-term funds such as bonds. The mechanism of the sale and purchase of bonds is dependent on interest rates. Most notably, when the interest rates are high, holding liquid cash becomes unattractive, and individuals opt to buy bonds that can earn them returns. Conversely, when the interest rates decline, holding bonds become unattractive because they do not generate significant interest. Therefore, in such a scenario, people may prefer to hold money in liquid cash. Besides the interest rate, the motives for holding money also determine the amount of liquid cash held by individuals. For example, if a person’s transaction motive is high, then they may keep more cash than bonds to facilitate their everyday transactions. Similarly, if a person speculates a decline in the prices of bonds, they may prefer to sell them in present times and hold more money.
The money market is at equilibrium when money supply and demand are equal at a given interest rate. When the central bank keeps the money supply constant, it means that there lack no changes in the total amount of money circulating in an economy. The decision of firms and individuals to hold bonds or cash in such a scenario does not affect the money supply. Therefore, if the money supply is at its initial level (M1), the interest rates remain at the equilibrium (i), where money supply equal to money demand.
- A recession implies that the money supply declines significantly in an economy. This recession could be caused by multiple economic factors such as an increase in interest rates, a decline in real wages, and a reduction in bank lending. An economic recession causes the supply curve to shift to the left. The shift in the money supply curve causes a rise in interest rates and a decline in the prices of bonds in the market.
- The BoC can restore the interest rate target by implementing expansionary monetary policies such as open market operations and reserve requirements. For example, the BoC can reinstate a high interest rate by buying bonds in the open market. Purchasing bonds would increase the money supply in the economy to a greater extent than required by households. The household would respond to this excess money supply by purchasing bonds to lower the amount of liquid money held. As a result of the increased purchase of bonds, the prices of the financial instruments would increase significantly, leading to a decline in interest rates back to the equilibrium. If the interest rate is lower than the target, the BoC can restore it by selling bonds in the open market to reduce the money supply in the economy. This sale would lead to an increase in money demand, and individuals would sell their financial instruments and hold liquid money. This liquidity preference would, in turn, lower the price of financial instruments and lead to an increase in interest rates.
- An inflationary gap occurs when the actual Gross Domestic Product (GDP) is higher than the potential output. An inflationary gap can be depicted in the AD-AS diagram, as shown in figure 1.
Figure 1: Inflationary gap
Explanation: As can be seen in the figure, the inflationary gap occurs where Y1 is greater than YP. Furthermore, during an inflationary gap, the aggregate demand curve labeled AD, and the short-run aggregate supply curve (SRAS) intersect on the right side of the long-run aggregate supply curve (LRAS).
- The central bank can eliminate an inflationary gap using a contractionary monetary policy. A contractionary policy would help reduce the amount of money supply in the economy. Some of these policies would include increasing the bank discount rates, selling securities in the open market, and raising banks’ reserve requirement rates. A contractionary monetary policy would eliminate the inflationary gap by shifting AD to the left; thus, creating a new equilibrium at potential GDP.
- While a contractionary monetary policy helps close an inflationary gap, it also affects other economic variables such as interest rate, investment spending, consumer spending, real GDP, and aggregate price level. Most notably, the policy leads to an increase in the interest rates, which is critical in reducing the money supply in the economy. Furthermore, the policy raises the interest rates, which discourage firms from borrowing; thus, leading to a decline in investment spending. The policy also causes a reduction in consumer spending and a decline in GDP. Besides, with the decline in investment spending and reduced capital, the aggregate price level also declines significantly.
- In the short run, a contractionary monetary policy leads to an increase in interest rates, a reduction in the aggregate price levels, and an equal decline in the real GDP. This effect can be mirrored in a diagram, as shown in Figures 2 and 3.
Explanation: As shown in Figure 2, a contractionary monetary policy causes a decline in price levels from P0 to P1 and a decline in real GDP from Y to Y1.
Explanation: A contractionary policy leads to a decline in the money supply. This decline leads to an increase in interest rates from I0 to I1, as shown in figure 3.
- Similar to the short run, a contractionary monetary policy leads to a decrease in aggregate price levels and interest rates in the long run. However, the monetary contraction lacks a significant effect on the real GDP in the long run. Instead, in the long run, the real GDP returns to full employment where the unemployment rate and natural rate of unemployment are equal.
- Based on the above analysis, it is evident that the contraction of the money supply in the long run only causes changes in price levels and interest rates. Conversely, the real GDP, in the long run, remains unchanged.
- Variable costs in the Fitness AC consists of costs that vary depending on the service that the firm offers. On the other hand, revenue in such a facility consists of income generated from its day-to-day activities, such as the fitness membership fee paid by the firm’s clients. If the firm shuts down temporarily, it may minimize the variable costs but still incur the fixed costs such as the rental fee and the costs incurred to purchase the equipment. Nevertheless, the firm can remain in operations if it makes enough revenue to cover the variable costs.
- When losses persist in the long run, a competitive firm should implement a shutdown. The firm should base this decision mainly on the fact that the revenue cannot cover the firm’s variable costs. Furthermore, rental contracts might likely have expired in the long run, thus enabling the firm to avoid the fixed costs.