What effect does the increase of the money supply have on the nation's monetary policy aimed at stimulating growth and reducing unemployment?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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An increase in the money supply is an effect of monetary policy.  It is not something that affects monetary policy.  When a central bank like the Federal Reserve believes that unemployment is too high and growth is needed, it pursues monetary policies that will increase the money supply.

When unemployment is too high and an economy needs to grow, a central bank should increase the money supply.  To do this, it needs to engage in appropriate monetary policies.  There are three possible types of monetary policy that could be used (either singly or in combination) to try to reduce unemployment.  First, the central bank could reduce the reserve requirement.  This means that banks would be able to loan out more of their deposits and money supply would increase.  Second, the central bank could reduce interest rates.  This would make it cheaper for people and firms to borrow money.  More borrowing means a larger money supply.  Finally, the central bank could buy government securities in open market operations.  This would mean that banks would have more money (because the central bank paid them for the government securities) and the money supply would increase.

With an increased money supply, borrowing is cheaper and easier.  This allows more economic activity to occur.  When more economic activity occurs, unemployment should decline.