it’s not about the money (Chapter 18 Q & A)

16/05/2013 § Leave a comment

#3. 25 marks.

a) Analyze the methods by which the central bank might decrease the money supply. 

Money supply is the combined value of the currency and demand deposits of a country. The government has three methods in which it can change the money supply. They are to increase the discount rate, sell government bonds, and raise the reserve requirement ratio. Firstly, the discount rate is the rate charged by central banks when making loans to big commercial banks. If the discount rate is higher, big commercial banks will be given a signal that will discourage them from borrowing money from the central bank. This ends up raising the interest rates for borrowers and decreasing the money supply in the money market. Secondly, a government bond is a certificate issued by the government that can guarantee repayment of an initial amount charged with an agreed upon interest rate. When central banks sell government bonds into the open market, the reserves of of commercial banks will be taken out of private banks. The private banks will then charge more for what they have left, and because the bonds are sold with liquid money, the over supply in the money market will decrease. Selling bonds puts a downward pressure on price levels, output and employment, and it also increases interest rates, contracting consumption and investment as a result of reducing the money supply. Finally, raising the reserve requirement forces banks to reduce the amount they can loan out. The reserve ratio is the percentage of deposits that banks are required to hold at all times. Obviously if the required amount of money increases, there is less supply of money left in the money market.

 

b) Discuss the likely impact on an economy of a substantial decrease in the level of interest rates.

At first, a substantial decrease in the level of interest rates will give the economy beneficial consequences in the short term, but could possibly pose some difficulties in the long run. Interest rates are the opportunity cost of spending money, shown as an amount charged out of the initial amount of money provided. A substantial decrease with interest rates can only be accomplished through an expansionary monetary policy. This would involve decreasing the discount rates, buying government bonds, as well as lowering the reserve ratio. If at first the interest rates are what will fall, in the short run, investments will increase as a result. Firms and households see that the interest rates aren’t as high as they used to be and they don’t know when they’ll be low again so more often than not, investments will rise because firms and households are willing to spend more. This also means that growth and consumption may increase, and as a result, employment and inflation could increase in the long run. Since growth and consumption are part of the factors that make up the aggregate demand, or national output (GDP) of a nation [C + G + I + (X – M)], their increase could result in the rightward shift of the AD, which suggests economic growth for the nation. The shift could be great because the decrease in interest rates was substantial. That’s in the short run, but the long run could show a possible shift in the AS curve, which involves factors of production such as human capital (wages), and physical capital (technology). A shift in the supply is caused by the shift of the AD, as typically the supply tries to meet the demand. This means the people and the government can invest more on education, but a higher educated population could introduce lower wages to households and firms. There would be more competition because of a higher educated society – people would know how to use technology and fewer workers would be needed to do the job that previously forty workers were needed to accomplish. This would then put people into structural unemployment and they would need to learn new skills, perhaps go back to a school that would teach them more modern skills that could be of more use. Typically, a substantial decrease in the interest rate could increase investments but only assuming that the individuals in households and firms are confident enough to make those investments. If this is the case, like with countries like Japan, then investment won’t actually rise after the government decreases interest rates by a lot. In the end, it also really depends on the nation, its current conditions (if it’s experiencing steady growth or a recession) and the nation’s values.

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