Question

Consider a closed economy’s money market.

a) Briefly define money supply and explain the measures of M1 and M2. What is a reserve requirement? Write down the formula for the money multiplier.

b) Write down the formula associated with the quantity theory of money. Define all variables and comment how a 10% decrease in money supply would affect the economy using this theory. As a result, how much would the economy’s real GDP change?

Answer 1

A. Money supply: supply of money is a stock concept. It refers to the total stock of money held by the people of a country at a point of time. The supply of money only includes stock of money held with people who demand money, not by those who supply money, such as governments and banks.

According to M1 measurement, money supply includes the following:

1. Currency held by the public, coins as well as paper notes.

2. Demand deposits: these are chequeable deposits of the people held by the banks which can be withdrawn or transferred on demand.

3. Other deposits: demand deposits with central banks of public financial institutions, foreign central banks and governments and international financial institutions.

M2 measurement of money supply:

It consists of M1 measurement and deposits with post office saving bank accounts.

Reserve requirement: it refers to the amount of money banks need to keep with themselves. It is usually a percentage of the deposits liabilities of the commercial banks.

Money multiplier formula: 1/r. r here refers to the reserve ratio. It can also be called as the reserve requirement percentage that the banks need to obtain.

B. The formula for Quantity Theory of money:

MV = PT where

M = total amount of money in the economy

V = velocity of circulation of money

P = general price level in the economy

T = total index of physical volume of transactions

A 10% decrease in money supply will reduce the velocity of circulation of money in the economy, there will be contraction of aggregate demand and thus the gdp will reduce.

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