UGB 109 Economics Report: Elasticity, Money Creation Analysis

This economics report delves into key macroeconomic and microeconomic concepts. It begins by explaining and calculating three types of elasticity: price, income, and cross elasticity, followed by a critical evaluation of their usefulness in business decision-making. The report then transitions to macroeconomics, detailing the process of money creation by commercial banks through lending and the measures implemented by central banks to control the money supply. The report uses examples and formulas to illustrate the concepts, providing a comprehensive overview of elasticity and monetary policy. The report is based on the UGB 109 Economics module and is designed to fulfill the requirements of an alternative assessment, covering both microeconomic and macroeconomic principles.

Economics

TABLE OF CONTENTS
INTRODUCTION......................................................................................................................3
MAIN BODY.............................................................................................................................3
CONCLUSION..........................................................................................................................7
REFERENCES...........................................................................................................................9

INTRODUCTION
Economics is the study of mankind in an ordinary business life. It is concerned with
the production, distribution and consumption of goods and services. It studies how the
businesses, individuals and the nation as a whole makes choices on allocating resource in
order to satisfy their needs and wants. Economics is divided into two, microeconomics and
macroeconomics. Microeconomics focuses on the individual consumers and businesses
whereas macroeconomics focuses on the aggregate economy as a whole. This report presents
about the different types of elasticity and its usefulness. It also covers how commercial bank
creates money and the measures taken by central bank to limit its ability.
MAIN BODY
1.
a) Different types of elasticity in economics
The quantity of the product demanded per units is dependent upon the various factors
such as price of the commodity, price of the related goods, taste and preference of the people
etc. Any change in these factors will bring change in the quantity of product purchased over a
specific period. In economics, elasticity refers to the change in the demand and supply of the
product with respect to change in consumer income or price of the product. The three main
types of elasticity are stated below.
Price Elasticity of Demand
The price elasticity of demand refers to the degree of responsiveness of quantity
demanded to change in relation to change in price (Slater, 2018). In other terms, it is the
proportion of change in quantity demanded of the product caused by the given proportionate
change in the price of the product.
The formula for calculating price elasticity of demand is
Price elasticity of demand = % change in the quantity demanded / % change in price
Ed = Δq X P
Δp Q
For example, the price of the good fall from £10 per unit to £9 per unit. The decline in price
has led to the increase in demand from 125 units to 150 units. The price elasticity will be
calculated as:
Δq = 150-125= 25
Δp = 10-9= 1
Original quantity = 125
Original price = 10
Ed = 25/1*10/125 = 2
The elasticity of demand is greater than 1 which means demand for good is elastic.

Types:
The price elasticity of demand is divided into three groups.
1. Elastic: In case, when the percentage change in the quantity of the good is greater
than the percentage change in its price, then the demand is called elastic. The
elasticity of demand is more than 1, the fall in price leads to increase in revenue
(expenditure) and the increase in price will lower the total revenue (expenditure).
2. Unitary elasticity: This happens when the percentage change in quantity demanded
equals the percentage change in the price, then the elasticity is said to be unitary or 1.
3. Inelastic: In this, the percentage change in quantity demanded is less than the
percentage change in price, the demand is said to be inelastic or less than 1.
Income Elasticity of Demand
It explains that when there is a change in the level of the income of the consumers,
there is a change in the demand of the good, making other factors constant (Ghoddusi and
Roy, 2018). The degree of responsiveness of quantity demanded with change in income is
known as income elasticity of demand.
The formula for calculating it is
Ey = Percentage Change in Demand
Percentage Change in Income
Ey = Δq X P
Δp Q
For example, income of the person is £4000 per month and use to purchase 6 CDs every
month. If the income increases to £6000 per month and demand for CDs increased to 8. The
elasticity of demand will be:
Δq = 8 - 6 = 2
Δp = $6000 - $4000 = $2000
Original quantity demanded = 6
Original income = $4000
Ey = 2 / 2000 x 4000 / 6 = 0.66
The income elasticity of demand is less than 1.
Types:
When the income of the person changes, the demand for the good also changes which
depends upon whether the good is normal or inferior. In case of normal goods, the value f
elasticity is more than 0 but less than 1. For inferior goods, income elasticity is less than 1.
Cross Elasticity of Demand

