An economy facing recessionary gap can be improved through the use of certain monetary policy. The Fed would ease the monetary policy. For example, the lowering of the discount rate and the RRR or the Fed purchasing more bonds, it will increase the overall money supply causing an outward shift in the money supply curve. The situation would lead to a decline the market interest rates that stimulates increased borrowing and increased business investment. Additional investment leads to increased aggregate demand.
Money multiplier can be described as the maximum level to which the money supply is influenced by the adjustments in the level of deposits. Money supply could be determined by getting the ratio of increase or decline in the level of money supply corresponding to the level of decrease of increase in the overall deposits. The formula, money multiplier can be obtained as follows, Money Multiplier= 1/Required Reserve Ratio (RRR).
RRR refers to the proportion of deposits that the bank is required by Fed to hold. The banks can only give out money in loans equal to the excess reserves that matches (1-required reserves) (Galí, 2015). A high level of RRR leads to lesser excess reserves. It means the bank is now able to lend less money in form of loans and thus, lowering the money multiplier. On the other hand, a lower level of RRR leads to higher amounts of excess reserves that the banks is able to give out as loans and thus, increasing the money multiplier.
The discount rate is usually applied the commercial banks lends money to each other. In contrast, the federal funds rates describes the interest rates that banks and credit unions lends other similar institutions overnight without any collateral. The discount rate is often lower than the federal funds rate. The deposit rate describes the rate that is usually paid to the clients depositing their money in the commercial banks. On the other hand, the prime rate is the banking index applied in determines the consumer loan rates. High level of prime rates could make it difficult for consumers to borrow money from the commercial banks.
There is an indirect connection between the level of interest rates and the pricing of the bonds. When the interest rates increases, the bond prices increases. On the other hand, a fall in the interest rates leads to the price of the bonds to fall. Any new bonds issued in the market, they assumes the coupon rates at the current market rates (Arnold, 2017). Bondholders always review the nature of the interest rates in order to make investment decisions.
Considering the Fed decides to use the expansionary monetary policy through the purchase of bonds through the open market operation. Applying the expansionary monetary approach would lead to the reduction in the interest rates. It is because the purchase of bonds increases money supply in the economy making it easy for businesses to get more money to invest in expansion plans. The situation would lead to an increase in the aggregate demand level that increases the price levels and the real GDP in the economy. The process is referred to as the Keynesian Transmission mechanism.
The monetary policy role is achieved through the adjustment of the interest rate and the money supply. The first failure of the policy is ineffectiveness that emerges from the liquidity trap. At liquidity trap, a reduction of interest rates does not lead to an increase in investment and spending levels. It means that the monetary policy fails due to the liquidity trap. The second failure is the occurrence of vertical investment schedule. At this condition, the spending on investments is usually non-responsive to the changes in the interest rates. Changes in the level of interest rates do not lead to adjustments in the investment patterns. The situation indicates a failure on the expansionary monetary policy.
If$4m million is transferred from the checkable deposits into the money market mutual funds, what will happen to the M1 and M2? M1 will be reduced by $4million. However, M2 will not change because the M1 component of M2 reduced by $4million, but the mutual fund component of M2 increases by $4million. So, only M1 will reduce by $4 million as M3 remains constant.
The question is how money emerged out of the barter economy? The individuals in barter trade sought to reduce the level of transactions. The people in the barter economy sought to hold the most marketable goods to trade with it even though they do not need it. The most tradable good is described as money as it is used in acquiring others and repayment of debt borrowed during the trading activities.
The question is to determine the connection between RRR and the overall money supply. There is an inverse relationship between the two variables. As the required reserve ratio increases, the money supply reduces due to the increase in the checkable deposit. And a follow-up question on how to determine the connection between the overall money supply and the simple deposit multiplier. There is a direct relationship between the simple multiplier and the money supply as the simple multiplier falls, the money supply also falls.
The question is what does it mean to state that a bank is reserve deficient? The bank does not hold adequate reserves against the checkable deposits. Required requires equal required ratio multiplied by checkable deposits. When the bank is supposed to hold $10million in reserves and it holds $9million, it means that the bank is reserve deficit by $1million. The example defines how a bank can be said to be reserve deficient.
Question is to explain the changes in the price level based on the equation of exchange. The equation equals to MV= P X Q. P is also equal to MV/Q. When money supply (M) increases, it leads to an increase in velocity (V) which leads to decline in Q, which causes increase in the price levels. On the other hand, when M decreases, V decreases that leads to an increase in the Q that causes a fall in price.
Based on the long-run equilibrium and using the monetarist model, what is the changes in the price level and real GDP in the short run and long run because of a decline in the velocity? A decline velocity shifts AD curve to the left that lowers the price level. In the short run, the decline in price level leads to a reduction in the real GDP. In long run, the SARC will shift to the right lowering the price. However, there is no change in the real GDP in the long-run.
The questions demands for the representation of the Keynesian transmission mechanism.
The three diagrams help to show how a change in interest rates would translate in the economy such as impacting on investments and the real GDP in the economy. Based on the three diagrams above, a change in interest rates that affects investments in the good markets that in turn affects the real GDP in the economy.
The question is how under certain conditions the monetary policy can remove an economy from a recessionary gap. The monetary policy should affect the aggregate demand curve such that the AD curve could shift to the right to pass through the point the intersection of the LRAS and SRAS. At the point of intersection, the real GDP improves removing the economy from a recessionary gap through an expansionary monetary policy.
Arnold, A.R. (2017). Economics, 13th Edition, mindtap. Boston, MA: Cengage Learning.
Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton, NJ: Princeton University Press.