Macroeconomic Literature Suggests Money Multiplier
Added on 2019-09-20
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1.Macroeconomic literature suggests money multiplier as the inverse reserverequirement ratio. For example, if the reserve ratio is 5% then the moneymultiplier will be 1/0.05 =20. Money multiplier plays an important role in banking system. Banks actuallyhold the fraction of reserve as the required reserve and lend out the excessreserve. Money multiplier is the key reason why the initial deposit leads to alarger increase in the money supply. In the real world the actual money multiplier is likely to be smaller thantheoretically calculated money multiplier. For example, for a 5% reserverequirement, then money multiplier is supposed to be 1/0.05=20 but in realworld the money multiplier is found to be less than 20. The calculation ofmoney multiplier is based on the assumption that what money banks lendsout, all will return. But it does not happen in reality. One of the primaryreason for the money multiplier in US smaller than the inverse of requiredreserve ratio is tax- a percentage of income is taken away as tax. The otherreason is import spending. For example, if the consumer spends more onimports then the money will not be in the economy rather it will move out ofthe economy.[ CITATION Tej17 \l 16393 ]In US the money multiplier is estimated as between 2 and 3- this is muchsmaller than theoretical calculated value of money multiplier. This isbecause in reality people usually hold considerable portion of their loan ascash. So, the cash hold by the public are not available to the bank system to
lend. As a consequence, the value of money multiplier comes down. [ CITATIONJam05 \l 16393 ]2.Depositing cash into checking account does not change the total moneysupply. For example, if we deposit $100 cash into checking account of BankA. Banks keep the deposit of the cash into the vault- it results a $100decrease in the money supply. We know that currency held by the bank isnot considered as the part of economy’s money supply. Due to the deposit of$100, the checking account component of money supply will be increasedby $100. Hence total money supply does not change. Moreover, Bank A willnot able to make any profit if it keeps all the money (that it receives) in thevault. It has to make loans to the public. [ CITATION Rob17 \l 16393 ]3.Money multiplier works in reverse manner also. If o If one individual writes a check and give to other, money supply in theeconomy will not change. For example, if individual X writes a check ofbank A and give it to Y, and if Y deposits the check into his bank B, thentotal money supply will not change. The reason is very simple. Theexpansion of one bank’s reserve (Bank B) will offset by the contraction ofthe reserve of other bank (Bank A) resulting no change in money supply.[ CITATION Jam05 \l 16393 ]
Part B 1.According to Keynesian view, the money wag rigidity that is inflexibilitytowards downward are the key reason behind involuntary unemployment.Keynes believe that money wage will not change in a sufficient way in theshort run to bring the economy in full employment level. It implies that dueto stickiness or rigidity of money wage, wage rate will not respond quicklyespecially towards the downward direction to restore the equilibrium at thefull employment level. Keynesian school of economics strongly advocatesthat aggregate demand has the greatest impact on real output andemployment in the short run but not on prices. Keynes argues that wageand prices are somewhat sticky- when demand falls the wages will notrespond in the similar manner. Since prices and wages reacts slowly withthe changes in the demand, it causes a shortage or surplus especially in theshort run. Prices and wages only have limited amount of flexibility but theimpact, as believed by Keynes is restricted only in the short run. Hebelieves what is true in the short run may not be true in the long run.[ CITATION Ala1 \l 16393 ]According to classical view, the long run supply curve is inelastic andvertical in nature. The key assumption of classical view is that the price andwage are flexible. And markets will be clear and efficient in the long run.The main idea of classical economists is without the government
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