The Money Multiplier - Essay Example

? Assignment Q1. Money multiplier is a measure of the extent to which money creation impacts the growth of money supply in the economy. If the money multiplier is 5, then each dollar increase in the monetary base will raise the money supply by $5; and vice versa if the monetary base falls. One of the tools of the central bank to influence the amount of money in circulation is via Open Market Operation (OMO), this comes under Fed’s monetary policy tools. This is an activity by a central bank to buy or sell government bonds to commercial banks and agents. It impacts the reserves held by banks and other institutions to lend money to corporations and households. On a larger scale, it affects the supply of reserves in the banking system, and thus the interest rates and overall growth in the economy. a) If central bank sells government bond, it takes money in exchange for the bonds. This reduces the reserves of private sector banks, and their capacity to make loans to households and corporations and thus cause money growth to decline through money multiplier mechanism. The central bank usually targets a certain level of bank reserves or a particular interest rate for these reserves. OMO allows Fed to affect the supply of reserve balances in the banking system and therefore influence short term interest rates. Given that Fed sold 1 million dollars’ worth of government securities, and that the money multiplier is 5. The reserves of banks and lending institutions to go down by $1 million, this money could have been used to give out loans worth $5 million (Amount X Multiplier). This is part of Fed’s tightened the monetary policy. The graph below shows how a change in the supply of money influences interest rates. The supply curve of money shows the quantity of money supplied, with all other things remaining constant. As the quantity of reserves is determined by the Fed’s monetary policy, the supply curve of money is assumed to be vertical line. As the Fed sells $1 million of government securities, it reduces the supply of money in the economy, thus shifting the supply curve to left from M to M’. Assuming all other things constant, this will raise the interest rates in the economy from r to r’. b) Now that we have established how the fall in money supply causes the interest rates to rise, we’ll proceed further to see how it impacts the economy at large. The components of GDP include: Consumption (C) Investment (I) Government Expenditure (G) Net exports (X - M) These components are easily influenced by changes in interest rates. When interest rates are high, people do not want to borrow money through loans as it is more expensive to repay. This reduces the demand for most of the products such as cars, new houses or house renovation, large appliances, luxury goods etc. which causes the overall consumption in the economy to fall. Businesses also avoid raising money for expansion or start up through loans because the interest rates are higher. Similar is the case for government borrowing. As interest rates increase, the foreign investment will tend to rise because foreigners will get a large return on their investment. This drives up the demand for dollar and causes exchange rate to rise. As exchange rates surge, our imports will become cheaper and their demand will rise; exports will be more expensive for foreigners, so their demand will fall. The graph below depicts how a change in the aggregate demand will impact price level and real GDP of the economy. The graph above shows a shift in aggregate demand curve from AD to AD’, it shows the impact on price level as prices have reduced from P to P’; the real GDP in the economy has fallen from Y to Y’. As we know that the demand for labor is a derived demand, that is, it is required only when a higher quantity of other goods is required. If the aggregate demand for goods and services in the economy goes down, a lower quantity of labor will be required to produce these goods. People who are willing and able to work will not find jobs, hence unemployment will increase. Answer 2 Questions 2a.) Graph and Explain the short and long run impact of expansionary fiscal policy on the aggregate economy and on the balance of the federal budget.  b.) Is there a tradeoff between unemployment and inflation? Answers Q2. a) Fiscal policy involves the use of government spending and taxation to affect the GDP of an economy over a period of time. It affects the level of aggregate demand in an economy and the economic activity. It can also be aimed at redistribution of income and wealth among the population and reallocation of resources between different sectors. An expansionary fiscal policy aims to increase the aggregate demand in an economy. It includes cutting down taxes (income tax, sales tax, corporation tax etc.) and increasing government spending on social goods and infrastructure, such as schools and hospitals. The graph below shows the impact of an expansionary fiscal policy. Originally the economy was operating at point A. Due to the expansionary fiscal policy, the aggregate demand curve shifts to the right from AD to AD’. In the short run output will expand from Y to Y’ and the price level rises from P to P to the point B’. As the economy is operating at a level beyond the long-run aggregate supply level, it now faces an inflationary gap, measured by the difference between Y’ and Y. Higher wages and input prices shift the SRAS supply curve to the left (SRAS to SRAS’) this situation will create an upward pressure on prices in the short run. An increase prices and input costs will bring the economy back to the long run output level of Y. So in the long run it affects prices only. The government has to finance its spending through revenues from taxation. In an expansionary fiscal policy, the government spending exceeds taxation; hence it leads to budget deficit. Government has to borrow the difference from public in order to fund its expenditures. Government borrowing may cause a fall in private sector investment because larger government demands will raise the interest rates, thus creating a crowding out effect. b) Inflation is the general and sustained rise in the general price level in the economy. Traditionally it has been the result of creation of excessive money without the increase in production of goods and services, raising the demand of goods too high or pushing the input costs too high, thus forcing the price level up. Unemployment is when people who are willing and able to work cannot find a job. It increases as the aggregate demand in the economy falls and less labor is required to produce goods and services. It is said that in the short-run, inflation and unemployment move in the opposite direction, because the policies and events that raise production and income tend to lower the unemployment but increase the price level and vice versa. An economist by the name of Phillips highlighted this relationship through a graph called the Phillips curve. 4a.)Explain what fiat money is and how it differs from commodity money. b.) What is one advantage and disadvantage of each of the above types? c.) Explain why money was invented in the first place. Answers Q4. a) Fiat money or paper money is the currency that a government of a country has declared to be legal tender, even though it has no intrinsic value of its own. The common characteristics of money are that it is a medium of exchange, durable, transportable, divisible, and difficult to counterfeit. It differs from commodity money in a number of ways because: 1. Commodity has a known value but fiat money is just a piece of paper with no value of its own except what the government has printed on it. 2. Commodity is higher in weight and large quantities of it is difficult to transport without making it known, whereas large quantities of fiat money can be exchanges and transferred without any physical exchange (online). 3. Commodity will have different worth for every person, whereas fiat money has a known value. 4. Commodities such as fruits and grains are perishable and not a reliable store of wealth, whereas money could be kept in banks for years and will not rot away. b) Fiat Money Advantage: It is a convenient measure of value and unit of account, as prices can be established for all goods and services for which it might be exchanged. Disadvantage Fiat money sometimes does not act as a store of value, especially in times of high inflation, when money loses its worth and becomes less valuable relative to goods. Commodity Money Advantage: Precious metals can be used as money because they can act as a medium of exchange, as people will accept them in exchange for goods and services. Disadvantage: Commodities usually have high value relative to its weight and can be indivisible for very cheap products such as one apple. c) Money was not always there to pay for goods and services, so people used to trade or exchange one good or service for another, this is called barter. An economy where such exchange of goods and services takes place is called barter economy. This exchange required that both the parties sell something that the other wants, this is known as double coincidence of wants. Furthermore people should have the commodity in the right quantity, as there will be a problem if the good is indivisible. One more major issue was that goods could not be stored safely so that they retain their value for future, especially if the goods are perishable such as milk or other food items. Last but not the least, in barter system it is difficult to determine the value of a good for example how many oranges can be exchanged for apples, and what if the size of each is different. So the barter did not allow products to have a common measure of value that would make transactions simple. All this required a common unit of exchange and a unit of account to facilitate transactions and exchange of goods and services. Read More