Question

The general public perceives a possibility of bankruptcy in banks (in the absence of deposit insurance) because of the surge of bad debts.

(a) How will the money multiplier and money supply be affected? Briefly explain.

(b) Use diagrams to describe how the LM curve will be affected. Please indicate the

money-market equilibrium interest rate and output clearly in your diagram.

Answer 1

(a)

If public fears banks to go bankrupt, they will keep more of their money as cash with them, instead of keeping it as deposit in bank. Therefore, cash drainage ratio will increase, which will decrease money multipler. Lower money multiplier will decrease money supply, ceteris paribus.

(b)

Lower money supply will shift money supply curve to left, increasing interest rate.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. Lower money supply shifts MS0 leftward to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money M1.

Decrease in money supply will shift LM curve left, increasing interest rate and decreasing output.

In following graph, IS0 and LM0 are initial IS and LM curves, intersecting at point A with initial interest rate r0 and output Y0. Lower money supply shifts LM0 leftward to LM1, intersecting IS0 at point B with higher interest rate r1 and lower output Y1.