The cross elasticity of demand is used for measuring the degree of responsiveness of
change in the demand of the good in relation to change in the price of the related goods
(Andruszkiewicz and et.al, 2018).
It is calculated as follows-
Exy = % Change in Quantity Demanded of Good X
% Change in Price of Good Y
The numerical value depends upon the whether the two goods are substitutes or
complimentary to each other or unrelated.
Types
1. Substitute goods: Two goods like Coke and Pepsi are substitute of each other. An
increase in price of one will lead to the increase in demand of other. The numerical
value is positive. For example, if there is an increase in price of Pepsi called good Y
by 10% and there is an increase in demand of Coke called good X by 5%, the cross
elasticity of demand will be Exy = 5% / 10% = 0.5, since the value is positive, it means
Coke and Pepsi are close substitutes.
2. Complementary goods: In case of complementary goods like bat and ball, a rise in
price of one will lead to fall in demand of another. For instance, 7% rise in price of
bat has cause 6% fall in demand of ball. Thus, cross elasticity of demand is Exy = 6% /
7% = -0.85.
3. Unrelated goods: It refers to the goods which are not related to each other. The
change in the price of apple will unlikely to affect the demand of pens. Therefore, the
elasticity is zero.
b) Critical evaluation of usefulness of the elasticities
Price Elasticity of Demand
It is used by the business firms because it helps in predicting the effect f change in
price in relation to the total revenue and expenditure of the good. It is important for
predicting the effect of price volatility following the change in the supply. It is crucial for
producers as they may suffer huge price movement during different intervals of time. The
firm can also use it to predict the effect of change in indirect tax on the price and quantity and
whether the firm is able to pass on some of the tax on the consumers (Guirguis, M., 2019). It
will be very useful in case business is planning a promotional discount would like to know
how responsive the demand of the customer will be in respect to the pricing tactic used. In
contrast to it, it is important to understand that the price elasticity of demand is just an
estimate which might change over time. Also, with the change in market, customers become
more or less sensitive to price. The methods of distribution, change in taste and preferences
of customers and so forth will affect the elasticity as these factors can influence the demand
and the firm should act accordingly.
Income Elasticity of Demand
The knowledge and understanding of income elasticity of demand will help the firms
in predicting the effect of economic cycle on the sales. Luxury products have high elasticity
and sees a greater sales volatility than necessities as the demand is less sensitive to business
cycle. It helps the firms in sales forecasting and also helps in deciding the pricing policy

(Hummels and Lee, 2018). It helps the firm in deciding whether to increase or decrease the
price with respect to change in the consumers income. If the income is falling and elasticity is
positive, which means that reduction price can help business to compensate for the reduction
in demand. The major limitation of income elasticity of demand is that it will change for
different consumers and it is not possible to measure the change in the consumer’s income
individually.
Cross Elasticity of Demand
The cross elasticity of demand can be used by the business entities in predicting the
future demand of the product with having a little idea about the probable future prices of the
substitute or complementary goods. It helps in classifying market. Higher the value of cross
elasticity of demand, greater is the competition in the market and the lower the value, less
competitive is the market. In the same way, if elasticity is zero or near to zero, that means
there is monopoly or zero competition in the market (Bems and Johnson, 2017). Price of the
one product will affect the price of another product in case of related goods. That is why, the
large businesses which are producing more than one product must use cross price elasticity to
evaluate each of the products in order to effectively price it. This kind of information can
help the businesses in reducing the exposure to the financial risk. The major drawback of it is
that it takes into consideration only two goods at a time.
3.
a) How commercial bank creates money?
Most of the money in the economy is created by banks which is in the form of bank
deposits, which is the number that appears in the account. The bank creates new money
whenever they make a loan. Approximately, 97% of the money made in the economy today
exists because of bank deposits while just 3% is the bank deposits. The money that is created
is not the paper money owned by Bank of England, it is the electronic form of money deposit
and that 97% is this form of money (Rodríguez, 2017). Every new loan that bank makes
creates new money. It is hard to believe but in March 2014, Bank of England released a
report which states about the “Money creation in the Modern Economy”. The commercial
banks mainly create money in the form of deposits and by making new loans. The principle
way of creating money is through commercial banks making new money. Whenever the
commercial banks make a loan, it creates a deposit in the borrower’s account, thus, it creates
new money. For example, when a bank makes a loan like someone taking out a mortgage
with the purpose to buy the house, the bank des not give them directly thousands of pounds of
banknotes but credits the borrower’s account with the bank deposit of the same amount. At
this moment, new money is created. Because of this reason, economist are of the view that
bank deposits should be referred to as ‘fountain pen money’ as money is created at the stroke
of bankers pen when they approve the loan.
Through this way of creating money banks have increased the amount of money flow
in the economy by an average of 11.5% a year in the last 40 years (Botos, 2016). But there is
another side of it as well. With the creation of money, there is creation of new debt as well
which is created out of nothing by the banks and eventually leads to increase in the debt
burden which becomes too high that may cause financial crisis. In short, money exist in the
bank as bank deposits- IOUs of commercial banks and is created through some simple

