Money Market, Budgeting and Monetary Policy-Making

Money multiplier vs. income-expenditure multiplier

Money multiplier measures the extent to which credit creation by the commercial banks leads to the growth of money supply over and above the monetary base. For example, a money multiplier of 5 implies that a $1 increase in the monetary base will give rise to A $10 increase in money supply (Kaplan, 2003). On the other hand, income-expenditure multiplier refers to how the economy responds to changes in private and public expenditures.

Interest rate vs. exchange rate

Interest rate is the cost of capital that an individual borrower will pay for a specific loan amount over a given period of time. On the other hand exchange rate refers to the value of the Australian currency expressed in terms of the American dollar.

The supply-side shocks vs. demand-side shocks

Shocks refer to disturbances that may originate either from within a country or externally or from without. Supply shocks are those factors that cause unforeseen changes in the aggregate supply, for instance increase in the international oil prices. While demand-side shocks refer to factors that impact on the countrys aggregate demand, for example inflation in the local economy.

A trade deficit vs. the budget deficit

A country is said to be suffering from a trade deficit if the volume of its exports far outweigh the volume of imports such that the net exports (Exports-imports ) are negative. On the other hand, a budget deficit refers a situation where the total government expenditure exceeds the total revenue such that the government will have to fiancé the excess part by borrowing either from the domestic market or the international market.

Effects of a rise in the money supply on the money market

IS-LM Model.
Figure: IS-LM Model.

Equilibrium in the money market is attained at the point where the LM intersects the IS curve, point P. When the central bank increases money supply in the economy, the LM curve shifts outward from LM0 to LM1. Because more money is now available in the economy the interest rate charged on loans will reduce from the original i0 to i1 and the economy reaches a new equilibrium O. with the low interest rate, the citizens prefer to hold more of their money in cash than invest in government bonds and securities. The low interest will equals encourage private investments because individuals can borrow and undertake private investments, with more investments the economy expands, output increases from Q0 to Q1 and more jobs are created (Krugman, 2009).

Budget deficits today mean tax rises in the future

A country whose budget exceeds the revenue sources will have to finance the deficit either by borrowing internally or from the international market. These debts will ultimately be paid from the public coffers and because interest accrues on them year after year and governments borrow more money, the level of debt keeps rising (Krugman, 2009). This therefore implies that the citizens will have to be taxed more in order for the government to repay the principal amount plus the accumulated interest.

Flexible exchange rates and their benefits for monetary policy-making

Under a foliating exchange rate system, the market forces of demand and supply determine the exchange rate, and it fluctuates depending on the prevailing market conditions. To illustrate why a nation with a flexible exchange arête need not worry of its B.O.P, let’s take the example of trade between Australia and Japan. The Japanese will have to purchase the dollar using yen if they want to import goods and services from Australia or undertake any other investment in Australia. This implies that Japans demand for dollars is reflected in their supply of yen and Australia’s demand for yen is reflected in their supply of the dollar.

In other words, transactions taking place in the foreign exchange market reflect the volume of international trade and other financial transactions summarized in the balance of payment accounts. The desired results are therefore achieved automatically without government intervention (McGregor, 2011). Under a floating exchange rate addition, the monetary authorities are in a better position to implement policies that enhance macroeconomic stability for example during inflation, the central bank with the objective of reducing inflation in the short run.


Kaplan, J. (2003). University of Colorado: ECON 2020 Course Notes; The banking system and the money multiplier.

Krugman, P. (2009). Macroeconomics. New York, NY: Worth Publishers.

Maslen, G. 2011. In the wake of the boom. Economic Review, 10(1), 34-46.

McGregor, L. (2011). Economic implications of floating exchange rates. Web.

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