1. Knowing what you know about the multiplier, why do you think that the Fed doe
ID: 1226229 • Letter: 1
Question
1. Knowing what you know about the multiplier, why do you think that the Fed doesn’t change the reserve rate as it changes these other listed money creation factors? (discount interest rate, bonds rate of interest, quantity of money).
2. Use the Quantity of Money Theory to discuss why money growth and inflation tend to be closely linked? (In our Discussion below you can see the why of Bernanke’s monetarist philosophy).
3. Was Ebenezer Scrooge (Charles Dickens’ famous book ~ in The Christmas Story, really a promoter of Economic Growth like all the rich like Gates and Buffet? Explain!
Explanation / Answer
A)THE RESERVE RATE
1)The multiplier effects describes how an increase in one economic activity leads to a much greater increase in economic output.In the baking system , money that gets deposited multiplies through the economy, going from depositor to borrower multiple times.For any change in bank reserves, the money supply will ultimately change by a multiple of that amount.
Now,the reserve ratio represents the fraction of a customer's deposit that a bank is required to withhold on reserve in their vault or on deposit with the central bank.For example,
With a 10%reserve requirement on net transaction accounts , a bank that experiences a net increase of $200 million in the deposits will be required to increase its reserves by $20million. The bank would be able to lend the remaining $180 million of deposits, resulting an increase of a bank credit.The increase in the deposits affects the money supply.There are two situations:-
a) Increasing the reserve rate reduces the volume of deposits and reduces the money stock thereby raising the cost of credit.
b)Decreasing the reserve rate leaves depositories initially with excess reserves, which can induce an expansion of bank credit and deposit levels with the decline in interest rates.
RESERVE RATES ARE NOT FREQUENTLY CHANGED:-
1)Because open market operations provide a much more precise tool for implementing monetary policy.When Fed purchses $10 million in securities for its own portfolio,it adds $10 miilion to bank reserves.
2)Also the impact of changes in reserve requirements is diffcicult to estimate as they potentially affect thousands of depository institutions in different ways depending upon instituitions depository base.
3)Changing in reserve rates will lead to changes in pricing schdules for some bank services,because some bank fees and credits are based on reserve requirement.
B) QUANTITY THEORY OF MONEY
The link between the volume of transactions and the quantity of money is expressed in the following equation known as QUANTITY EQUATION OF EXCHANGE:
MV=PT where,
M=Quantity of money
V=Trancaction velocity of money
P=Number of rupees exchanged per transaction
T=Total number of transaction per period
NOW from Transaction to Income were PT was replaced by PY so,
MV=PY where,
Y=the amount of output produced per year or GDP
V=income velocity of money
It defines velocity V as the ratio of PY(nominal GNP) and M(the nominal quantity of money). If we make the assumption that V remains constant , then the quantity equation is converted into hypothesis,viz., THE QUNATITY THEORY OF MONEY.
THUS, as soon we make the assumption that V=V(bar) a constant ,the qunatity equation becomes theory of determination of nominal GDP.Thus equation is,
MV(bar)=PY were V(bar) means a fixed value of V.In this case a change in the quantity of money(M) will cause an exact proportion of change in nominal GDP(PY).Thus, if V remains fixed , the quantity of money determines the money value of the economy's output,its nominal GDP.
Since real GDP remains constant in the short run when factor supplies remain fixed and technology remains unchanged,any chnage in the nominal GDP must represnt a change in the general proce level(P).Thus, the price level P is propotional to the money supply M.
Since the rate of inflation measures the percentage increase in the price level, the quantity theory is also a theory of the rate of inflation.The quantity equation expressed in percentage form,is,
%change in M+%change in V = %change in P+%change in Y.
In this equation the second term on both the left and right hand side is constant. So the growth in money supply determines the rate of inflation.Thus, the central bank has ultimate control over the price or rate of inflation.
If the central bank keeps money supply fixed, price will remain fixed but if it increases M very fast then P will rise quite rapidly, as seen under hyperinflation.
TO SUM UP,inflation is the rate of increase of price level.In an economy where GDP does not rise or fall, price level will be propotional to money supply according to quantity theory of money.More money simply raises prices.
C) EBENEZER SCROOGE-REALLY A PROMOTER OF ECONOMIC GROWTH??
In Charles Dicken's novel " A CHRISTMAS CAROL", Scrooge was a miser as he was always reluctant to spend any money.Although he earns a substantial income he used to live in cold, dark house, refuses any heat or light properly,and he eats a meagre food of gruel(watery porridge) as he refuses to buy expensive food. Throughout the book his behaviour was in unfavorable way, only at the end he was a transformed man and begins to spend lavishly on himself and others.
Lets consider the pre-reform and post-reform actions of Scrooge to make out his contribution to economic growth.
Pre-reform Scrooge spens very little and put his money in financial markets where funds were available for firms to build new factories and carry out research and development.
Post-reform Scrooge spens much more and save much less as he spend those funds on Bob-Cratchit's family.He contributed more to consumptions goods and fewer to investment goods.
THUS WE CAN CONCLUDE THAT,
Scrooge's reform caused economic growth yo slow down-by a liitle.Though the point is this, savers provide the funds that are indispensable for the investment spending that economic growth requires, and the only way to save is not to consume.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.