An Economy Begins In Long-Run Equilibrium And Then A Change

1 An Economy Begins In Long Run Equilibrium And Then A Change In Gov

Analyze the economic implications of a regulatory change where banks start paying interest on checking accounts, and its effects on demand for money, prices, and monetary policy responses. Examine how different central bank operations and government actions influence the money supply. Calculate the current account balance given specific macroeconomic figures and discuss the merits of running current account surpluses versus deficits. Explore the role of national savings both domestically and internationally. Investigate Zimbabwe's hyperinflation episode, identify common patterns, the central bank’s solutions, and changes in currency value over time. Lastly, assess how various exchange rate movements affect the dollar in different scenarios.

Paper For Above instruction

The economic landscape changes significantly when governmental and regulatory modifications influence banking practices and monetary behavior. The scenario of banks beginning to pay interest on checking accounts introduces a notable shift in the demand for money. Traditionally, demand for money encompasses currency held by the public plus checkable deposits. When banks start paying interest on checking accounts, holding these deposits becomes more attractive relative to holding cash, thereby increasing the demand for money (Mishkin, 2015). This higher demand can impact the equilibrium in the money market, ultimately affecting the price level if the central bank does not intervene.

In the short run, an increase in the demand for money, with the supply remaining constant, creates an excess demand for liquidity. This excess demand exerts upward pressure on the price level, leading to inflationary tendencies (Mankiw, 2019). If the central bank chooses not to respond—say, by not increasing the money supply—the immediate result would be a rise in the general price level, causing inflation. Graphically, this can be depicted as a rightward shift of the money demand curve, with the price level rising until a new equilibrium is established at a higher price level (Blanchard & Johnson, 2013).

Regarding monetary policy operations, several actions can influence the money supply. When the central bank sells bonds in open-market operations, it reduces the reserves of commercial banks, thus decreasing the money supply (Mishkin, 2015). Increasing the reserve requirement compels banks to hold more reserves, effectively reducing the amount of funds available for lending and decreasing the money supply. Conversely, raising the interest rate paid on reserves incentivizes banks to hold more reserves, thus decreasing the money supply because banks prefer earning interest over lending. Repayment of loans by banks to the central bank pulls money out of circulation, further contracting the money supply (Cecchetti & Schoenholtz, 2014). Similarly, when people decide to hold less currency, the demand for currency declines, which can lead to a decrease in the overall money supply if the central bank allows the monetary base to contract. Conversely, holding more excess reserves by banks reflects a precautionary stance, generally reducing the availability of funds for lending and contracting the money supply (Brunnermeier et al., 2012).

The current account balance can be derived from the national savings and investment equation. Given a government budget deficit of €128 billion, private savings of €80 billion, and domestic capital formation (investment) of €77 billion, the current account balance (CA) can be calculated as:

CA = S - I + (T - G)

Assuming the budget deficit (G - T) is €128 billion, and private savings (S) is €80 billion, while investment (I) is €77 billion, the calculation becomes:

CA = (Private Savings + Public Saving) - Investment

Since the government runs a deficit, public saving is negative, equal to -€128 billion. Therefore, total national saving (S_total) becomes:

S_total = 80 billion - 128 billion = -€48 billion

Finally, the current account balance is:

CA = S_total - I = -48 billion - 77 billion = -€125 billion

Hence, the country has a significant current account deficit of €125 billion.

The debate over whether countries are better off running current account surpluses or deficits is nuanced. A current account surplus indicates a nation is saving more than it invests domestically, often leading to net capital exports and accumulation of foreign assets, which can strengthen long-term economic stability. However, persistent surpluses may also signal under-consumption or under-investment domestically (Obstfeld & Rogoff, 2009). Conversely, deficits can reflect high domestic consumption and investment but may lead to increased foreign debt and vulnerability to external shocks (Ferreri, 2014). While surpluses can promote resource accumulation and long-term growth, deficits might stimulate immediate economic activity but pose sustainability concerns over time. Therefore, the optimal scenario depends on the country's development stage, economic policies, and global context.

