Question

1. i) Using the money multiplier theory, explain how money lent by banks is related to the money supply of an economy. How can the central bank of a given economy control the money supply?

ii) “Inflation is always and everywhere a monetary phenomenon”. Using economic knowledge, explain the statement. Explain whether this is this true for only the short run or the long run or both.

iii) Suppose that the central bank announces a new quantitative easing programme for the future, where money supply will be permanently increased. Explain what will happen to the price level today due to the announcement.

Answer 1

i)

Money lent by the bank is used by the borrowers to spend on goods and services for their personal use. This spent money then becomes the income of the producers. In between, the multiplier works and enhance the credit creation power of the banks as the increased income is then deposited in the same banks. In this process, the money multiplier works and increases the flow of money supply.

So, amount of money lent by the banks is positively related to money supply.

The Central bank uses following tools to control money supply in the economy:

- Open Market Operations: buying and selling of government securities

- Change in the discount rates

- change in the reserve requirements

- Interest rate targeting

ii)

“Inflation is always and everywhere a monetary phenomenon”: this quote was proposed by Monetarist Milton Friedman. This quote is based upon the quantity theory of money which says that:

M*V = P*Y

where M = Money Supply

V = Money Velocity

P = Price

Y = Real GDP

In the short run, it is assumed that the velocity and the real GDP is fairly stable and does not change. However, there exists a direct relation between M and P. A 50 % increase in the money supply will reflect a 50 % rise in the inflation rate. Higher prices implies higher inflation. So, changes in the money supply only affects the nominal/monetary variables and hence a monetary phenomenon.

Some economists argue that the quote is true also in the long run due to the concept called MONETARY NEUTRALITY which says the change in the money supply only affects the nominal variables like price, wages and keep the real variables like Real GDP unchanged.

iii)

So, announcement of quantitative easing (higher expected money growth) will have an upward pressure on today's price

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