Impact Of Reserve Ratio On Money And Economic Variables

1. Consider an economy in which initially there are no banks. Suppose that one consumer initially holds the entire money supply in the form of $1,000 in currency. Then assume a new bank is opened, The First National Bank, and the consumer deposits the entire $1,000 into the bank. Based on this scenario answer the following questions 

1. Assuming that the First National Bank has a 100% reserve ratio, use a T account to show what effect this deposit will have. 

1. Still assuming a 100% reserve ratio, explain what effect this deposit will have on the economy’s total money supply. 

1. Show how the First National Banks T account will look, if instead it has a 10% reserve ratio and holds no excess reserves. 

1. Following form c. if other banks now open up and face a 10% reserve ratio, and assuming that every consumer holds her or his money as deposits instead of currency, explain what effect the initial deposit will eventually have on the money supply. 

1. Are consumers as a group wealthier when the banking system chooses a 10% reserve ratio.  Explain the reasons for your answer.

2. Using the AD-AS framework consider the following scenario. The economy is operating at full employment when an unanticipated crisis hits the banking sector that results in a credit squeeze. 
3. Explain in detail how this event in the financial system is likely to impact the real economy and what will be the implications for unemployment and inflation in the short term. In your answer be sure to also address which components of the AD-AS model may be impacted by this scenario. Your answer should be around ½ page. 

1. Using the diagram below, illustrate how this scenario will:
2. Influence equilibrium in the short run (SR) labelling the new SR equilibrium A.  
3. Influence equilibrium in the long run (LR) assuming no government or policy intervention labelling the new LR equilibrium B. 

Reserve Ratio and Its Effect on Money Supply

1. Consider an economy in which initially there are no banks. Suppose that one consumer initially holds the entire money supply in the form of $1,000 in currency. Then assume a new bank is opened, The First National Bank, and the consumer deposits the entire $1,000 into the bank. Based on this scenario answer the following questions 

1. Assuming that the First National Bank has a 100% reserve ratio, use a T account to show what effect this deposit will have. 

1. Still assuming a 100% reserve ratio, explain what effect this deposit will have on the economy’s total money supply. 

As the reserve ratio is 100% hence, it implies that the bank is not lending any money and keeping all the money with them. Hence, since no money is lent, hence the deposit would not have any impact on the total money supply.

1. Show how the First National Banks T account will look, if instead it has a 10% reserve ratio and holds no excess reserves.

1. Following form c. if other banks now open up and face a 10% reserve ratio, and assuming that every consumer holds her or his money as deposits instead of currency, explain what effect the initial deposit will eventually have on the money supply. 

Money supply would increase as the reserve ratio is 10%. Hence, the other banks after segregating the 10% amount from the $ 1,000 can essentially lend the remaining $ 900 to the public and hence there would be an increase in the money supply arising in this manner.

1. Are consumers as a group wealthier when the banking system chooses a 10% reserve ratio.  Explain the reasons for your answer. 

The consumers as a group would emerge wealthier on account of the lower reserve ratio of 10%. This is because now the consumers can park their funds in the bank and since the banks can lend, hence the depositors would also earn some interest which would be absent in the previous case. Also, owing to lending by the bank of the 90% deposits, there would be increased money supply which would lead to lowering of the interest rate and the related financial costs. the AD-AS framework consider the following scenario. The economy is operating at full employment when an unanticipated crisis hits the banking sector that results in a credit squeeze. 

1. Explain in detail how this event in the financial system is likely to impact the real economy and what will be the implications for unemployment and inflation in the short term. In your answer be sure to also address which components of the AD-AS model may be impacted by this scenario. Your answer should be around ½ page. 

The above crisis would lead to situation where credit shortage would be observed as banks would be unwilling to lend. As a result, the financial sector would be adversely impacted and lead to an economic downturn. This in turn would lead to decrease in both consumer spending and private sector investment. Due to difficulty in availability of credit, the firms would not get access to credit at affordable plans thus stalling their plans. Also, the overall savings of the consumers would also decrease as they would not have lucrative investment avenues in terms of stock market and also the bank rates would be lowered.

