In this chapter we are going to look at the special role that money plays in the economy. Changes in the amount of money can have a powerful effect on all the major macroeconomic indicators, such as inflation, unemployment, economic growth, interest rates, exchange rates and the balance of payments.
But why do changes in the money supply affect the economy? The answer is that the supply of money and the demand for money between them determine the rate of interest, and this has a crucial impact on aggregate demand and the performance of the economy generally.
First we define what is meant by money (not as easy as it may seem), and examine its functions. Then in Sections 9.2 and 9.3 we look at the operation of the financial sector of the economy and its role in determining the supply of money.
We then turn to look at the demand for money. Here we are not asking how much money people would like. The answer to that would probably be ‘as much as possible’! What we are asking is: how much of people’s assets do they want to hold in the form of money?
Then, in Section 9.5, we put supply and demand together to show how interest rates are determined. Finally, we examine how money supply and interest rates are controlled by the authorities and the effect this has on the economy. In other words, we examine monetary policy: how it operates and how effective it is.