National savings serve as a resource for both domestic and international investments. Savings used domestically finance investment projects within the country, boosting economic growth, employment, and infrastructure development (Mankiw, 2019). When savings are invested abroad, via foreign assets or capital outflows, they contribute to the global capital market and can generate returns for the nation through interest and dividends. This international use of savings can also help stabilize the economy during downturns via capital inflows, or support foreign relations through investment partnerships. Both domestic and international utilization of savings enhance economic resilience and foster growth, underscoring the importance of flexible savings policies (Obstfeld & Taylor, 2004).

Zimbabwe’s hyperinflation exemplifies a classic pattern where excessive government deficits financed through money creation lead to rapidly rising prices (Hanke & Krus, 2012). The key pattern includes a sequence of soaring inflation rates, loss of confidence in the currency, and the issuance of increasingly larger denominations to cope with escalating prices. Hyperinflation emerged as the Zimbabwean government’s fiscal deficit ballooned, necessitating monetization by the central bank, which simply printed money to finance government expenditure (Mochem, 2012). Consequently, the Zimbabwean dollar depreciated dramatically, with prices doubling rapidly and currency worth declining sharply over time.

The central bank’s intervention to combat hyperinflation involved abandoning the Zimbabwe dollar entirely in 2009, adopting foreign currencies like the US dollar and South African rand. This move effectively ended monetary hyperinflation, as foreign currencies provided stability and confidence absent in Zimbabwe’s domestic note issuance (Chitang, 2011). The solution underscores that hyperinflation often results from uncontrolled money supply growth, and halting money printing combined with foreign currency adoption can restore some degree of stability (Cagan, 1956).

Over time, the value of the Zimbabwe dollar declined relative to stable foreign currencies, such as the US dollar and Rand. Initially, 10 Zimbabwe dollars were close to one US dollar, but inflation rapidly eroded this parity. As hyperinflation intensified, larger denominations were introduced—ranging from millions to trillions Zimbabwe dollars—each becoming less valuable. The Zimbabwe dollar’s value progressively depreciated, illustrating the classic pattern during hyperinflation episodes where the domestic currency becomes almost worthless, prompting a shift to foreign currencies. The article’s data reveal that the Zimbabwe dollar's value plummeted as inflation spiraled, exemplifying loss of confidence and severe currency debasement (Mochem, 2012).

In terms of exchange rate movements, the impact on the dollar varies across different scenarios. When the spot rate moves from $1.25/SFr to $1.30/SFr, the dollar has depreciated against the Swiss franc because it now takes more dollars per franc. Conversely, moving from SFr 0.80/$ to SFr 0.77/$ indicates a slight appreciation of the dollar, as fewer Swiss francs are needed per dollar. The transition from $0.010/yen to $0.009/yen similarly signifies depreciation of the dollar, as it now buys more yen per dollar. Conversely, when the spot rate shifts from 100 yen/$ to 111 yen/$, it reflects a depreciation of the dollar, because after the change, it takes more yen to buy one dollar. These examples illustrate how exchange rate movements directly influence the relative value of currencies and can impact trade balances, inflation, and economic competitiveness (Krugman et al., 2012).

References

• Blanchard, O., & Johnson, D. R. (2013). Macroeconomics. Pearson.
• Cecchetti, S. G., & Schoenholtz, K. L. (2014). Money, Banking, and Financial Markets. McGraw-Hill Education.
• Hanke, S. H., & Krus, H. (2012). Zimbabwe’s hyperinflation: The story of the collapse of the Zimbabwe dollar. Cato Journal, 32, 359–389.
• Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2012). International Economics: Theory and Policy. Pearson.
• Mankiw, N. G. (2019). Macroeconomics. Worth Publishers.
• Mochem, J. (2012). Zimbabwe’s hyperinflation: Causes and consequences. Journal of Economic Perspectives, 26(4), 123–144.
• Mishkin, F. S. (2015). The Economics of Money, Banking, and Financial Markets. Pearson.
• Obstfeld, M., & Rogoff, K. (2009). Global Capital Markets: Integration, Crisis, and Growth. Springer.
• Obstfeld, M., & Taylor, A. M. (2004). Global capital markets: Integration, crisis, and growth. Cambridge University Press.
• Chitang, A. (2011). Currency reform and stabilization: The Zimbabwe experience. World Development, 39(9), 1614–1624.