What is Monetary Theory

Monetary theory holds that change in money supply is the main driver in changes in economic activity. When monetary theory works in practice, central banks, which control the levers of monetary policy, can exert much power over economic growth rates.

BREAKING DOWN Monetary Theory

According to monetary theory, if a nation's supply of money increases, economic activity will increase; the reverse is also true. Monetary theory is governed by a simple formula, MV = PQ, where M is the money supply, V is the velocity (number of times per year the average dollar is spent), P is the price of goods and services, and Q is the quantity of goods and services. Assuming constant V, when M is increased, either P, Q or both P and Q rise. General price levels tend to rise more than the production of goods and services when the economy is closer to full employment. When there is slack in the economy, Q will increase at a faster rate than P under monetary theory.

In many developing economies, monetary theory is controlled by the central government, which may also be conducting most of the monetary policy decisions. In the U.S., the Federal Reserve Board ("Fed") sets monetary policy without government intervention. The Federal Reserve operates on a monetary theory that focuses on maintaining stable prices (low inflation), promoting full employment and achieving steady growth in the gross domestic product (GDP). The idea is that markets function best when the economy follows a smooth course, with stable prices and adequate access to capital for corporations and individuals.

Controlling Money Supply

In the U.S. it is the job of the Federal Reserve Board to control the money supply. The Fed has three main levers: reserve ratio, discount rate and open market operations. The reserve ratio is the percentage of reserves a bank is required to hold against deposits. A decrease in the ratio enables banks to lend more, thereby increasing the supply of money. The discount rate is the interest rate that the Fed charges commercial banks that need to borrow additional reserves. A drop in the discount rate will encourage banks to borrow more from the Fed and therefore lend more to its customers. Open market operations consist of buying and selling government securities. Buying securities from large banks increases the supply of money while selling securities contracts money supply in the economy.