Dynamics of Money Market and Monetary Policy

Abstract

Objective: Contemporary research on monetary policy does not account for the loss/gain in efficiency during the adjustment of the market and the after-policy vis-a-vis pre-policy equilibrium in the money market. After a central bank exercises a monetary policy, the central bank’s cost as a supplier of money rises to pre-policy cost plus the per unit money cost incurred due to monetary policy, which affects money supply and pushes the money market out of equilibrium. Demand and supply of money along with the interest rate follow certain adjustment mechanism until the final equilibrium arrives. The basis of adjustment is lack of coordination regarding decisions of consumers and suppliers of money at the prevailing interest rate. For the design of an optimal monetary policy, efficiency considerations both during the adjustment of the market as well as in final equilibrium are important to be taken care of. This research designs a dynamic money market model and derives an optimal monetary policy. Methods: A perfectly competitive money market with five agents has been modeled. The equations maximizing their objectives have been derived and solved simultaneously to solve the model. An optimal monetary policy has been derived by minimizing the objective function of efficiency loss, i.e., supply or consumption of money lost in post-policy equilibrium vis-a-vis the pre-policy one, and the loss during the time market is adjusting subject to central bank’s cost constraint. Results: Derived mathematical expressions outline the optimal expansionary and contractionary monetary policies considering the adjustments in demand and supply over time. Conclusion: The expressions are functions of demand, supply, and inventory curves’ slopes as well as initial pre-policy equilibrium quantity of funds.