Question

Question 1: Suppose the government forces everyone to deposit all their cash holdings in a bank account. What will happen to overall money supply in the economy? Use money multiplier model and explain your answer.

Question 2: Why did oil prices become negative in the middle of April? Why didn't consumers see negative prices at gas stations?

Question 3: The current crisis has reignited the debate about the relative usefulness of fiscal policy and monetary policy in the presence of zero lower bound. Explain the limitations of fiscal and monetary policy under zero lower bound. Which policy do you think is more effective?

Answer 1

1) If people deposit all their cash holdings in the banks ,then banks total reserves will increase.The banks will keep some of it in hands as required reserves and will loan out the excess reserves.When that loan is made,money supply increases.The money multilpier refers to how an initial deposit can lead to a bigger final increase in the total money supply.

Money multiplier=Change in total money supply/Change in monetary base

The amount of money generated here is determined by the reserves , hence money multiplier is 1/R, where R is the reserve ratio.A higher reserve ratio means a lower money multiplier and likewise a lower reserve ratio means a higher money multiplier.If reserve ratio is 10% the money multiplier is 10. If someone deposits $ 50 , the bank must reserve 10% of $ 50 or $ 5 total.Then bank lents out $45. Now $4.5 is retained as reserves and $40.50 is lent out. And this cycle continues.

2) The oil prices have went negative in the mid of April for the very first time in history because of the dried demand for oil due to the lockdowns across the countries because of the coronavirus pandemic.Negative oil prices means that oil producers are paying buyers to take the commodities off their hands over the fears that the storage capacity could run out in May.As a result oil firms have resorted to renting tankers to store the surplus supply and that has forces its price to go into negative especially on the futures contract of oil. On the other hand, consumers cant see negative prices at gas stations as cheap oil leads to cheap oil at pumps which is a boon for the consumers but falling prices today will hardly have any effect on the consumers as people are not driving at all due to the lockdown and vice versa.So nobody can take advantage of it.

3)Zero lower bound means interest rates cannot fall any further below 0%.The main tool of the monetary policy is interest rates set by the central banks.If inflation is low and economic growth negative , the Central government will cut interest rates to stimulate demand and boost economic growth but there comes a stituation when interest rates cant fall below that(zero lower bound) , if it happens, then the economy will be caught in a liquidity trap. It is ineffective to increase money supply in the liquidity trap to stimulate the economic activity. As increasing money supply shifts LM curve to the right but real GDP doesnt change. On the other hand Fiscal policy provides direct injection of money into the economy under zero lower bound when the economy is stuck in such a crisis.This injection of demand raises economic growth and make use of surplus savings.Expansionary fiscal policy may have a positive multilplier effect. Also at ZLB, bond yields are low and the government will be able to borrow at low cost.The drawback to use fiscal policy is rise in government borrowings. But definitely fiscal policy is more effective than monetary policy at zero lower bound.