accounting at the time when ban makes a loan. Thus, this is how money is created in the
commercial banks.
b) Measures used by the Central Banks to limit money creation
Central bank is the heart of the economy as it pumps money in the economy with the
purpose of keeping it healthy and growing. The measures used by central banks to control the
quantity of money flow varies as it depends upon the economic situations and the powers of
the central bank. In doing this, it quantity of money circulating in the economy matters (Kim,
Sohn and Sung, 2018). At the micro level, if there is a large supply of money in the market it
means that there will be more spending by the people and businesses as they will easily get
loans for various needs and businesses can easily secure finances too. At the macroeconomic
level, the amount of money circulating in the economy will affect the gross domestic product
(GDP), overall growth rate of the country, interest rate and unemployment rates as well. The
Central bank plays a key role in controlling the quantity of money circulating in order to
achieve the economic objectives. Measures used by Central bank are stated below.
Setting reserve requirement: This is one of the basic methods, used by the banks for
controlling quantity of money in an economy. According to it, the central bank mandates the
depository institutions to keep aside a certain amount or percentage of funds in reserve with
respect to the amount deposited by the customer. The amount that is set aside is always kept
as back up and never used in circulation. For example, central bank has set 9% reserve
requirements, if the commercial bank gets the deposits of £100 million, then it is required to
set aside £9 million and can put £91 million in circulation. If the bank intends to circulate
more money in the economy it can reduce the reserve rate which means bank can lend more
money. In the opposite situation it can increase the reserve rate in order to reduce the money
supply in the economy.
Interest rates: The Central bank cannot directly set the interest rate but it can use
certain tools to influence the interest rate. For instance, the central bank holds the power to
the policy rate, which is the rate at which commercial banks borrow money from the Central
Bank (BAJPAI, 2020). When the bank gets the money at the lower rate, they pass on the
benefit by reducing the loan rates to its customers. In the other case, when the rate of
borrowing is high then it will lead to increase in loan rates to the customers. This limits the
money creation of the bank.
Open market operations: Central Bank can control the money supply by buying and
selling the government securities through the open market operations. It purchases
government securities from the commercial bank and institutions in order to increase the
circulation of money. This frees up the bank assets and Central bank do this type spending for
easing the monetary policy and bringing down the interest rate in the economy. The opposite
happens when it needs to remove or reduce the money from the system.
CONCLUSION
It can be summarized from the above that the elasticity plays an important role and
helps the businesses in making predictions. These estimations and predictions help the
business entities in taking relevant business decisions and also it is very easy to calculate the
elasticities. The commercial banks mainly create money through deposits and when it makes
loan. It is completely dependent upon the bank with respect to how much money should be

created. The various measures such as reserve requirements, interest rates and open market
operations can be used by the Central bank to exercise control over the money supply in the
economy.

REFERENCES
Books and Journals
Andruszkiewicz, J. and et.al, 2018, June. Household price elasticity of demand as a tool for
tariff system design leading to increase of electricity use for space heating purposes.
In 2018 15th International Conference on the European Energy Market (EEM) (pp. 1-
5). IEEE.
Bems, R. and Johnson, R. C., 2017. Demand for value added and value-added exchange
rates. American Economic Journal: Macroeconomics. 9(4). pp.45-90.
Botos, K., 2016. Money Creation in the Modern Economy. Public Finance Quarterly. 61(4).
p.442.
Ghoddusi, H. and Roy, M., 2018. Income Elasticity of Demand Versus Income Elasticity of
Consumption. Available at SSRN 3122844.
Guirguis, M., 2019. Price Elasticity of Demand and Supply, Income Elasticity, Direct and
Indirect Taxation, and Economic Fairness. Income Elasticity, Direct and Indirect
Taxation, and Economic Fairness (March 13, 2019).
Hummels, D. and Lee, K. Y., 2018. The income elasticity of import demand: Micro evidence
and an application. Journal of International Economics. 113. pp.20-34.
Kim, M., Sohn, W. and Sung, B. M., 2018. The Effects of Central Banks’ Rate Change
Patterns on Financial Market Variables. Global Economic Review. 47(3). pp.311-336.
Rodríguez, P. A., 2017. Money creation by commercial banks (Doctoral dissertation,
uniwien).
Slater, J., 2018. Teaching Price Elasticity of Demand. Teaching Business &
Economics. 22(1). pp.12-13.
Online
BAJPAI, P., 2020. How Central Banks Control the Supply of Money. [Online]. Available
Through:< https://www.investopedia.com/articles/investing/053115/how-central-banks-
control-supply-money.asp>.