Money supply and demand // the equations that drive economic stability

It involves manipulating interest rates and the money supply to achieve macroeconomic objectives, such as controlling inflation, stabilizing the currency, and promoting economic growth. Maintaining stable prices is the primary goal, and it sometimes helps boost the economy and create jobs.

Through tools such as interest rates, the buying and selling of government bonds, and setting reserve requirements, its aim is to manage the amount of money available in the economy. In this way, the link between the money supply and the demand for money becomes the balancing point that keeps the overall economic picture stable.

The money supply (M) is primarily determined by the central bank and the banking system, by creating money in a broad sense. A simple way to grasp the essence is:

M = m×MB

When discussing money, M is equal to the money multiplier times the monetary base, M = Mb * m. This mechanism shows how credit and financial intermediation can increase or decrease the amount of liquidity in an economy.

On the other hand, the demand for cash (L) is shaped by factors such as the amount of income people earn, the cost of borrowing money, and what people expect to happen in the economy. The Keynesian formulation can be expressed as:

L = L1​(Y) + L2​(i)

Where the demand for money is positively related to income (y) and negatively related to the interest rate (i). In simpler terms, when people have more money, they are willing to spend more on goods; but when interest rates rise, they are less interested in holding cash and more interested in investments that earn money.

When the supply and demand for cash are in perfect balance, monetary equilibrium occurs.

M = L(Y,i)

This point determines the equilibrium interest rate in the money market, which directly affects investment and, as a result, the level of economic activity. An expansionary monetary policy, meaning pumping more money into the economy, lowers interest rates, encouraging people to invest; on the other hand, a contractionary policy aims to adjust the money supply, limiting credit.
The key point here is that monetary policy is the primary tool for managing the overall state of the economy, where cash flow, its availability, and people's spending habits all interact in a constantly shifting balance.

Understanding the central bank's decisions and their effects allows us to analyze how these choices influence spending, investment, and the overall health of the economy. In a world where things are highly unpredictable, having sound monetary policy is crucial for maintaining economic stability and avoiding constant cycles of crisis.