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What is a Monetary Theory?

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  • Written By: John Lister
  • Edited By: Kristen Osborne
  • Last Modified Date: 06 October 2018
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Monetary theory is one of the leading ideas in economics. It is based on the idea that the supply of money is linked closely to the performance of an economy. Belief in monetary theory often leads to monetary policies designed to control the supply of money.

The money supply consists of all the money available in a country's economy. This is usually taken to mean the total of the actual cash in circulation, plus the money in bank accounts that can be withdrawn on demand. This effectively means the money supply covers everything that could be spent immediately.

It's largely, but not unanimously, accepted that the money supply affects inflation. This is because if more money is in circulation, businesses believe they can demand higher prices for their products and services. This puts average prices up and reduces the spending power of any fixed sum or money. Monetary theory holds that the money supply also affects other economic indicators such as production and employment.

There are several ways of turning monetary theory into policy. The most straightforward is to simply create money, whether literally printing it or through quantitative easing, which involves artificially increasing the central bank's balance and using it to buy assets from commercial banks, thus boosting the money they have available for lending. Both of these methods run a risk of creating inflation and overriding their own benefits.

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The more common implementation of monetary theory is the control of interest rates. The central bank can raise or lower the rates banks must pay to borrow money, which usually directly affects the rates they charge for loans to the public and businesses. The idea is that lower rates mean people have more money left over that they can then spend on goods and services, boosting the economy's performance. Interest rates can also be increased in an attempt to reduce the money supply and counter inflationary pressures.

Toward the end of the 20th century and into the 21st century, monetary theory became more widely questioned. One reason for this was that the previously close link between money supply and inflation appeared to be less consistent. Another was that in the United States, monetary policy was often regarded as having failed to stimulate the economy early in the 21st century. Economists are still debating whether these trends were caused by specific unusual events, or if the underlying monetary theory is flawed.

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