Question

Question 1: Elaborate with an example that how commercial banks create money under fractional-reserve banking. Elaborate the tools used by Central bank of a country to increase and decrease the money supply.

Question 2: Based on the material of the chapter “ money growth and inflation” of your text book explain how inflation starts in an economy? Why multinational companies feel unsafe to invest in those countries that have high inflation rate? Write your answer the light of your text book materials.

Question 3: In the light of Purchasing-Power Parity theory explain how inflation rate a county affects its nominal exchange rate?

Question 4: Explain why and how net exports and net capital flow are related to each other. Does trade deficit necessarily create trouble for a county’s economic growth? Discuss.

Answer 1

Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, most of the money supply is in the form of bank deposits. Central banks monitor the amount of money in the economy by measuring the so-called monetary aggregates.

For example, in the United States, money supply measured as M2 grew from $6.407 trillion in January 2005, to 18.136 trillion in January 2009.

When commercial banks lend out money, they are expanding the amount of bank deposits.The modern banking system can expand the money supply of a country beyond the amount created or targeted by the central bank, creating most of the broad money in the system through fractional-reserve banking.

Banks are limited in the total amount they can loan by their capital adequacy ratios, and their required reserve ratios. The required-reserves ratio obliges the bank to keep a minimum, predetermined, percentage of their deposits at an account at the central bank. The theory holds that, in a system of fractional-reserve banking, where banks ordinarily keep only a fraction of their deposits in reserves, an initial bank loan creates more money than is initially lent out.

The maximum ratio of loans to deposits is the required-reserve ratio {\displaystyle {\mathit {RRR}}}, which is determined by the central bank, as

{\displaystyle {\mathit {RRR}}={\frac {R}{D}}}

where {\displaystyle R} are reserves and {\displaystyle D} are deposits.

In practice, if the central bank imposes a required reserve ratio ({\displaystyle {\mathit {RRR}}}) of 0.10, then each commercial bank is obliged to keep at least 10% of its total deposits as reserves, i.e. in the account it has at the central bank.

The process of money creation can be illustrated with the following example in the United States: Corporation A deposits $100,000 into Bank of America. Bank of America keeps $10,000 as reserves at the Federal Reserve. To make a profit, Bank of America loans the remaining $90,000 to the federal government. The government spends the $90,000 by buying something from corporation B. B deposits the $90,000 into its account with Wells Fargo. Wells Fargo keeps $9,000 as reserves at the Federal Reserve, and then lends the remaining $81,000 to the government. If this chain continues indefinitely then, in the end, an amount approximating $1,000,000 has gone into circulation and has therefore become part of the total money supply.

Furthermore, the Federal Reserve itself can and does lend money to banks as well as to the federal government. There is currently neither an explanation on where the money comes from to pay the interest on all these loans, nor is there an explanation as to how the United States Department of the Treasury manages default on said loans (see Lehman Brothers). A negative supply of money is predicted to occur in the event that all loans are repaid at the same time.

The ratio of the total money added to the money supply (in this case, $1,000,000) to the total money added originally in the monetary base (in this case, $100,000) is the money multiplier. In this context, the money multiplier relates changes in the monetary base, which is the sum of bank reserves and issued currency, to changes in the money supply.

If changes in the monetary base cause a change in the money supply, then

{\displaystyle M_{1}={\mathit {MB}}\cdot m\,}

where {\displaystyle M_{1}} is the new money supply, {\displaystyle {\mathit {MB}}} is the monetary base, and {\displaystyle m\,} is the money multiplier. Therefore, the money multiplier is

{\displaystyle m={\frac {M_{1}}{\mathit {MB}}}\leq {\frac {1}{\mathit {RRR}}}}

The central bank can control the money supply, according to this theory, by controlling the monetary base as long as the money multiplier is limited by the required reserve ratio.

Inflation is a measure of the rate of rising prices of goods and services in an economy. Inflation can occur when prices rise due to increases in production costs, such as raw materials and wages. A surge in demand for products and services can cause inflation as consumers are willing to pay more for the product

Inflation is a measure of the rate of rising prices of goods and services in an economy. Inflation can occur when prices rise due to increases in production costs, such as raw materials and wages. A surge in demand for products and services can cause inflation as consumers are willing to pay more for the product

Some of the factors of inflation are:

• Inflation is a measure of the rate of rising prices of goods and services in an economy.
• Inflation can occur when prices rise due to increases in production costs, such as raw materials and wages.
• A surge in demand for products and services can cause inflation as consumers are willing to pay more for the product.
• Some companies reap the rewards of inflation if they can charge more for their products as a result of the high demand for their goods The relative price of goods is linked to the exchange rate through the theory of purchasing power parity. As illustrated, PPP tells us that if a country has a relatively high inflation rate, then the value of its currency should decline.The theory of purchasing power parity (PPP) states that the ratio of price levels between two countries is equal to their exchange rate. ... Inflation, the general increase in prices, is inversely related to exchange rates: as one goes up, the other must go down to maintain equilibrium.

A trade deficit also referred to as net exports, is an economic condition that occurs when a country is importing more goods than it is exporting. The trade deficit is calculated by taking the value of goods being imported and subtracting it by the value of goods being exported.