Since there is a decrease in the overall wealth of the consumers, hence spending also decreases. As consumer spending and private investment both fall, hence there would be a drop in the aggregate demand or AD and hence it leads to a lower price and drop in the real output or GDP.Using the diagram below, illustrate how this scenario will:

1. Influence equilibrium in the short run (SR) labelling the new SR equilibrium A.   
2. Influence equilibrium in the long run (LR) assuming no government or policy intervention labelling the new LR equilibrium B.  

Illustrate here (Tips: to create new lines, simply copy the existing curves and move to the new locations)

3. Suppose that inflation in Australia was expected to be 3% in 2016, but that prices rose by 5% instead. Would the unexpectedly high inflation help, hurt or have no effect on the following. After identifying the effect that the higher than anticpated inflation has in each case, briefly explain the reason why in one of two sentences for each case.

The higher inflation would be of help for the federal government in the sense that it would lead to higher tax collections. This is primarily on account of indirect taxes and also due to the high profits that people would make on selling these goods.

The higher inflation would lead to rising interest rate in order to tackle the inflation. However, the interest rate for a fixed rate mortgage would not vary and hence no effect on the homeowner.

1. A private school that has invested some of its endowment in government bonds 

With the increase in inflation, the market interest rates would also rise which would lead to a decrease in the value of the bonds and hence the private school endowment fund value would be hurt by the higher inflation.

1. A pensioner whose pension has been indexed based on the forecasted anticipated rate of inflation. 

The pensioner would be hurt by the higher inflation than expected since the adjustment in index was only for 3% inflation but the actual price rise was at 5%.

4. Milton Friedman states: ‘Inflation is always and everywhere a monetary phenomenon.’In ¼ of a page explain what he means by this statement. 

The above statement has been made by Friedman taking into consideration the expected results derived from quantity theory of money. This theorem highlights that rise in money supply would lead to rising prices assuming that other factors are held constant. The requisite equation for the representation of this theory is highlighted below.

M = k*P*Y

Here M indicates the money supply

k- Ratio desired between real or nominal money holdings to real or nominal income levels

P*Y indicates the money demand

However, the above theory has a shortcoming that it is often not correct in the short run. But, in the long run, it is quite often found true.  Hence, essentially Friedman intends to indicate that inflation is the direct result of supply of money and therefore is a monetary phenomenon controlled by the monetary policy.

5. Based on what you have studied so far in Macroeconomics1, discuss and describe something that you have found interesting and insightful that helps you understand the relevance of Macroeconomics to the real world. Answers should be between ½ a page and 1 page in length.(Note: This is an open question in which students should provide a real world example and explain how some part of the course has aided understanding relevant to the example provided.)

Macroeconomics essentially refers to the average conduct at the industry level and not at the firm level. One of the key concepts in macroeconomics is economic indicators. In this regards,  a key indicator is inflation which tends to be linked to the monetary policy and the overall consumer demand and supply of money. It is overall very fascinating to see how the various things are interconnected and the role of Central Bank in this regards which needs to achieve growth, manage unemployment and also ensure prices are kept under check.

To achieve these objectives are indeed tough as no phenomenon is essentially only a monetary policy based phenomenon and a crucial role is also covered by the fiscal policy which needs to aid the monetary policy so as to achieve the desired objectives. Further, this problem is complicated by the presence of time lags and influence from global factors. When all these parameters are looked at collectively, it starts to dawn that the role of Central Bank along with government in order to control inflation which ensuring economic growth is easier said than done. It clearly involves a profound knowledge of macroeconomics on the part of the policy makers in order to outline the likely impact and the timeframe of the same.

Further, in making policies, policymakers sometimes need to accommodate conflicting goals. One such situation is stagflation i.e. high inflation and high unemployment. Hence, the task of the Central Bank becomes very vital and also active coordination is required from the government in order to build a stable and healthy economy.