Question

1. Answer all parts (a) – (c) of this question.

1. [8 marks] In the context of the money multiplier explain how lending activity of banks is related to the money supply of an economy. How can the central bank of a given economy control the money supply?
2. [9 marks] “Inflation is always and everywhere a monetary phenomenon”. Provide an economic explanation for that statement. Is the statement more likely to be true in the long-run, in the short-run, or in both? Explain.
3. [8 marks] Suppose that the central bank announces a new quantitative easing programme for the future, where money supply will be permanently increased. What should happen to the price level today as a result of that announcement? Explain.   

Answer 1

a) Money multiplier = 1 / Required Reserve requiement

Required Reserve requiement is the proportion of every deposit which bank keep it with themselves and lend rest of the money. If banks keep Required Reserve requiement as low, they will lend more money in the economy which raise money supply.

Central bank control money supply through open market operations. They can issue bonds and government securities and sell it to public in exchange of cash when they wants to reduce money supply from the economy. To raise money supply, they buy bonds and securities from market and give them money in exchange of it.

b) This statement implies that inflation occurs due to rise in money supply than in rise in output. It is likely to be true in short run because in long run government or Fed will take necessary actions or counter policies such that inflation rate is at its natural level. Assume Fed raised moeny supply which shifted LM curve to its right from LM to LM1 which reduces rate of interest from "r" to "r1" and raise output level from Y to Y1. Rise in money supply will give more money in the hands of public which tends to raise willingness to pay by customers and eventually raise aggregate demand. A rise in aggregate demand in long run will induce government to adopt recessionary fiscal policy which tends to reduce government spending and raise ta such that it reduce aggregate demand in the econony and shift IS curve backward.

c) If money supply is to rise in future which will reduce rate of interest. Investors will stop investing on new investments and wait till interest rate are lowered. Fall in investment will reduce aggregate demand in the economy which tends to reduce aggregate price level today.