Consider a model of money supply. Suppose that in 2008, monetary base B is $100

Question

Consider a model of money supply. Suppose that in 2008, monetary base B is $100 billion, the reserve-deposit ratio rr is 0.005, and the currency-deposit ratio cr is 0.07.

(a) What would have happened to the money supply if the currency-deposit ratio had risen but the reserve-deposit ratio had remained the same? Explain.

(b) What would have happened to the money supply if the reserve-deposit ratio had risen but the currency-deposit ratio had remained the same? Explain.

(c) Which of the two changes in (a) and (b) was more responsible for the fall in the money supply? and why?

Explanation / Answer

The supply of money in any economy is very important. money supply has many crucial effects on the economic activities like production, distribution, consumption, price level, inflation, exchange rate etc.

Broadly every economy has three types of policies.

1.-Price policy

2.-Monetary policy

3.-Fiscal policy

here we are discussing the monetary policy because this question is related to the monetary policy.

first of all, we have to understand -what is the money supply

Money supply- money supply is the total amount of money which is in the circulation and in the existence in the county at a specific time.

money supply has many components- M0,M1,M2,M3,M4

for simple understanding money supply is the sum of -currency note+coin+demand deposits+othe deposits+........and so many items

To understand the impacts of the reserve-deposit ratio and currency-deposit ratio on the money supply we have to understand the basic concept of Deposit multiplier or money multiplier (denoted by K)

formula -K=1/r

k= multiplier

r= reserve ratio

meaning- K is the amount of money that a bank generate with each unit of money reserve.

in the question, the initial monetary base is the 100 billion US dollar.

let's see the impacts.

(A) if the currency-deposit ratio had risen but the reserve-deposit ratio had remained the same that means the banks have to hold more money in form of cash with themselves. which can not be used by the banks for granting loans to the public or companies.

thus money supply will decline in the market because banks have to hold in form of cash.

Higher the currency deposit ratio lower the cash balance with the banks for granting or advancing loans.

(B) Reserve-deposits ratio means the amount or money deposit which have to deposit with the central bank by the commercial banks.it is also called cash reserve ratio.

if the rate of CRR increase means the higher amount of money has to deposit with the central bank.

and the result of it is that the less amount is available to the bank for granting and advancing loans and this will decrease the money supply in the economy.

(c) Both ratios are in the form of the reserve in which the money is blocked with the bank and is not used for the further lending and investment purposes.

usually, the currency deposit ratio is the higher than the reserve deposit ratio and bank do not get any interest on these deposits.

so currency deposit ratio is more responsible for the fall in the money supply.....

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.